Market Views

An Italian utility company missed their emission target: what does it mean for the Sustainability Linked Bonds (SLB) market?

On April 23rd 2024, Enel announced that it will raise the coupons on several bonds as a result of missing its 2023 Greenhouse-Gas (GHG) emissions targets. The bonds affected amount to EUR 10.3 billion and will now pay an estimated extra EUR 83 million in additional interest. The event – which in most part was the result of the European energy crisis – had been largely anticipated. Nevertheless, this is an important moment for the Sustainable Linked Bonds market.

What are SLBs?

Sustainability-linked bonds (SLBs) are debt instruments that link the cost of funding for the issuer to the achievement of predefined sustainability targets. Typically, SLBs will stipulate a step-up in the coupon in the event of the sustainability targets being missed. In rarer cases, the mechanism is reversed, and the coupon is stepped down for positive performance.

These instruments are still a niche in the broader sustainable finance market, and in 2023 they accounted to just 4% of all sustainable debt. Their structure, however, has the potential to make them a powerful transition finance tool. Differently from Green Bonds – where the use of proceeds must be earmarked to specific green activities – SLBs are a general-purpose funding instrument with a behavioral overlay. As such, they could play a significant role in providing transition finance and promoting the decarbonization of companies in hard-to-abate sectors, if the underlying targets are ambitious enough.

SLBs issued by EU Companies (2021 – 2024)
Source: own calculation based on Bloomberg LP data. As of 22/04/2024.

Do SLBs work?

The effectiveness of SLBs as an incentive mechanism hinges on two things: the ambition of targets and the size of the penalty. Greenhouse gas emissions are the most common SLB metric: from 2021 to 2024, companies incorporated in the EU issued a total of EUR 118 bn in SLBs, 62% of which had at least one GHG emission reduction target. For the majority of GHG-linked SLBs, targets cover only Scope 1 and Scope 2 emissions, leaving the more complex (and typically more sizeable) Scope 3 component out of the picture.

SLBs issued by EU companies (2021 – 2024) – Step-Up Distribution
Source: own calculation based on Bloomberg LP data. As of 22/04/2024.

The penalty for missing the underlying sustainability targets tends to be small for most outstanding SLBs. Out of all SLBs issued by EU companies between 2021 and 2024, 70% featured a step-up of 25 basis points or less. In only 5% the increase in the cost of funding for missing the target would exceed 75 basis points. Moreover, based on Bloomberg data, more than 60 % of outstanding SLBs issued by EU companies are callable, which many feared could further reduce the effectiveness of SLBs as a transition incentive.

What happened to Enel?

Enel Spa is the largest issuer of SLBs in the world, and one of the pioneers in this market that was only born in 2019. Enel has raised approximately EUR 27 billion raised across 28 SLBs, which is equivalent to almost 14% of the total SLB market. Between 2021 and 2022, Enel issued almost EUR 30 billion in SLBs, all including targets for the carbon intensity of electricity generation. The Group targets to reach 70% of sustainable finance sources as a share of total gross debt by 2026.

Five bonds – issued between June 2021 and January 2022 – featured a 25-bps step-up that would trigger if Enel’s failed to lower its 2023 Scope 1 emissions below 148 g CO2 per kWh. Enel had reported higher emission and higher thermal generation for the third quarter of 2023 on the back of Europe’s energy crisis, so by end-year it looked likely that the target would be missed. Enel is also not the first issuer of SLBs to be caught off guard by Europe’s energy crisis – with Greek utility PPC being as the first ever case of an issuer missing their SLB target last year.

The next key deadline for Enel’s SLBs will be in 2025, based on 2024 emission targets. If the company will have failed to bring its 2024 emissions below 140 g CO2 per kWh, a 25 bps step up will be triggered on the coupon of bonds issued in 2022 and worth EUR 5.1 billion. The company has been reducing its issuance of SLBs in 2023 and changing the framework – most notably, it started to also include targets for CapEX aligned with the EU Taxonomy. 

So far, Enel seems to be on track to meet its 2024 target. Despite the exceptional events, the 2023 miss has been small enough to keep Enel’s Scope 1 emissions below the net zero path it validated with the Science Based Target Initiative (SBTI), and the energy crisis has eased since. 2023 production data show that coal as a share of energy production declined to 5.2% from 8.7% in 2022 (-40%). Generation from other conventional sources also decreased, whereas generation from renewable sources increased by 13%.

Enel – Net Zero path (Scope 1 GHG)
Source: own calculation based on Bloomberg LP data. As of 22/04/2024.
Source: own calculation based on Bloomberg LP data. As of 22/04/2024.

What does this mean for the SLBs market?

Conceptually, SLBs can be a powerful tool to finance the transition. So far, however, the effectiveness of SLBs in incentivizing change had been dubious and untested. The Enel case changes the picture in three important ways.

First, it shows that SLBs targets can be missed – challenging the argument that SLBs are useless because companies will only set targets that they are sure to meet. This perception is so strong that while Enel’s coupon step-up was largely expected, it was still not fully priced in (as evident by Enel’s SLB outperforming equivalent regular bonds on the news).

Second, it shows that if things go wrong, the financial impact can be significant even if the individual bonds feature small step-ups. While the step-up may look small when compared to the total cost of debt for the Enel group, the annual interest expense on the bonds that were triggered went up by ca 9% – which is significant. 

Third, it shows that callability does not necessarily kill credibility. The bonds documentations included a clause whereby failure to meet the targets due to factors outside the company’s control would not result in step-up being triggered. Enel chose not to use those clauses, which send a strong message of credibility to investors.

Following a drop in issuance in 2023, the latest events place the SLB market at a crossroad. The three lessons from the Enel case suggest that SLB can offer investors a valuable pay-off for missed emission targets and that they can work as a transition incentive if targets are ambitious. But in a non-standardized and relatively un-transparent new market segment, there is also a risk that companies will lower the ambition of SLBs targets to reduce the risk of being caught off guard.

As Europe is currently the largest market for behavior-based debt instruments, this is a strong argument for the introduction of an EU standard for SLBs – similarly to the recently approved EU Green Bond Standard. The standard should include a set of relevant and common KPIs to be used for SLB issuance, criteria to ensure ambition in target setting (e.g. a ‘waterfall’ plan for SLB maturities covering the full decarbonization path), and a methodology to evaluate the credibility of transition plans including ideally independent verification (e.g. by the Science Based targets Initiative, or similar institutions). This would allow unlocking the full potential of SLBs as a transition finance tool, while reducing the risk of greenwashing.

Silvia Merler, Head of ESG & Policy Research (Algebris Investments)

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