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Global ESG-linked bond market faces its first set of penalties

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The revival of fossil fuels in European energy policy risks triggering the first wave of financial penalties in the global market for ESG bonds.

A test case is about to unfold in Greece, where energy supplier Public Power Corp. may find it “virtually impossible” to meet the end-of-year emissions target on some of its debt, according to an analysis conducted by the Anthropocene Fixed Income Institute.

That’s as regulators, government officials and industry representatives agree on crisis policies that are delaying the company’s phase-out of lignite coal production, which could also make it challenging to meet a separate end-2023 target, AFII said.

The debt in question is a sustainability-linked bond. SLBs typically see issuers pay a penalty if they miss pre-determined environmental, social or governance goals. But with Europe’s decision to ramp up coal production in response to the current energy crisis, near-term climate commitments are being derailed. And that’s left many utilities with little choice but to adapt.

PPC “takes its environmental and social role very seriously,” a spokesperson for the Athens-based company said in an emailed comment. “In this context and prior to the energy crisis and the conflict in Ukraine, PPC has communicated an aggressive delignitization plan, adopting a move toward renewable energy sources which would lead to substantial reductions in CO2 emissions.”

The current situation “may result in the step-up clause on our SLB bonds to be put in place,” the spokesperson said. “However, given our stated commitments, we do not see issues with our credit institutions, debt holders or credit agencies from the enforcement of the step-up.”

In July, it emerged that PPC planned to double its output from lignite coal over the next 12 months, to ensure demand can be met. That’s as Russia’s invasion of Ukraine disrupts supplies and forces a rethink of energy policy across Europe. It’s a pattern that threatens to repeat itself across the wider SLB market, as issuers that had set emissions targets struggle with the fallout of the energy crisis.

Market growth

Global SLB sales grew almost tenfold last year to around $108 billion, according to Bloomberg Intelligence, with an additional $80 billion so far in 2022. The debt differs from the better-established green bond market, where proceeds are earmarked for environmental projects. Funds raised through SLBs can be used for anything, boosting their appeal for issuers.

The rapid growth in SLBs has also attracted criticism, with weak and flexible targets alongside tiny penalties leaving some creditors cautious. A number of the world’s largest ESG bond investors refuse to touch SLBs, while early investors have voiced concerns that corners of the market risk losing credibility.

The first ever SLB was sold by Italian utility Enel SpA in 2019. The company faces an end-2023 target that has also been made more difficult to reach by changes in Europe’s energy policy, according to AFII said.

“Our view on Enel is that even if a Sustainability Performance Target is missed, it does not necessarily represent a detrimental adjustment to its sustainability targets, and should not be accompanied by a downgrade in credit,” AFII said. “A coupon step-up, potentially accompanied by technical selling from green funds, could present an attractive opportunity to increase exposure if investors believe in the company’s long-term sustainability performance.”

A spokesperson for Enel declined to comment, citing the company’s silent period ahead of its business strategy presentation next week.

PPC sold two sustainability-linked bonds last year. The first, a €775 million security maturing in 2026, will pay a half-a-percentage-point coupon step-up if it fails to reduce direct emissions from its assets by 40% by end-2022, from a 2019 base year. That works out to around €3.9 million per year if PPC doesn’t achieve the goal.

The company said it has “successfully phased out 1.4GW of capacity” since 2021, leading to a 30% reduction of CO2 emissions compared to 2019.

“However, the conflict in Ukraine in the beginning of 2022 has created significant energy related issues throughout Europe,” the spokesperson said. These are developments that were “unforeseen.”

A novelty

Witnessing an SLB trigger go off would be a novelty in international markets. Most issuers’ either have targets that are several years away, or so unambitious that they can be easily met even in difficult markets.

UK grocery chain Tesco Plc was criticized last year for tying its SLB to goals that covered only 2% of annual emissions. France’s Carrefour SA raised eyebrows by leaving out emission-reduction targets altogether.

As a result, there’s no playbook to show how markets will react when targets are missed, the AFII said. Investors would get a higher coupon, which could raise demand for the bond. On the other hand, an issuer’s failure to meet an ESG target might spark a selloff by funds that have sustainable investment mandates.

“This relationship would need to be considered on a case-by-case basis,” the AFII said. “Watching SLBs as they go through their triggers should give pricing information that can be used for this purpose.”

© 2022 Bloomberg

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