When luxury fashion brand Chanel issued €600 million of bonds last September, there was an unusual catch: if the company fails to meet its sustainability goals, it will have to pay penalties to investors.
The deal is an example of a new type of debt known as a sustainability-linked bond, which is a way for businesses to finance themselves while tying repayments to their sustainability targets. That is different from traditional green or sustainability bonds, where the money raised has to be spent on a specific green or social project.
“Sustainability-linked bonds essentially help companies create an ambitious and accountable pathway to support their overall sustainability strategy,” says Delphine Queniart, global head of sustainable finance and solutions at BNP Paribas Global Markets.
Chanel’s bond sale consisted of two separate deals for €300 million each. The first commits the company to cutting its greenhouse-gas emissions in half by 2030 and reducing emissions in its supply chain by 10 per cent. The second pledges to transition to 100 per cent renewable electricity across the company’s operations by 2025.
If Chanel fails to meet its emissions targets, it will have to pay a cash penalty of 0.75 per cent, almost doubling the 1 per cent interest rate it is paying to borrow the money. Likewise, if it fails to meet its renewable electricity target, it will have to pay an additional 0.5 per cent premium on top of the 0.5 per cent interest rate for that bond.
In addition to emissions targets and renewable energy goals, some issuers have included targets related to diversity. Schneider Electric’s deal in November 2020, for instance, included a target to improve gender diversity across its business so that by 2025 women will account for half of all new hires, 40 per cent of front-line managers and 30 per cent of its leadership teams. It has also committed to training one million underprivileged people in energy management by 2025.
“A few years ago it wasn’t that easy to hold companies to account and track their ESG [environmental, social and governance] improvements, but sustainability-linked bonds will help you to do that,” says Mark Munro, fund manager at Standard Life Investments. “These will help move the conversation forward; it’s much better to think about a holistic ESG target for a company rather than just a specific project.”
Italian energy company Enel issued the first sustainability-linked bond in 2019, taking a cue from the loan market where interest rates could be ratcheted up or down depending on whether or not certain metrics had been met. That remained the only deal until last year, when the introduction of the International Capital Market Association’s Sustainability-Linked Bond Principles, which provide guidelines around how the bonds should be structured, spurred more companies to follow suit.
Chanel, Novartis and Suzano! all issued bonds in September 2020, with more deals following in November after the European Central Bank said it would accept sustainability-linked bonds as collateral.
In total, companies issued roughly $9 billion of sustainability-linked bonds in 2020, according to Ángel Tejada, head of the green bonds group at Spanish bank BBVA. He believes there could be anywhere up to double that amount issued over the coming year.
The real game-changer is the way ESG and sustainability criteria are becoming embedded much more deeply and holistically into investment strategies
“We will likely see issuers trying to complement their green bonds with sustainability-linked bonds because they offer more flexibility and less limitations on what they can spend the proceeds on. But we are also likely to see new issuers that aren’t able to fund sufficient eligible assets to issue a green bond, but want to engage with ESG investors,” says Tejada.
Tesco was one of the first companies to tap the market this year, issuing a €750-million sustainability-linked bond in January that commits the supermarket chain to a 60 per cent cut in its greenhouse-gas emissions by 2025.
While bankers predict the volume of sustainability-linked bond issuance could eventually match the green bond market, which according to Dealogic saw $235 billion of deals last year, they also caution against moving too fast.
“It is important for us how these bonds are structured, that the targets are ambitious and credible so there is no greenwashing,” says Queniart at BNP Paribas. “We prefer there is a considered pace of shaping the market, rather than people quickly setting non-credible targets, which may erode confidence in the nascent market.”
Reputational risk could also dampen potential issuance given that if a company failed to meet its sustainability goals, it could attract negative publicity and discourage others from pursuing deals.
“If you set yourself high targets and miss them, and then get criticised for it, that will ultimately hurt the development of the market,” says Clare Burgess, partner at Clifford Chance.
Some companies are also questioning the value of rewarding investors for missing targets. For example, Hong Kong real-estate group New World Development issued a sustainability-linked bond at the start of this year, which instead of paying investors a higher interest rate if it fails to meet its target will spend the equivalent amount of money to buy carbon offsets.
While it is too early to gauge how much impact sustainability-linked bonds will have on broader efforts to achieve net-zero emissions by 2050, the development of the market is part of a wider ESG trend that is reshaping how people invest.
“The real game-changer is the way ESG and sustainability criteria are becoming embedded much more deeply and holistically into investment strategies,” says Andrew Carey, co-head of Hogan Lovells’ impact financing and investing group. “What is potentially far more powerful than the bonds themselves is the more seismic shift in the way investors think about sustainability.”
That deeper ESG focus among investors is also likely to change how companies approach sustainability.
“As we’ve seen with green finance in general, the real benefit is it elevates sustainability issues to the treasury function and board level because it’s no longer just the territory of the corporate responsibility group,” says Burgess. “It makes people talk to each other and that creates the momentum behind the sustainability changes in the business, which can have a much greater impact.”
