The treasurer of building product and safety conglomerate Johnson Controls is calling for investors in the sustainability-linked bond market to differentiate between companies that are setting aggressive environmental goals and those that are aiming for easier targets as they tap into demand for ESG related investments.
A sustainability-linked bond ties a company's borrowing costs to its performance on certain environmental targets, such as reducing greenhouse gas emissions or water usage. The interest cost on the bond increases if the company fails to meet those key performance indicators by a certain date. But in almost every deal brought to the market since 2019, the coupon "step-up" penalty has been largely the same, regardless of how ambitious or achievable the target is. In most cases the company pays an extra 25bp if it fails to meet its target.
Marc Vandiepenbeeck, vice president and treasurer at Johnson Controls, said it is time the market started to differentiate.
"Not all frameworks should be valued around 25bp," he said. "As an investor you’re not going to be paid the same spread on a Triple A rated company versus a Triple B company or Triple C. There’s an external party that tells you what the creditworthiness of a company is and you assess the valuation against that. The same thing should happen around [an ESG] framework."
Johnson Controls has been building a track record in sustainability finance in recent years and sees itself as a leader in ESG. The company produces fire, HVAC and security equipment for buildings and generated US$22bn of sales in 2020. Half of the company's revenues come from building products that cut energy use and improve sustainability, it said in its 2021 sustainability report.
In 2019 it became one of the first industrial companies to tie its senior revolving debt facilities to sustainability performance, and in 2020 it priced a US$625m 10-year debut green bond, which allocated proceeds to projects including green buildings, pollution prevention and control, sustainable water and renewable energy.
The company, rated Baa2/BBB+, priced its debut sustainability-linked bond in US dollars on September 13, raising US$500m with a 10-year bond that priced at 77bp over Treasuries for a yield of 2.091%.
Scope 3 included
Johnson Controls set two environmental targets in its framework – to reduce Scope 1 and 2 emissions by 35% by 2025 and by 55% by 2030 globally, from a 2017 baseline; and to reduce Scope 3 greenhouse gas emissions from the use of sold products by 5% by 2025 and 16% by 2030 from a 2017 baseline. The coupons on the SLB increase by 12.5bp per each target missed by September 30, 2025.
The framework goes further than most in targeting Scope 3 emissions, which are those generated by products sold as well as their suppliers and distributors as opposed to emissions that are more directly under a company's control. In addition, the company's emissions targets are approved by the Science Based Targets initiative, which is increasingly seen as a gold standard for SLBs.
Sustainalytics described both targets as “very strong”, with the first seen as “highly ambitious” and the second as “ambitious”.
Vandiepenbeeck said this “seal of approval” from second party opinion providers such as Sustainalytics should have more value from a spread standpoint.
"Maybe frameworks that are easier to achieve should have a bigger step-up because really you shouldn’t be missing on those goals. At the same time if you have a very aggressive framework, the way we have set up ours, maybe 25bp is a really big penalty relative to the lofty goals the company has set for the market,” he said.
So far, however, investors have not yet pushed aggressively for greater differentiation in step-up coupons. It is hard to make comparisons between issuers when there are no standardized KPIs, even within sectors. In addition, booming debt markets have not made it easier for money managers to extract bigger concessions from issuers in general, and some feel a standard step-up coupon is adequate.
“I question if these are enough incentive to get companies to change behavior,” said one bond investor.“It’s more like an insurance to investors than a penalty to the company, as it is so little money.”
Coupon evolution
Still, issuers are hopeful that the one-size-fits-all approach to step-up coupons may change as the asset class evolves. Some have even started to float the idea that companies should be rewarded for hitting environmental goals, rather than penalized for missing them.
"Environment and sustainability have been on the periphery of the core financials and P&L for some time, but they are becoming more strategic and integral to the overall assessment of performance," said Katie McGinty, vice president and chief sustainability, government and regulatory affairs officer at Johnson Controls.
"We are still somewhat on that trajectory. But two to five years from now we may see that the dynamic between credit assessment and the appropriate ambitiousness of climate targets aren’t two separate considerations and are in fact closely integrated," she said.