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Sustainability-linked bond (SLB) issuance has had a surprisingly strong start to the year despite the lack of activity in European high-yield. According to 9fin data, in Q1 23 around 30% of EHY bond issuance has been sustainability-linked. Featured in this group are new entrants Air France KLM and IHO Verwaltungs (Schaeffler), as well as previous SLB issuer Teva Pharmaceuticals.

This follows a strong 2022 where SLBs held up their share of issuance, representing 15% of the total EHY bond market, versus 16% in 2021. Despite a gloomy macroeconomic backdrop sustainability-linked issuance still persists, with market participants becoming more accustomed to the debt type. But as we explore later, frustrations still remain around penalty packages and the targets themselves.

Sustainability-linked issuance has also managed to keep traction in the leveraged loan universe. According to 9findata, ESG ratchets featured in around 47% of SFAs in 2022, which is similar to the prior year. The lack of loan issuance in 2023, except for the odd add-on and A&E offer, has meant sustainability-linked features have been sparse. For add-ons, if there is an ESG margin ratchet in the original deal, it will likely apply to the add-on. However, recent A&E offers have been linked to deals from around 2018, which pre-dates the ESG-based margin ratchet.

The start of 2023 also saw Public Power Corporation become the first HY SLB issuer to face a penalty after failing to meet its sustainability performance target (SPT). We calculate the borrower will pay an additional €3.9m in annual interest expenses. We will be on the lookout for more borrowers with testing dates in 2023, including Pfleiderer and Rexel — the latter of which is confident its targets will be met.

To get up to speed with Sustainable Finance, we released a 9fin Educational, showcasing the deal structure and intricacies which surround sustainability-linked debt. In this piece we uncovered the flaw in sustainability-linked deal structures, which allows borrowers to refinance before the testing date occurs, due to their call schedule stepping down.

Dr. Julian Kölbel, an assistant professor of sustainable finance at the University of St. Gallen, spoke more on the topic during a 9Questions:

It seems most SLB issuers are now taking care of this risk by making provisions in the definition of the call option that you need to compensate depending on the target status. There are exceptions where this isn’t the case but that is an omission and is not ideal. Ultimately, this was a growing pain that was initially missed.

In 2022, we found there were no issuances which only incorporated a coupon step-up. Instead, redemption premiums were included alongside coupon step-up clauses, to ensure borrowers would be penalised if they failed to meet a SPT and end up redeeming early.

We found the majority of borrowers who incorporate a redemption premium only included the provision after the make-whole period, however. This is likely due to targets being tested later down the line, sometimes after the first call date. Structural features used to mitigate this include “Intermediate SPTs”, first incorporated by Kem One in November 2021. In this structure, the borrower is tested annually after the issue date, in order to monitor the trajectory of the target before the testing year.

SLB issuers have also been in the firing line recently, for having ‘higher emissions intensity, and lower targets’ than sector peers. A study on euro-denominated SLBs by Commerzbank uncovered that SLB targets tend to be less ambitious than those of other firms who don’t have sustainability-linked instruments outstanding. Stephan Kippe, the bank’s head of ESG research, went on to say SLBs should apply an incentive to deploy above-average emission reduction targets. Instead SLB targets are weak, and have small penalties, which could push demand down for the debt product in the future.

In February 2022’s edition of Sustainable Junk, we commented on Dr. Kölbel’s work on the greenium. Recently he went on to tell us that:

Initially, we found a greenium of 30bps when you match SLBs with a counterfactual plain vanilla bond by the same issuer. Inevitably, there is an issue with bonds being issued at different times. The most interesting thing we found was that there was strong evidence of a greenium for 2021 SLB issuances but by 2022 it had disappeared. There could be multiple reasons for this, one of them being that the market in 2022 was very different, with both inflation and the Ukraine war.

In Q1 23, Public Power Corporation (PPC), the Greek energy provider became the first European HY SLB issuer to trigger a penalty after failing to meet its target. Announced in March, the group missed the SPT related to the reduction of scope 1 GHG emissions for FY 22, achieving a 36% reduction in comparison to 2019, with the initial target being 40%.

This comes after the decision by European governments to ramp up coal production in response to the current energy crisis. In July 2022, PPC announced its intent to double lignite coal output over the next 12 months to ensure demands were met. 

Failure to achieve the target resulted in a 50 bps coupon step-up, which will apply from the next coupon date in October 2023. PPC’s penalty is one of the highest in the SLB market, and we calculate it will increase annual interest costs by ~€3.9m when applied across the original €650m SUNs and the €125m tap notes. We note the bond price didn’t react to the news of the penalty.

Interestingly the €500m sustainability-linked SUNs PPC issued four months later, in July 2021, will not be impacted by the penalty. The company altered the documentation, pushing back the to trigger date until 2024. It is unclear whether PPC deliberately did this to reduce the risk of increased interest expenses.

Market participants have continued to vent their frustration over the size of penalty packages. We did see a slight improvement in the average total step-up across sustainability-linked bonds in 2022, however, with the average total coupon step-up (penalty if all SPTs are not met) increasing to 42 bps versus 35 bps in 2021. The lack of SLB issuance last year skews this data slightly, and we believe more could be done to set penalty package standards in the future.

Similar could be said for sustainability-linked loans. Tepid margin ratchets market-wide, typically ranging from 5-15 bps, provide little risk/reward for achieving/missing SPTs. Our data finds the most common margin ratchet is 10 bps in SLLs — featuring in around two thirds of instruments.

Issuers shouldn’t expect a higher penalty will impact pricing of instruments. As Dr. Kölbel uncovered:

The greenium does not respond to the size of the actual penalty. This is quite odd from a rational pricing perspective. You could make the case that there is a way to price the step-up as an embedded option. For example, you would think about what the penalty is and the likelihood of getting that penalty. However, the greenium at issue is often larger than the maximum potential penalty.

Air France became the first issuer to print in the sustainability-linked market in 2023. The borrower incorporated different penalty packages for each of its three and five year tenor notes. The shorter dated notes featured a larger 75bps coupon step-up, compared to 37.5bps on the longer term notes. The targets set include a 10% reduction in scope 1 and 3 jet fuel GHG emissions intensity vs 2019 with both testing dates set as 31 December 2025. 

Teva came back to market in March 2023, issuing four sustainability-linked SUN tranches across euros and dollars, totalling $2.49bn. As one of the leading manufacturers of generic drugs globally, the company has had more than its fair share of ESG-related issues, particularly linked to the opiod crisis. It recently came to a settlement with US states, which required the company to pay up to $4.2bn. Despite the increasingly watchful eye of regulators and investors, management made the decision to reduce the penalties for the recently issued notes. 

Teva’s new notes have a total coupon step of 30 bps (10 bps per SPT), a reduction from 37.5 bps (12.5 bps per SPT) step-up in its previous issuance. The targets and testing dates were carried over and remained the same, with three KPIs related to customer welfare and the reduction of scope 1 & 2 GHG emissions. 

Despite stating its intention of reducing scope 3 emissions in 2021, and having 92% of total emissions for that year coming from scope 3 GHG emissions, Teva’s SPTs do not cover scope 3 emissions. Read out ESG QuickTake on Teva.

In Q1, 9fin’s ESG Team released a selection of Sustainable Finance-related analysis:

ESG 9Questions — Julian Kölbel, University of St. Gallen (9fin)

ESG within LevFin — New insights from issuer data (9fin)

Double and Dynamic Materiality (9fin Educational)

9fin’s ESG filter has brought to light some important social and governance-related news items from the previous month which are worth highlighting:

UK regulators hit 888’s William Hill with £19.2m fine for failures to meet social responsibility and anti-money laundering obligations. The Gambling Commission stated that failings included a lack of customer checks, and a license suspension was seriously considered 

British energy supplier Drax, is back in hot water again after its £2bn carbon capture project fails to get Track-1 status from the Department of Energy Security & Net Zero. The company has been “invited to enter formal bilateral discussions with the government immediately”

Former CEO of utility company Eskom is set to appear before South African lawmakers to speak on the corruption, theft, cartels, and other irregularities at Eskom. This comes after intelligence agencies found that cartels within Eskom were responsible for instances of sabotage and malpractice

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