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Good morning. Imagine a shoebox of any width, length or height. If one of its sides measured zero centimetres, you wouldn’t be able to fit any shoes in it, however small your feet and however big the box’s other sides.
The same logic shows that so-called sustainability-linked bonds won’t help finance the energy transition, because of the incentive to game at least one of its attributes, Julien Lefournier, an ex-Crédit Agricole banker, argued in a paper last month for research group Chair Energy & Prosperity. The group’s backers include utility company Engie and Caisse des Dépôts, an investment arm of the French state.
Some $60bn of the popular new type of green bond were issued in 2022. This year’s major issuers include French supermarket Carrefour, state-controlled Italian utility Enel and Chile’s debt office. They make the issuer, the buyer and the structuring bank look good, but do they serve any other purpose?
Today I go deep into this intriguing structure that seeks to create a unique market-led rap on the knuckles for failure on sustainability issues and share my analysis of what anti-ESG Republicans in the US can learn from them.
Let us know what you think about the questions I raise about the (sometimes tenuous) link between green finance and the real economy, by commenting below or writing to [email protected]. — Kenza Bryan
Few parts of the financial sector have been more controversial than the private equity industry. Yet PE firms are now making serious efforts to position themselves as sustainability leaders. Is this a mere marketing ploy — or can this sector play a vital role in tackling the world’s biggest environmental and social challenges? That will be the focus of our next Moral Money Forum report, and we want to hear from our readers. Click here to fill out our short survey.
Four reasons to be suspicious of new bonds
Some of the world’s biggest polluters, from airlines to meatpackers, have been rushing to issue so-called sustainability-linked bonds (SLBs). These raise general-purpose cash, with the threat of a higher interest rate if the issuer fails to meet a sustainability goal.
In theory, this should funnel the cheapest capital towards governments and businesses with the most ambitious decarbonisation targets, regardless of whether they sell crude oil or solar panels. The higher the chance of cashing in on a missed target in future, the more incentive a bondholder has to accept a lower return than usual upfront.
But when it comes to making progress on climate change, these are “a very bad product, destined to fail”, French academic Julien Lefournier argues, because gambling on the cost of capital is “abhorrent” to company treasurers.
Issuers have a built-in incentive to drive at least one of the bond’s three key “shoebox” metrics down to close to zero: the size of the penalty, its duration, and the probability of the target being missed. If just one metric is gamed, the future win for the bondholder becomes too small to justify offering a lower interest rate at the start, making the whole thing largely pointless.
Academics, activists and regulators have all flagged evidence that these metrics are indeed being gamed. Imtiaz Ul Haq and Djeneba Doumbia, economists at the World Bank group, have found that the average step-up is about a tenth of overall coupon rates (and has stagnated as interest rates rise). They also found that penalties typically kick in only a few years before the bond matures, and the higher the coupon, the closer to maturity this is. The Financial Conduct Authority in the UK has highlighted that targets are sometimes too weak to be credible.
A fourth area of weakness was identified in a Bloomberg New Energy Finance Report earlier this month. SLBs are more often “callable” than usual bonds, meaning companies can just retract them by repaying the capital early. “They are riddled with exit clauses, toothless terms and conditions, vague timelines and opaque targets,” its author wrote.
I had a go at applying these four tests to a debut €650mn SLB that Heathrow airport in the UK issued to great fanfare earlier this month. The penalty of up to one percentage point above the existing rate is unusually high. Although this would be paid only from 2030, the bond cannot be called early. Finally, its headline goal is reasonably impressive: a 15 per cent cut in emissions from planes by 2030, through a combination of switching to more sustainable fuel and using less of it.
But what about the probability of failure? Low, presumably. The 2030 emissions cut target is at the centre of Heathrow’s net zero commitment to investors. It is hard to imagine the company betting big against the risk of an embarrassing flop.
Lefournier is a rare voice trying to give mathematical credibility to the sceptical view that green finance, in its current form, has little impact on the real economy. This is an idea that anti-ESG Republicans in the US would do well to tune into; it leads to a conclusion that painting ESG investing as a bogeyman is rather pointless.
While the French paper is stuffed full of equations, what it lacks — as well as a formal peer review — is imagination.
A bunch of solutions have been proposed. The UK’s Financial Conduct Authority, for example, is exploring whether to “prompt” bond issuers to disclose in prospectuses what makes a target “ambitious and meaningful”, and how the penalty will incentivise them to meet it.
Ulf Erlandsson — another ex-investment banker, who now leads the Anthropocene Fixed Income Institute, a think-tank — makes the case for “greenback” SLBs. These instruments would have a penalty of at least one dollar and a probability of payout of at least half. This should convince bondholders to offer cheaper capital upfront, Erlandsson argues.
He rightly acknowledges, though, that dynamic pricing models for SLBs are “still in their infancy” — and that financial instruments are what regulators and market participants make of them. (Kenza Bryan)
Smart read
A new special report from the FT highlights some of the most interesting sustainability-related research happening at leading business schools, on subjects ranging from carbon pricing to food processing.
Read the full article here