Pricing step-ups on sustainability-linked bonds need to show greater variation from a 25bp flat rate to better reflect issuers' credit profiles and sustainability ambitions and improve transparency for investors, according to Fitch.
Most SLBs are currently structured with a 25bp step -up penalty for missing targets, regardless of the original coupon, credit quality or scale of the issuers’ operations. This means that borrowers’ sustainability ambitions and credit profiles are not currently reflected in SLB pricing.
“We do not see the need for mass consolidation at a specific step-up level,” said Melissa Cheok, an associate director in ESG research at Sustainable Fitch.
Fitch sees the universal 25bp step-up as a hurdle for the development of the product, which is otherwise diversifying across a wide range of sectors and increasingly used as a transition instrument, and is being used to address a broader range of sustainability topics.
SLBs totalling US$52.9bn had been issued by the end of the third quarter, down 15% from US$62.3bn at the same time last year, according to Refinitiv data. A total of US$91.2bn of SLBs were issued in 2021.
SLBs made up 10% of the total sustainable bond market in the first half of this year, compared with 1% at the end of 2020, according to Fitch, which puts the total volume of outstanding SLBs at US$147bn since Italian utility Enel first tapped the market in September 2019.
Energy and utilities companies have issued the largest amount of SLBs by dollar value, followed by manufacturing and agriculture, food and beverage firms.
SLBs are increasingly being used to address supply chain sustainability, including indirect Scope 3 greenhouse gas emissions, purchased renewable energy, water consumption and recycling and waste reduction targets, as well as some social supply chain factors.
Alternatives to step-ups include purchasing carbon emission offsets, allocating funds to additional green or social capex or donating amounts to charitable organisations. The SLB market is also exploring two-way pricing that would include a pricing step-down as well as a step-up to incentivise improvement.
Assessing KPI quality
Work by the International Capital Market Association to clarify key performance indicator targets that are material and relevant to issuers in each sector is helping investors to better assess the quality of SLB targets and potentially vary pricing.
ICMA’s update to the sustainability-linked bond principles included a "KPI registry" of 300 KPIs across 22 sectors as well as a matrix to help identify the most relevant ESG themes for specific sectors.
Fitch reviewed the first 30 SLBs that were issued in the market and their KPI targets, and found that less than 50% included a KPI designated as core to the issuers’ economic activities as defined by ICMA’s registry.
Another 18% had another KPI that was only partially fulfilled, such as greenhouse gas emissions with Scope 1 and 2 intensity, when the recommendation includes Scope 3.
Some 15% of SLB issuers had KPIs that are neither core nor secondary, and were not material to their business. Examples of non-material KPIs include reducing pollutants such as sulphur oxide and investment in non-green but lower emitting vehicles that are beneficial but do not mitigate issuers’ primary sustainability impacts.
The data indicate that "while some issuers have ensured relevance in their KPI selection, many others still need clarification. This is especially important for non-emissions targets,” the report said.