The use of proceeds model is under threat, what is KPI-linked and transition bonds?

11 Jun, 2020 11:28
source: Singularity Financial

Singularity Financial Hong Kong June 11, 2020 – While most labelled bonds remain ‘good, old fashioned green bonds’ that designate their use of proceeds, as recommended by the Green Bond Principles, with such a plethora of labels emerging, the market is in danger of becoming increasingly fragmented.

The AGM of the Green Bond Principles and Social Bond Principles this week has published some very interesting news, in particular, the KPI-linked bonds, and the transition bonds.

KPI-linked bonds

The KPI-linked bond model has been borrowed from the sustainability loan market. It sees a bond’s coupon vary according to whether a pre-determined sustainability target is met.

It is therefore a move away from the ‘use of proceeds’ format – issuers do not have to go through the rigmarole of identifying green assets or activities that are to be financed or refinanced with the proceeds, and then report on the impact of the issue.

It was pioneered, in the bond format, by Italian utility Enel, which issued two bonds last year with a coupon that would rise if it failed to hit renewable energy targets by a set date. The bond (confusingly called an SDG-linked bond) has provoked controversy , but many investors welcomed it because it incentivises change at the company level. One of the big criticisms of ‘green use of proceeds bonds’ is that they do not necessarily bring about radical change in the issuer.

The International Capital Market Association’s head of sustainability Nicholas Pfaff thinks the KPI-linked bond market has the potential to be at least as big as the green bond market.

Transition bonds

The Green Bond Principles set up a climate transition finance working group last year, after Axa Investment Managers penned transition bond guidelines.

Many in the market argue that a transition bond label is needed to accommodate issuers from dirty sectors, such as oil and gas, which struggle to issue ‘use of proceeds green bonds’ without attracting controversy. However, while these sectors are not pure green, they still have an important role to play in the transition to a low-carbon economy.

Sustainalytics today became the first of the second party opinion providers to launch a service for transition bonds. This will look at the transition strategies of issuers as well as the use of proceeds, judged against their own internally-produced scenarios. But at the mean time, the use of proceeds model remains important in the Sustainalytics methodology.

Conclusions

The use of proceeds model, is a good starting point for a conversation about what is green, and can encourage companies to develop more green assets. But is not, in its current form, the entire solution.

Green bonds need to not only designate the use of proceeds for financing or refinancing green activities. They also need to show how the financing is helping them to solve an environmental problem. They need to show whether they also have a clear strategy to be in line with the Paris Agreement.

The use of proceeds format will continue to come under pressure until this situation is resolved. Otherwise, it risks obsolescence, as investors increasingly scrutinise sustainability strategies as part of their ESG considerations.

Reference link: https://www.environmental-finance.com/content/analysis/green-bond-comment-june-2020.html

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