Sustainable Junk - October 2021 Wrap

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Sustainable Junk - October 2021 Wrap

Josh Latham's avatar
Alex Manolopoulos's avatar
  1. Josh Latham
  2. +Alex Manolopoulos
9 min read

In a month which saw almost €3bn in ESG bond issuance, the sustainability-linked bond (SLB) took centre stage. The structures are increasingly common, but investors remain lenient around the ambitiousness of KPI targets, due to a number of factors including; the infancy of the debt class, the fact that there is only guidance in place, its unregulated, there is little incentive to set overly ambitious targets and greeniums can still be collected with a Business-as-Usual target. Recently, rumours of using carbon credits or charitable donations to replace margin ratchets have been circulating. 

Similar to Itelyum’s deal last month, which saw a change in the way the coupon-step up will be distributed, banks are exploring adding voluntary carbon credits to sustainability-linked loans, bonds and derivatives. The new structure would force issuers who fail to meet their targets to purchase carbon offset credits. This method allows companies to contribute to emission reduction projects, such as forestry plantations or carbon capture machinery, by purchasing carbon offsets. However, the credibility of these projects are increasingly under scrutiny due to the market being unregulated and with big price discrepancies between carbon credits and carbon offsets globally. 

A few years down the line companies issuing these instruments may find carbon credits lack credibility, or they may have to pay more than they bargained for if projects become more regulated. Carbon offset credit structures have already been proven to work in investment grade bonds, with Etihad Airways combining sustainable performance targets (SPTs) with carbon offsets into its October 2020 deal.

Another potential option for issuers is using charitable donations to replace coupon step-ups. This would see issuers donate a sum equivalent to the coupon step up to a charitable cause - potentially linked to their KPIs. 

This answers a difficult question about the SLB structure - why should investors benefit from companies' lack of ESG performance? Issues surrounding whether companies would be able to reduce their tax bill by the value of their charitable donation will still need to be addressed. Carlyle-backed wind turbine gearbox manufacturer, Flender has previously volunteered to donate half of its interest savings from the KPI ratchets in its sustainability-linked loans to a charitable cause, as have several other sustainability-linked leveraged borrowers.

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