The new Sustainability-Linked Bond Principles

In September 2019, Enel Finance International N.V., a Dutch group company of the Italian energy group Enel, offered and issued, as far as we know, the first-ever Sustainability-Linked Bond (SLB), borrowing the concept from the already developed sustainability-linked loan market and applying it to a notes issue. The new structure was well received by the market, with the deal being oversubscribed by almost three times. Our capital markets team assisted on this transaction.

Over the past years the market’s growing appetite for green, social and sustainability bonds has led the International Capital Market Association (ICMA) to develop voluntary process guidelines for Sustainability-Linked Bonds with the dual aim of supporting and promoting supranational, sovereign and corporate endeavours in this respect and providing a framework for investors to assess such endeavours in all transparency. The cornerstone of ICMA’s Green Bond Principles, Social Bond Principles and Sustainability Bond Guidelines (together the Principles) is that proceeds are exclusively used to finance or re-finance green and/or social projects. The Principles have become the leading guidance globally for the issuance of green, social and sustainability bonds.

However, a new market sector emerged recently, viz. sustainability/KPI-linked bonds where the coupons of general corporate purpose bonds vary according to the achievement of certain environmental, social or governance (ESG) related key performance indicators (KPIs). ICMA responded by creating the “Sustainability-Linked Bond Principles” which outline a voluntary set of guidelines focused on cultivating an SLB market. While the Principles require the issuer to use the proceeds for a specific project, the new Sustainability-Linked Bond Principles allow the issuer to use the proceeds for general purposes whilst committing to attain predefined sustainability objectives within a pre-set timeframe. The Sustainability-Linked Bond Principles are meant to be complementary to the existing Principles, allowing issuers more flexibility when choosing a financing tool. Like the Principles they are designed to provide the market the necessary information to increase capital allocation to these newly desired products. It’s all about transparency.

How does an SLB work? First, the issuer selects a set of KPIs relevant to the sustainability objectives it wants to commit to and through which such objectives will be measured. The KPIs should be credible, material and relevant to the issuer’s business and in any case measurable and verifiable. The principles underline that transparency regarding the KPI selection process and their place in the issuer’s overall sustainability strategy is key. Next, these KPIs will be evaluated against so-called “Sustainability Performance Targets” (SPTs). The SPTs express the ambition of the issuer and should go further than “business as usual”, benchmarked against the issuer’s own performance over time, against that of its peers and with reference to science-based target scenarios. As indicated, the excitement over SLBs originates from the fact that their financial or structural characteristics may vary according to whether the issuer succeeds to raise the KPIs to the SPT levels. This means that certain triggers must be built in in the bond documentation which will lead to, for example, a higher coupon where SPTs are not met. Again, transparency pops up as a prerequisite in this process: SLB issuers are required to provide all information on the performance of KPIs including verification assurance reports setting out performance against SPTs and the impact on the bond’s financial and/or structural characteristics. A disclosure data checklist for SLBs setting out the types of information to be provided and the location and timing for disclosure is appended to the Sustainability-Linked Bond Principles, available on ICMA’s website. Lastly, issuers must seek independent, external verification of the performance of the KPIs against the SPTs by a suitably qualified reviewer, such as an auditor or environmental consultant.  

SLBs will most likely be attractive for issuers who desire explicitly to commit to sustainability goals but lack sufficient green or social projects to justify the issuance of a green, social or sustainability “use of proceeds” bond. We note that it will be of utmost importance carefully to draft the bond documentation with clear KPI descriptions and unambiguous but sufficiently ambitious SPTs. The structure must address a multiplicity of new scenarios such as (i) the disappearance of the verification provider or its inability to confirm the achievement of an SPT or (ii) where an SPT is not met, subsequent step-ups might be desirable in case the SPT is hit at a later date.

The expectation is that SLBs will follow in the footsteps of the successful sustainability-linked loans whose use has grown exponentially over the past year. The SLB initiative is part of a wider movement in the market towards green, social and sustainable financing and in this respect we look forward to the efforts to establish a EU Green Bond Standard as initiated by the European Commission.

Important to flag is the recent Taxonomy Regulation, in which the European Union introduced a taxonomy for sustainable activities aimed at providing investors with clear and transparent information on environmental sustainability in order to promote sustainable investments. Financial products with sustainable investment as their objective will receive the “EU sustainable product” label provided they meet a set of conditions and satisfy certain disclosure requirements in their pre-contractual documentation and periodic reports as imposed by the Taxonomy Regulation. An SLB itself is not a “financial product” within the meaning of the Taxonomy Regulation, but the portfolios or funds in which it may be held are. In case such fund or portfolio is not or only partially compliant with the Taxonomy Regulation, a disclaimer to that effect must be included, potentially dissuading certain investors. It is not entirely clear how the Sustainability-Linked Bond Principles resonate with the new Taxonomy Regulation and the provision of further clarity by ICMA would be very welcome. Also, it remains to be seen whether the market moves towards considering the EU sustainability label as a must-have or whether fund and portfolio managers are happy to include “non-compliant” SLBs and the accompanying disclaimer. More detailed information about the Taxonomy Regulation can be found here.

Expansion of Social Bond Principles in a Covid-19 context

At this year’s general meeting, ICMA also released further updates to its Social Bond Principles (SBP) inspired by the Covid-19 context. To set the stage, the SBP define a “Social Bond” as “any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance in part or in full new and/or existing Social Projects and which are aligned with the four core components of the SBP”. The core components referred to are (1) use of proceeds for social projects; (2) process for project evaluation and selection; (3) management of proceeds; and (4) reporting, each permeated by the ambition of more transparency in the social bond market.

Since the publication of the SBP in 2017 Social Bonds have become hugely popular, but especially over the last few months, in the context of the Covid-19 pandemic, Social Bonds have surged. According to Simone Utermarck, Director of Sustainable Finance at ICMA, Social Bond issuances aligned with the SBP represented almost 17 billion USD up to the end of May 2020, compared to 16 billion USD in Social Bonds over the whole of 2019. 17% of all Social Bonds have been Covid-19 themed, which means that they mention Covid-19 in their use of proceeds. With Social Bonds there can often be a debate on what constitutes a “social issue” (often depending on the local context), however, in the current situation everyone globally agrees that the Corona pandemic is the relevant social issue and the target population is the general population. Interesting to note is that the newly updated SBP now include a definition of “social issue” which reads: “A social issue threatens, hinders or damages the well-being of society or a specific target population.”

Furthermore, Social Bonds typically fund social projects in areas such as access to healthcare, access to education, affordable housing, socioeconomic empowerment and employment; all such categories have been found appropriate to tackle the current crisis. In addition, the updated SBP now specifically include the following project categories: (a) programs designed to prevent and/or alleviate unemployment stemming from socioeconomic crises and (b) food security and sustainable food systems. ICMA also added (i) aging populations and vulnerable youth and (ii) women and/or sexual and gender minorities to the list of so-called target populations. A few examples of Covid-19 related social projects can include expenditure to increase capacity and efficiency in healthcare operations, R&D, treatment, vaccines, repurposing factories to produce essential equipment, and job retention.

Following the Covid-19 shake-up in the financial markets, Social Bonds, often only seen as the little sister of the Green Bonds, are taking a far more prominent place in the sustainable bond market than initially expected. Hence the SBP (in their updated form) will play an increasingly important role in guiding issuers on how best to issue a Social Bond whilst ensuring that investors receive the appropriate information.

For any questions on this topic, please contact Sarah Libregts, Vanessa Marquette, Martijn Schoonewille or Cédric Raffoul.