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ESG Focus: The Next Big Thing – Part 5

The migration of the major players in the transition from vanilla product use and debt markets to SLBs must begin in earnest. We therefore examine the transitional SLBs as well as the brown taxonomy, which deals with the delicate demand of the obligatory principle of “doing no harm”.

– Transitioning the transitioners: the great migration
– Investors are looking for the best SLB structures and frameworks
– Beware of anticipated emissions and look beyond the carbon profile
– The frightening demand on companies to “do no harm”

By Sarah Mills

“When structured appropriately, we believe the SLB format is best suited to accelerate the decarbonization of carbon intensive sectors. ” – Jacob Michaelsen from Nordea.

Sustainability Bonds (SLBs) were designed in large part to accelerate the transition of “brown†companies, but will also be used for the transition of almost every large company in the world.

Until recently, green finance was exclusive.

The materials, energy and industrial sectors have been slow to enter the ESG debt market, as many carbon-intensive companies are not eligible for use green bonds. products (UoP).

These sectors have the highest carbon intensity (carbon intensity should become the universal carbon benchmark for GLS) in the equity and credit universe and carry a carbon stigma, leaving them vulnerable to capital shortages as big capital rushes to ESG.

Fossil fuel companies and companies heavily dependent on fossil fuels are also facing disruption to their revenue streams and the removal of fossil fuel subsidies on which they are heavily dependent.

But these are not the only sectors not to qualify for the green finance club.

Any carbon emission reduction investment that requires funding that is not “dark†green (such as solar and wind infrastructure) is generally classified as bridging funding.

SLBs, and their brethren Sustainability Linked Loans (SLLs), generally fall under the umbrella of bridging finance, and dark green investments remain within the purview of the green bond market.

SLBs also host non-pure green or social enterprises, which means they can be used for brown-to-green corporate issues and offer investors broader definition and diversity than product-use bonds.

The prospect of rising energy costs and increasing regulatory risks for lagging environmental investors is driving the appetite for sustainable development finance.

Global emissions must fall by -7.6% or move one year every year for ten years to meet the Paris Agreement target of -60% reduction by 2030.

It is also rumored that the 2050 horizon is brought forward to 2030.

At the very least, companies should read this to mean that they should focus heavily on the 2030 goals if they are to be in the race for 2050.

On the other hand, SLBs attract investors because they mitigate the risks of diversification in ESG bond portfolios.

Quick recap: carbon intensity, scope emissions and KPIs

Before reading this article, we recommend that you read the previous article on Transition UoP Bonds (link below), but here we include a quick recap.

One of the main issues with UoP Transition Bonds that fund internal projects is that often the majority of a company’s issuance can be outside of its own operations.

The financial incentive structure linked to sustainable development addresses these issues as key performance indicators (KPIs) can be linked to Scope 1 (operational emissions), Scope 2 (energy inputs) or Scope 3 (chain supply).

Add the three together and you get an organization’s total carbon intensity or footprint – and a risk profile.

Some companies have high Scope 1 emissions and low Scope 3 emissions. Others may have very low emissions from their own operations, but massive emissions throughout their supply chain.

For example, an oil producer might receive funds for carbon capture and storage projects (many of which at this point are very dubious and are seen by some as a subsidy to fossil fuels), while also accumulating a pound of carbon. in the rest of the business. and through its supply chains.

SLBs, which are tied to standard metrics such as carbon scale metrics rather than specific projects, solve this problem.

Mark-up coupons and penalties linked to pre-established performance measures introduce a more powerful accountability mechanism.

Investors should ensure that KPIs are relevant to a company’s issuance profile.

Companies can disclose 1, 2, 3 emissions but even within scope 3 there are 13 categories.

Thus, two companies could declare the same perimeter but declare on different categories, depending on their sector of activity.

The transition of people in transition – the great migration

“Decarbonization-focused SLBs account for 61% ($ 41 billion) of the market (SLB) – by linking the long-term cost of capital to decarbonization, SLBs can motivate companies to set CO2 reduction targets more ambitious ” Morgan Stanley reports in its report The race for net zero emissions.

To date, the Brown Sector is expected to use Product Use Transition Bonds (UoP), but the transition UoP issuance does not necessarily fund the transition from a carbon intensity state. existing at a better – funded projects just aren’t as dirty as they could be.

The Incentive SLB Progressive Coupon (see separate article in link below) was designed to motivate businesses to speed up their transitions and round off recalcitrant borrowers.

For example, the funds are not dedicated to a wind farm or a solar installation, but to a number of small steps towards decarbonization.

SLBs do not necessarily have key performance indicators on the use of products dedicated to environmental or social objectives, but they allow unrestricted use of the products (some SLBs may not even have structures supporting the resignations) creating a wider field for investor influence, and allowing funds to be separated from traditional vanilla markets.

The broader scope of SLBs is particularly useful in emerging markets and for holistic investors, encouraging engagement in challenging markets.

Theoretically, using the KPIs and sustainability performance targets (SPTs) of SLBs related to carbon emissions should also give a good idea of ​​the amount of carbon to be removed / avoided during the life of the bonds.

This incorporates an element of conscious planning into the equation, improves measurement and accountability, and, depending on reporting requirements, creates a clearer picture of global carbon intensity.

SLBs not only encourage more ambitious emission reductions, they reduce investor concerns about greenwashing given ever-increasing reporting requirements and forward-looking performance indicators built into bond contracts.

Pressure is therefore increasing to shift most of the “transition†bonds from UoP markets to SLBs, as well as vanilla debt to sustainability debt.

Migration of this world will require massive investment and fund managers will seek to protect this investment through SLBs and secure their long term future.

Emission: the good and the bad

Morgan Stanley reports two interesting examples of brown emissions.

The capital strategy of Italian energy and utility giant Enel has set a kind of benchmark.

Enel’s financing is now dominated by debt labeled ESG. It said that in the future all of its financing will be in SLBs and refinance its conventional debt using SLBs.

Its KPIs did not turn out to be too onerous either. They were selected from a very narrow list of pre-existing metrics, each linked to emissions with increases linked to 2023, 2030 and 2031.

If the pace of decarbonization is accelerating, Enel has at the very least locked in current expectations during a period of relative leniency and greenium.

Meanwhile, US-based Enbridge was the second oil and gas company to issue under the ESG label, issuing a 12-year US $ 1 billion SLB in June.

But Morgan Stanley reports that the obligation came with an almost insignificant 5 basis point penalty and did not include indigenous peoples in the report – one of their most important stakeholders.

Nonetheless, the issue was 3 times oversubscribed and proved to be 5 basis points tighter than unlabelled debt, again revealing demand for ESG bonds.

Enbridge has set Scope 1 and Scope 2 emissions targets and a diversity goal.

But Morgan Stanley says that in the case of large issuers, diversity is more marketing than substance as it won’t affect the company’s bottom line and long-term viability, and advises investors to ensure that KPIs correspond to the core business of a company.

Preferred structures for SLB investors

SLBs should be supported by a strong sustainability framework.

A well-structured SLB should drive the three pillars of ESG and support the UN Sustainable Development Goals (SDGs) to encourage organizations to position themselves more powerfully for the challenges ahead.

A good SLB transition should improve the ability of investors and borrowers to monitor carbon emissions and progress.

KPIs and SPTs must be relevant to the core business of a company and give issuers the ability to go beyond a usual sustainable development path.

SLBs can encourage entities to integrate their public sustainability commitments into their debt capital strategies; help them position themselves for the future; demonstrate commitment; and lower financing costs.

Lack of consistency in setting and measuring decarbonization targets hampers the effectiveness of SLBs as a decarbonization mechanism.

“To achieve net zero, the absolute amount of emissions matters most, and we believe that absolute reduction in emissions should become the norm for decarbonization-oriented SLBs,†Morgan Stanley reports.

Carbon intensity integrated into the risk-return equation

Carbon intensity is now a critical part of the risk-return equation, and investors will weigh this carefully.