Italy has been the source of countless inventions, from the first bank to the first pizzeria--and even the first piano. More recently, Enel, an Italian energy company, broke new ground in sustainable finance last month when its Dutch subsidiary Enel Finance International NV issued the world’s first SDG-linked bond. The five-year $1.5bn bond has a key performance indicator (KPI) of at least 55% of total capacity from renewable energy by the end of 2021 (vs. 46% as of June 30, 2019). Ernst & Young (EY) will gauge performance during its annual audit of Enel. If Enel misses this target, its annual interest payment will step up by 25 basis points. Three facets of this deal are noteworthy.
- Moving Up in the World
Enel’s SDG-linked bond is the first time that a sustainability KPI causes a fixed income rate to step up, rather than down. The potential for the interest margin to increase—rather than decrease—is important to investors, underwriters, and issuers. Let’s explore each perspective in turn.
Investors. ESG margins that step down have the potential to reduce income for investors, who have often made the additional effort to incorporate ESG considerations. By contrast, the Enel bond has the potential to increase income for investors who have taken the time to incorporate ESG. Investors recognized this, and the deal was three times oversubscribed.
Underwriters. Lower potential investor income from ESG margins that step down would lower appeal to investors and increase sell-down risk in general syndication for underwriters. However, higher potential investor income in the Enel bond reduced sell-down risk.
Issuers. Since bonds are priced based on the lowest potential interest rate—i.e., the lowest potential income that the bond would generate for a potential investor—a downward ESG margin ratchet reduces the issue’s price and therefore its attractiveness to issuers. The Enel bond was not only free from this challenge, but it also gained a 20 basis point sustainability price advantage due to strong investor demand.
- ESG Features on the Whole Capital Stack of an Issuance
Enel’s SDG-linked bond has a single tranche, and therefore the entirety of the issuance is linked to ESG criteria. Because of the lower potential income, increased sell-down risk, and lower issue price, step downs in ESG-linked debt have so far limited ESG criteria in European leveraged loan deal structures to revolving and capital expenditure tranches, which are primarily purchased by banks. And the institutional term loans that are purchased by a broader range of investors have interest rates without ESG performance ratchets.
The structure of Spanish telecom company Masmovil’s ESG-linked leveraged loan, issued in May 2019 as Europe’s first leveraged loan to include ESG criteria in its investment documentation, is a case in point. While Masmovil’s loan size was €1.7bn, the ESG-linked 15 basis point interest rate step down for an improvement in Masmovil’s sustainability rating was limited to the €250m revolver and capex tranches.
Structuring ESG-linked loans with coupons that step up would make ESG-linked loans eligible for collateralized loan obligations (CLOs), a $700bn+ market that makes up over 60% of the demand for leveraged loans, according to S&P Global Market Intelligence.
A few CLO issuers have ventured into sustainable investing by issuing negatively screened CLOs, which do not yet include ESG-linked loans. At least five European CLO funds have been issued since March 2018 with negative ESG screens to avoid weapons, gambling, tobacco, and pornography; and for the US market, two CLOs closed in August with explicit ESG restrictions from investing in thermal coal, landmines, and chemical weapons.
Channeling capital to negatively screened portfolios is an important first step for sustainability in structured credit. Greta Golz, Head of ESG Analytics at credit manager ZAIS Group, explains that securitization can do more to further sustainability: “The market is in a position to meaningfully engage corporations on their sustainability practices, and ESG-linked leveraged loans with coupons that step up and KPIs that are focused on material ESG issues would be an excellent fit for portfolios looking to address sustainability."
Nearly US$30bn of investment-grade ESG-linked corporate loans were closed in Europe during the first six months of 2019 in Europe, and the Masmovil ESG-linked loan could pave the way for further ESG-linked leveraged loan issuance.
- Expanding the Investor Base for ESG-linked Products
As we noted above, the interest rate ratcheting up broadens the appeal of ESG-linked products beyond banks seeking capex and revolver tranches of leveraged loans. Broadening the appeal of ESG-linked products beyond bank purchasers to asset managers and asset owners opens up over $100 trillion in potential demand.
And, Enel’s bond is the first time that a bond coupon—rather than the interest rate on a loan—moves based on a sustainability-linked KPI; this widens the range of potential investors to include those seeking exposure to ESG debt securities.
Further Broadening the Issuer Base Through Unconstrained Use of Proceeds: It’s Not Easy Being Green
More broadly, unlike green bonds, which fund projects with environmental and/or climate benefit, the funds raised by the Enel and Masmovil transactions are not contractually limited to a green use of proceeds. Enel has already issued three green bonds since 2017.
While sustainable finance enthusiasts can be encouraged by the record green bond issuance according to ratings agency Moody’s of $67bn during the second quarter of 2019 and the $117bn issuance during the first half of 2019, these numbers are still a small share of the total global long-term bond issuance of $17trn in 2018, according to the Securities Industry and Financial Markets Association.
An offshoot of green bond popularity, ESG-linked debt products have greater potential to scale given their greater flexibility on use of proceeds. In tandem with scaling, defining appropriate and material KPIs for ESG-linked debt products is critical to maximizing social and environmental impact. ESG-linked issuers and underwriters could look to the Green Bond Principles, Climate Bonds Standard & Certification Scheme, or sustainability frameworks like those developed by SASB or GRI for inspiration.
Rather than being green with envy, other bond and leveraged loan issuers and underwriters can emulate Enel’s innovation of ESG-linked coupons that step up, thereby scaling the sustainable finance market and furthering sustainability.
