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Sustainability bonds are a key funding source for projects that have environmental or social benefits. Photo: Shutterstock Images

Pitfalls of green finance: why credentials of some sustainability-linked bonds don’t stand up to closer scrutiny

  • Some bond issuers are seen as too lenient in setting performance targets and triggering penalties when they fail to hit their green targets
  • Popularity of green bonds is growing, with issuance in the year’s first seven months standing at US$49.7 billion versus US$8.2 billion in 2020

The desirability of sustainability-linked bonds (SLB), a nascent but fast-growing finance tool, is blighted by terms that limit the financial penalty for issuers missing their green targets despite rising interest in the instrument, according to asset managers.

There are concerns about “greenwashing” as issuers are seen as too lenient in setting performance targets and triggering a higher bond coupon rate when the goals are missed. And in some cases bond terms allow them to bypass the penalty altogether. Greenwashing refers to the creation of an impression of higher than actual sustainability benefits.

“The tailor-made nature of both sustainability performance targets and interest coupon adjustment potentially gives rise to concerns around greenwashing,” said Martin Dropkin, head of Asian fixed income at Fidelity International.

Investors should conduct a “bottom-up” assessment of issuers to ascertain whether they are undertaking significant changes to enhance their operation’s sustainability, and examine the specific bond features, he added.

Sustainability bonds are a key funding source for projects that have environmental or social benefits. Much of their proceeds go to renewable energy and energy efficiency enhancement projects that help fight climate change by cutting the emission of greenhouse gases.

Under the SLB principles published by the International Capital Market Association, issuers are expected to set performance targets that are ambitious, comparable, verifiable, consistent with its overall sustainability strategy and go beyond a “business as usual” trajectory.

Since the first SLB was issued in 2019, issuance rose to US$8.2 billion globally last year, according to financial data provider Refinitiv. It has ballooned to US$49.7 billion in the first seven months of this year.

Still, in the year’s second quarter, SLBs only accounted for just over 10 per cent of the US$253 billion wider universe of environment, social and governance (ESG)-labelled debt with over 10 years of history, Dropkin noted.

Linked to company-wide ESG objectives and unlike green bonds that specifically fund projects with environmental benefits, SLBs allow a wider range of companies to tap the market, according to DBRS Morningstar analysts Radi Annab and Cathy Cheng.

“As investors focus more on ethical and sustainable portfolios, the link between achieving or missing ESG objectives and the cost of debt may become an increasingly important credit consideration,” they wrote in a report published in June. 

However, all but one of the US dollar-denominated SLBs issued globally in the first quarter of this year featured a penalty of less than 10 per cent of the original coupon interest rate. Nearly half had a variation of less than 5 per cent of the original rate, according to research by Paul Lukaszewski, head of corporate debt for Asia-Pacific at Aberdeen Standard Investments.

“When markets move this far this quickly, inevitably some corners end up being cut,” he said. “We see a risk that money will flow into investments whose ESG credentials don’t stand up to closer scrutiny.”

In several cases, the potential penalty only applies in the final year of the bonds’ life, which makes any financial cost to the issuer even less significant, he added.

Sheldon Chan, portfolio manager for Asia credit bond strategy at T. Rowe Price, said a small coupon step-up or a measurement date that is a long time away suggests a lower incentive for the issuer to deliver on its goals.

“SLBs are a growing segment of the ESG-labelled bond markets, but the sample size in Asia currently remains small and the market has yet to gravitate toward a set of best practice standards,” he said.

Some asset managers like Aviva Investors are making sure that they do not get drawn into investing in dubious “green debt”. It recently avoided buying an SLB of an oil firm with targets linked to improvement in water recycling rates.

“Water recycling rates will not lead to a meaningful change in business strategy to address climate change,” said Richard Butters, an ESG analyst at Aviva.

“Oil will still be pumped, it will still be burnt, and absolute emissions will not be reduced.”

This article appeared in the South China Morning Post print edition as: Some bond issuers seen as ‘too lenient’