What happens if the biggest name in the sustainability-linked bond (SLB) market misses its targets on bonds worth a total of $10.8 billion? That’s what the market could find out if Italian energy company Enel misses its CO₂ emissions targets at the end of this year.
Research from the sustainable finance think tank, Anthropocene Fixed Income Institute (AFII), reckons that this event is very likely and that it would trigger the largest step-up in the history of the SLB market. The step-up on all 10 bonds is 25 basis points and, if triggered, it would lead to an annual increase on Enel’s coupon payments of around $27 million.
The bonds have sustainability performance targets (SPTs) around reducing Scope 1 CO₂ emissions intensity in power generation. They were issued between July 2021 and June 2022. Five are US dollar bonds, while the others are denominated in euros. The tenors vary, with some maturing in 2025 and others in each year until 2030.
Enel’s plan to meet its targets was based on Europe’s pre-Ukraine war transition from coal to gas. However, changes in energy policy followed concerns over energy security after the Russian invasion of Ukraine in February 2022.
Enel’s plan to meet its targets was based on Europe’s pre-Ukraine war transition from coal to gas
Issuers have triggered step ups before. Greece’s Public Power Corporation (PPC) missed its CO₂ emissions target for its €775 million SLB at the end of 2022. The five-year bond was issued in March 2021 and included a coupon step-up of 50bp from 2023 if it missed its target of reducing scope 1 CO₂ emissions by 40% before the end of 2022. Like Enel, the company’s strategy was heavily impacted by the change in the energy policy in Greece following concerns over the security of gas supplies.
According to Fitch, the impact on PPC’s cost of financing was limited and resulted in neither a significant bondholder sell-off nor a change in its pricing in the secondary market – despite 60% of bondholders being environmental, social and governance-labelled funds. The agency attributed this to the view that it was not a change in PPC’s sustainability strategy that had caused the company to miss its targets.
The outcome of Enel’s 2023 observation date has already attracted attention in the media and is expected to have a much bigger impact due to the size of the step-up and the firm’s position as a flagship issuer. Enel has issued 30 SLBs since 2019 with a total value of $31.1 billion, that’s almost four times larger than that of the second-largest issuer, Chile, which has five SLBs totalling $8.1 billion, according to AFII.
Market reaction
There are two ways to look at this. The flagship issuer missing its CO₂ emissions targets can be seen as a sign of the weak sustainability impact of these instruments. Or it can be seen as evidence that the market works as it should.
Important to this second perspective is the fact that Enel is not legally required to pay a step-up if it misses its targets. This is because of a force majeure clause that allows the company to change its baseline if there is an event outside its control that impacts its ability to meet them. A regional war and its impact on energy policy should fall into that category.
But Enel has said it won’t invoke the clause. The negative long-term impact of doing so would be to reduce investor confidence in the SLB market, to which the company is heavily committed. The company has not issued any non-SLB senior unsecured debt since 2019.
All eyes will be on the market reaction. The observation date for the targets is the end of 2023, but it won’t be until Enel reports in the first quarter of next year that it will be clear whether they were met or not.
Right now, Enel’s bonds with the 2023 observation date are trading tighter than those that have met SPTs in the past, according to AFII analysis, indicating that the step-up has been priced in.
This discount should translate through to primary market pricing, where issuers are rewarded for more ambitious targets through lower cost of capital, because the higher chance of receiving a step-up is priced in at issuance.
Of course, it’s not great PR for the SLB market if the flagship issuer misses a significant target. But this is how the market is meant to work. It shows that issuers are taking on ambitious targets rather than ones that they’ve comfortably already met.
