The market for sustainability-linked bonds is about to get an updated set of guidelines that should help make things clearer for issuers and investors about how to set and measure the most relevant targets for greenhouse gas emissions across different industries.
The guidelines from the International Capital Market Association, whose sustainable finance principles have a vital role in the ESG bond market, are expected essentially to be an expansion and revision of an existing list of key performance indicators published last June that provide more clarity around sector pathways to help comparison.
Yet the update, expected next month, will be particularly crucial for an SLB market that has grown to US$91bn in 2021 from just US$8bn in 2020 and has enticed issuers from a broad spectrum of hard-to-abate sectors like transport and energy that are not usually associated with green finance.
The wider array of industries issuing SLBs has meant increased confusion about which KPIs are most material for each sector, how to measure ambition, and just how focused issuers need to be on the notoriously difficult-to-gauge Scope 3 emissions in their frameworks. Scope 3 covers all indirect emissions in companies' value chains and makes up the bulk of greenhouse gases from polluting industries.
“It’s clear that Scope 3 is the big challenge, and the challenge of Scope 3 varies very significantly depending on what industry you are in,” said Nicholas Pfaff, deputy CEO and head of sustainable finance at ICMA.
“We should be careful not to oversimplify the challenges by asking issuers to overcome these difficulties without understanding them, and without calibrating in relation to the industry we’re talking about.”
ICMA is, of course, responding to broader market concerns about a class of emissions that is hard to identify and quantify, because they are produced by assets not owned or controlled by an issuer. KPIs based on Scope 1 and 2 emissions are welcome but often considered insufficient, because their volumes are so much smaller, market participants say.
“We’re now in a market where for certain sectors we find that investors and external reviewers struggle with an issuance not having an element of Scope 3,” said Arthur Krebbers, head of corporate climate and ESG capital markets at NatWest Markets.
Krebbers said, however, issuers do not always see things the same way.
“Scope 3 is one area where I would say investor and issuer expectations are currently somewhat mismatched,” he said. “While investors in SLBs tend to consider Scope 3 important, with many potential issuers it’s clear that they feel very uncomfortable attaching Scope 3 targets to financial instruments based on imperfect approaches they have to measure those emissions.”
Scope for improvement
This mismatch has not gone unnoticed elsewhere. Even for issuers like US tractor maker John Deere, for example, that print well-received ESG bonds, an absence of Scope 3 targets often gets at least one comment from external reviewers.
John Deere priced its first SLB last month, a US$600m seven-year offering. S&P, in its favourable second-party opinion, said that the issuer’s KPIs and sustainability performance targets, which only relate to Scope 1 and 2, were “strong” and “advanced,” respectively. Nonetheless, S&P also pointed out that 99% of John Deere’s “value chain emissions” are Scope 3 and omitting them as part of the KPI “constrains” its materiality.
Jonathan Laski, a Toronto-based director at second-party opinion provider Sustainalytics, said that assessing Scope 3-related KPIs and SPTs is a significant part of what his firm does.
“[Scope 3] comes up in our work,” he said. “We see that about half of our sustainability-linked bond and loan projects set KPIs around greenhouse gas emissions, and about half of those include Scope 3, so it’s definitely something that we’re seeing a lot.”
He said in Sustainalytics' role as an assessor of the strength and ambitiousness of KPIs and SPTs it realises the importance of Scope 3.
“We don’t have a default requirement for an entity to reduce Scope 3 emissions or not,” he said. “But definitely, we view that as meaningful because in many companies, in many industries, Scope 3 emissions are well over 50% of total emissions.”
ICMA’s guidance is intended to touch on the broader criteria that go into ESG-linked bonds, not only Scope 3 emissions.
“There is a debate arising about whether certain SLBs are credible enough,” said ICMA’s Pfaff. “The questions asked are focused on the materiality and objectives of some SLBs. So it certainly seems propitious for us to aim to provide additional guidance to the market and help best practices emerge.”