Sustainability-linked bonds are rapidly becoming unsustainable.
The bonds have only been around since 2019, but investors are already beginning to sour on a product once heralded as the first green financial instrument with teeth.
Money managers clambered to buy sustainability-linked bonds (SLBs) because they promised to penalize issuers that fail to meet specific environmental, social and governance (ESG) goals by forcing them to then pay higher interest rates.
In Canada, the bonds have become immensely popular, and more supply is constantly arriving to meet ravenous demand. According to an April, 2022, report from the Global Risk Institute (GRI), SLBs have gone from a negligible portion of total sustainable Canadian debt issued in 2020 to 5 per cent by the end of 2021, equivalent to roughly $3.5-billion.
Globally, the market for SLBs has grown seven-fold in terms of issuance volume since 2020, according to a February, 2023, report from S&P Global.
Unlike green bonds, which require proceeds to be spent on specific environmentally-focused initiatives, money raised through SLBs can be dispersed just as broadly as money raised from traditional corporate bonds. The key difference is that SLBs have specific ESG targets set by the issuer, and if those targets are not reached, the issuer must start paying more in interest as a penalty.
Investors liked how SLBs provided an easy way to meet their ESG quotas, while issuers liked how they were free to spend the proceeds as they saw fit.
That freedom, however, combined with the substantial discretion granted to issuers when setting their targets, have also made SLBs ripe for abuse. In the short time that SLBs have been available, experts have discovered that targets are often set too low to make any environmental difference or change corporate behaviour. And if issuers fail to reach their targets, the penalty rates can still be less than the standard rates on comparable corporate bonds.
“When I first heard about them, I thought that might be a good way to push some companies into actually doing something about their environmental impacts, but if you look at how SLBs are structured right now and how they are used, we are not there yet,” Deborah Debas, a senior specialist in responsible investments with Desjardins in Montreal, said in an interview.
“While I still like the concept, SLBs right now are an easy way for companies to build their environmentally-friendly reputation [without] actually driving any change in the economy or the environment.”
A Reuters analysis published in December, 2021, reviewed the targets of 48 SLBs issued globally and found nearly half of them – 23 – included a target that allowed the borrower to improve at a slower rate than they had done previously. That means a company could issue an SLB, collect the money, achieve less environmental progress than it had in the past, and still meet its goals and avoid paying the penalty rates.
Sucheta Rajagopal, a portfolio manager with Research Capital Corp. in Toronto who has focused exclusively on ESG investing for more than two decades, points to analyses such as that as clear evidence of SLBs failing to deliver any meaningful action on climate change.
“Companies are setting very low targets that they can already meet,” Ms. Rajagopal said in an interview. “Even if they are completely transparent and they meet those targets it is still not going to help us from an environmental perspective.”
Critics are now pressuring securities regulators to intervene to help prevent SLBs from including misleading or even false environmental claims.
In February, a group called Investors for Paris Compliance (referring to the 2015 Paris climate accords) filed a complaint with the Alberta Securities Commission (ASC). It asked provincial authorities to investigate allegations of misleading statements made by Enbridge Inc. in a recent SLB and to provide more guidance generally on how issuers ought to structure their SLB targets.
The ASC confirmed receipt of the complaint, but declined to say whether the requested investigation had been launched. Investors for Paris Compliance also filed two shareholder proposals at the Calgary-based company’s May 3 annual general meeting, requesting that Enbridge regularly disclose its Scope 3 greenhouse-gas emissions “using accepted definitions and in absolute terms.”
Scope 3 emissions refer to those generated outside a company’s direct control. In Enbridge’s case, that would include emissions from the production and consumption of fossil-fuel products the company transports through its pipeline network.
Enbridge officially recommended that shareholders vote against those proposals. But Investors for Paris Compliance convinced 28 per cent of Enbridge shareholders to either break with management or abstain in the vote at the AGM.
Asked to comment on the allegations made by the group, Enbridge spokesperson Jesse Semko said the tracking, measuring and reporting of Scope 3 emissions is “particularly difficult for midstream companies like Enbridge, as we do not own or control the products we transport.”
“Despite this difficulty, Enbridge is not waiting on the sidelines,” Mr. Semko said. “We already track and report on the Scope 3 emissions that we can confidently measure and report, including utility customer natural gas use, employee air travel and electricity grid loss.”
He also noted the company’s SLB framework is publicly available for scrutiny.
In regulatory filings, Enbridge said Investors for Paris Compliance “does not owe any duty to Enbridge’s shareholders and stakeholders.” It is also clear, the company said, that the group “has not assessed the risks and consequences of its request in the way that we… prudently and dutifully have.”
Matt Price, executive director of Investors for Paris Compliance, said Enbridge is hiding behind what it claims is a lack of guidance on how to measure and disclose Scope 3 emissions. Such guidance does exist, Mr. Price said, noting the Greenhouse Gas Protocol, a global standard, would apply directly to Enbridge’s pipeline business, with the only uncertainty being the rules are not directly enshrined in securities law.
“Enbridge can account for different estimates for emissions from the use of products, rather than use this uncertainty as a reason to not report on these emissions,” he said. “The GHG Protocol also anticipates companies potentially recalculating base year emissions when making data quality improvements over time.”
The battle between Enbridge and Investors for Paris Compliance reveals the sheer scale of challenge involved in accurately measuring and disclosing whether SLB targets are being met. More fundamentally, however, it raises the question of whether the benefits of SLBs are more about the free branding the bonds provide than anything to do with the environment.
In fact, the green branding power of SLBs is even better than free. Because of the green premium applied to sustainable finance products – also known as a greenium – SLB issuers can pay lower interest rates than comparable corporate bonds even if the penalty rate is applied. In other words, SLB issuers get a lower cost of capital and the brand benefits are a bonus.
“They are having their cake and eating it too because they are able to raise capital at a lower price and they are improving their reputation along the way because they get to show they are climate-conscious,” said Desjardins’ Ms. Debas.
Bruno Caron, co-chair of the national ESG and carbon finance group with Miller Thompson LLP in Montreal, said the penalty for failing to meet SLB targets “is sometimes very low.” The average increase in a bond’s coupon rate, he said, is about 25 basis points (a percentage point is 100 basis points).
If the penalties were higher, “there would actually be some credibility,” Ms. Debas said. “But right now, what we have is low ambition and no credibility.”
Raising penalties, however, would not be as simple as it sounds. If the gap between the base interest rate and the penalty interest rate in an SLB is high enough, Mr. Caron said, an investor betting on a certain issue to miss its targets could buy the SLB at a low price before the penalty rate kicks in, then sell at a higher price once the higher rate kicks in and pocket the difference.
“If the penalty is too high, then you run the risk of an arbitrage investor coming into the market and buying those bonds,” he said. “That would defeat the purpose of these instruments.”
Another problem with the existing structure of SLBs is the fact that many of those products are callable, meaning an issuer can choose to pay off the debt before the maturity date. That allows SLBs to be issued by companies with plans to ignore their targets and simply call back the bonds before penalties can be applied.
For example, a company could issue a 10-year SLB with penalties that kick in at year seven, then simply call it back in year six and avoid the penalties altogether.
“Sometimes the penalty mechanism kicks in very late in the life of those bonds,” said Mr. Caron, who is also a member of the University of British Columbia’s Canada Climate Law Initiative.
One way to close that loophole, he said, would be to require SLB issuers to pay a portion of the penalty if they choose to call in the bond early. That rule change, however, would require regulators to take a more active approach to sustainable finance oversight.
To some extent, regulators are starting to pay closer attention and clearer standards are on the way, though critics argue clear standards are still a far cry from more active enforcement.
The federally-appointed Sustainable Finance Action Council (SFAC) is set to release Canada’s first green taxonomy in the coming months, which would provide a set of rules for determining the difference between bona fide green investments and greenwashing.
Those are the sort of standards that would provide more certainty in disputes such as the one between Enbridge and Investors for Paris Compliance, with clear definitions to determine whether the company was being misleading or not.
Without them, advocates such as Investors for Paris Compliance have been forced to work on a case-by-case basis.
In April, 2022, the group filed a shareholder proposal for Royal Bank of Canada’s annual general meeting, asking RBC to update its criteria for sustainable debt that it helps companies raise. Investors for Paris Compliance wanted the bank to “preclude fossil fuel activity and products facing significant opposition from Indigenous peoples.”
The proposal was partially prompted by RBC’s role as joint lead manager for the Enbridge SLB that the group is fighting today.
The resolution received just 8-per-cent support in a shareholder vote, but the federal Competition Bureau said six months later that it was investigating potentially “misleading statements” regarding claims made by RBC about its efforts to fight climate change.
And while 8 per cent might seem low, the GRI report suggests that result could be a harbinger of changing shareholder sentiments.
“Many shareholder proposals, currently receiving majority support, received support in the single digits when first introduced,” Alexandria Fisher, manager of sustainable finance at GRI, wrote in the April, 2022, report.
In 2006, proposals on sustainability reporting received approximately 8-per-cent support, the report said. As recently as 2013, proposals on climate risk disclosures had just 7-per-cent support.
At Enbridge’s AGM, 24 per cent of shareholders representing nearly 275 million shares, worth $14.7-billion, supported Investors for Paris Compliance’s proposal requesting annual disclosures of Scope 3 emissions, 4 per cent abstained and 72 per cent sided with management by voting “no.”
“That is a pretty high vote result for us, actually,” said Mr. Price, “[It was our] first out, and almost a third broke with management.”
While government advisory groups and regulatory authorities work on potential solutions, Desjardins’ Ms. Debas notes there are already voluntary frameworks and systems in place that could allow companies such as Enbridge to gain the clarity they claim to be seeking. The international Science-Based Targets initiative (SBTi), for example, has nearly 5,000 corporate signatories and requires them to establish clear pathways to net zero and to regularly report and account for their emissions.
Such a framework could be made to apply to SLBs if targets were required to follow SBTi guidelines, though a key enforcement challenge lies in the fact that targets would be voluntary.
Something must be done to make SLBs more credible, Miller Thompson’s Mr. Caron said. Otherwise, sustainable finance advocates could end up losing what, in principle, could become a valuable tool.
“We have to make sure we don’t destroy this instrument, because at its most basic level it is a good instrument,” he said. “But it needs to be adjusted and regulated to avoid what is happening right now.”
But others, such as Research Capital’s Ms. Rajagopal, say the inherent flaws of SLBs have carried them beyond the possibility of redemption.
“It is fundamentally flawed to create a situation where the investor does better as the planet does worse,” she said.
“They really are all hot air in the end,” Ms. Rajagopal said. “All talk and no action.”