Sustainability-linked bond market worth $280B isn't working

One of Wall Street’s favorite financial innovations for helping reduce corporate greenhouse gas emissions isn’t functioning as intended.

That’s according to new research from the investor-focused nonprofit Climate Bonds Initiative. The group’s study found that more than 80% of 768 sustainability-linked bonds issued from 2018 through November of last year aren’t aligned with global climate goals.

Sustainability-linked bonds (SLB) make up roughly $280 billion of issuance and can, according to CBI Chief Executive Officer Sean Kidney, “play an enormous part in transitioning the world economy to a greener future.” The problem, Kidney said in a statement, is that the market is “operating in the wild west.” 

SLBs are similar to ordinary bonds, with one key difference: They have built-in incentives for issuers to achieve set sustainability targets. Often, the issuer will face an interest rate increase if they fail to meet those goals. 

Issuers like SLBs because their proceeds can be used for general purposes as opposed to specific projects, which isn’t the case for green bonds. As a result, the SLB market is accessible to heavy polluters like cement producers or steel manufacturers that might otherwise struggle to identify projects eligible for green bonds.

The first SLB was issued by a Chinese company in December 2018. Since then, European companies such as Italian energy giant Enel SpA have been big sellers of the bonds. In 2022, Chile and Uruguay became the first countries to issue sovereign SLBs, with new issuers, currencies, countries and sectors jumping into the market each year.

Issuance volume peaked at about $110 billion in 2021. Since then, investor demand has cooled as some companies in the SLB market faced greenwashing-related criticism for setting unambitious goals with minimal penalties.  

CBI’s research found that just 14% of SLBs issued are aligned with the Paris Agreement target of limiting global warming to well under 2C from pre-industrial times, according to its own assessment methodology.

“The sustainability credentials of many SLBs have been weak,” according to CBI. There’s a “high proportion of low-quality deals that lack adequate disclosure, ambition and credibility.”

But the core problems lie in design and execution, not the underlying concept, CBI said. Structural characteristics, calibration issues, poor reporting and weak decarbonization plans by issuers have impacted quality in the market. Investors, meanwhile, often don’t have capacity, resources or bond supply to screen out low-quality SLBs, the group said.

The nonprofit also singled out two loopholes in SLB legal documentation that can undermine deal credibility and require monitoring and possible regulation. One clause exempts issuers from paying the penalty if they miss targets due to changes to rules or policy. The other allows issuers to exclude post-issuance acquisitions, as well as certain investments, from their performance evaluation.

CBI said that it did identify some improvement last year, with 33% of SLBs by amount issued found to be aligned with climate goals. That coincided with the release of guidance by CBI, which the group said it hopes will help galvanize investment.

And Kevin Leung, an analyst at the Institute for Energy Economics and Financial Analysis, said sustainability-linked instruments still can drive decarbonization, as long as their performance targets are aligned with a 1.5-degree pathway across all scopes of emissions and actively promote the transition to “green activities.”

SUSTAINABLE FINANCE IN BRIEF

It’s not just SLBs that suffer from these afflictions. As companies increasingly tie executive pay to ESG, there’s growing evidence that bigger remuneration packages are being fueled by such add-ons without any meaningful environmental, social or governance improvement to justify it. Now, activist shareholder groups are demanding more disclosures around ESG-linked pay in an effort to force companies to produce transparent metrics. The criticism comes as the corporate appetite for such pay structures is on the rise. Roughly one-third of the 1,000 largest US companies link part of their executive compensation to ESG.