Underwriting banks are lobbying the European Central Bank to remove a roadblock to issuance of sustainability-linked bonds by making step-up payment structures eligible for its multi-billion euro bond-buying programmes but are also working on alternative structures as the wait for the next deal grows longer.
Neither the ECB's Corporate Sector Purchase Programme nor its newer Pandemic Emergency Purchase Programme will buy SLBs because they include a coupon step-up based on companies’ performance on environmental targets – and this is proving to be an impediment to issuance.
"There is some engagement happening right now directly with the ECB," said Farnam Bidgoli, head of sustainable bonds for EMEA DCM at HSBC.
The ECB’s bond-buying programmes have provided increasingly vital support during the Covid-19 crisis and the lack of eligibility for SLBs is becoming a bigger problem as banks and borrowers struggle to bring the next deal to the market.
Italian utility Enel is still the first – and only – borrower to sell such bonds. It attracted a blaze of publicity when it raised a US$1.5bn SLB in September and followed up with a similar €2.5bn triple-tranche deal in October. In each case, the bonds have a 25bp step-up in coupon payments if certain targets are missed.
SLBs, also known as KPI-linked or SDG-linked bonds, are tied to companies’ ESG strategies and the UN’s Sustainable Development Goals via key performance indicators. A failure to hit KPIs results in the bonds’ interest payments stepping up.
The ECB cannot buy such deals as it only accepts instruments with margins that change over time if they have a predefined path at issuance, which excludes SLBs as companies’ sustainability performance is uncertain. The ECB declined to comment.
As the central bank can account for 40% of all orders on euro-denominated corporate bonds, its absence can have a material impact on pricing that far outweighs the benefits of sustainable finance for issuers.
“Whatever benefits we think you may be able to achieve from the ESG element, it is a fraction of what you would be getting because of ECB eligibility. So [the lack of a bid from the ECB] is a big hurdle from the execution standpoint,” Bidgoli said.
Banks are talking to the ECB to try and get it to change its mind and the issue has already been discussed in ICMA working groups. No formal approach has been made by the trade body to the ECB yet, but it has not been ruled out.
"There are efforts to convey to ECB that it’s an issue as we try and get more of these bonds into the market, and to see if the ECB can be persuaded to review their policy," a banker said.
Bankers point out that the block on buying SLBs appears to contradict the ECB's strategic aims, as SLBs could be used to help the transition to a low-carbon economy. Christine Lagarde, the bank's president, has discussed using the central bank's €2.8trn asset purchase scheme to pursue green objectives.
Coupon step-ups are part of a wider discussion with the ECB, which is also being sounded out on alternative structures as banks try to find other workable options that could be CSPP/PEPP-eligible and give investors confidence around the incentive or penalty relating to sustainability targets.
"I think you will see other structures being developed that don’t necessarily have a step-up," Bidgoli said. "We have to look for alternatives until the ECB clarifies that point.”
The donation of a "sustainability premium" to charity if companies fail to hit their targets is one option that has already been used in the loan market, where sustainability-linked loans are relatively common (US$40bn of SLLs were raised in EMEA in the first half of this year, for instance). Another possibility, also seen in the loan market, is for companies to pay a premium into an account used by the borrower specifically to improve its ESG performance.
Such structures would not conflict with ECB-eligibility as it would not be part of the terms and conditions of bonds but done through side agreements. Banks think that bond investors may accept such deals as they would also avoid accusations that investors had profited from the missed targets.
“Most investors are willing to consider alternatives to a coupon adjustment if it's meaningful," said Malte Kolb, associate director for sustainable finance advisory at UniCredit. "It must be convincing and with a size and impact that justifies why they invested.”
Some bond investors could be harder to convince than their loan counterparts, however, and are unimpressed by what they see as an artificial solution to a problem that does not concern them.
“Why do issuers have to shoehorn deals into CSPP-eligible bonds anyway? Investors will buy things that are not CSPP-eligible. I’d prefer a coupon step-up to be given to a charity or dedicated fund for the right reason rather than banks solving a methodology problem,” one investor said.
Other options, including using redemption prices or put options to punish failures to hit KPIs, are also under discussion. Issuers could pay 101 to redeem the instrument (instead of 100) if they did not hit targets, although this has obvious difficulties for bonds trading well above par.
ON THE BLOCK
Deals are still expected soon regardless of whether the ECB issue is solved. Companies most likely to do the next deals are those where ECB buying is less important and those with sophisticated ESG strategies and clear targets.
Perhaps surprisingly, big oil and gas companies might be near the front of the queue – at least those making some efforts to transition to providing lower carbon energy sources.
BP, for example, last week announced plans to reduce its oil and gas output by 40% and boost investments in renewable energy over the next decade.
"The fact that some European super majors have a single metric that reflects the carbon intensity of their overall business model presents an obvious opportunity to link their financing to that target using a sustainability-linked bond," said Paul O’Connor, head of EMEA ESG DCM at JP Morgan. "I'm expecting to see more from the oil and gas sector."