A new financial instrument to encourage companies to be more virtuous
Faced with global social and environmental challenges, and in particular the threat of global warming, finance has an essential role to play. To this end, it now has a new instrument at its disposal:sustainability-linked bonds, which were used for the first time in September 2019 by Enel, the Italian energy giant, with a $1.5 billion issue.
Pascal Nguyen, University of Montpellier
This instrument is characterized by the fact that the issuer sets a specific target linked to one or more of the United Nations Sustainable Development Goals. Failure to do so results in a penalty in the form of a higher loan repayment.
The obligation thus allows companies to demonstrate their commitment in this area by agreeing to be subject to penalties in the event of even partial failure to fulfill these promises.
An incentive role
In practice, the penalty is fairly low. On average, it corresponds to 0.5% of the nominal value of the loan. In the case of a five-year bond, this additional cost amounts to a 0.1% increase in the annual coupon. Not really enough to give a CFO cold sweats.
However, the impact on the company's reputation will be greater if it fails to deliver on its promises. In addition to the penalty, its credibility could be seriously damaged. This will only become apparent at the end of the term, when progress is compared with the ambitions set at the outset.
Given that sustainable performance translates into higher value, it is likely that failure will lead to a decline in the company's value. Therefore, we can expect the company to make real efforts to keep its promises.
The obligations in question could therefore act as an incentive for companies to adopt more sustainable development practices.
At first glance, such an approach does not seem obvious. On the contrary, the pursuit of non-financial goals is often perceived as incompatible with financial performance. Recall the famous remark by Milton Friedman, Nobel Prize winner in economics, in his 1970 op-ed in the New York Times: "The sole objective of a business should be to create value for shareholders."
The world today would not be characterized by profound social inequalities and advanced environmental degradation if companies spontaneously took into account the social and environmental impact of their activities.
By subjecting themselves to the threat of penalties that could tarnish their image, companies are encouraged to serve stakeholders other than just their shareholders.
Schneider Electric gets involved
In most cases, the goals to be achieved are very demanding.
This is the case with the bond issued in November this year by Schneider Electric. The goal is to raise the company's rating on certain key indicators from its current score of 3/10 to 9/10. This is a significant improvement that the company is committed to achieving. In particular, Schneider aims to almost triple the reduction inCO2 emissions linked to the use of its products within five years and to train four times as many disadvantaged households in how to reduce their energy bills.
Similarly, Australian company Wesfarmers, which employs nearly 220,000 people in the distribution sector, has committed to the economic integration of Aboriginal peoples by increasing the proportion of this disadvantaged minority among its employees from 1.7% to 3%. The loan (in this case a loan rather than a bond) taken out with the Commonwealth Bank (CBA) last March provides for lower interest rates if the company exceeds its targets and higher rates if it fails to meet them.
In both examples cited, debt (bank or bond) associated with ambitious commitments reinforces the image of companies already recognized for their good practices.
This is why these companies take on such challenges, even at the risk of paying penalties: the benefits they derive from them are far from negligible.
Beneficial for issuers and investors
Firstly, the company's social reputation helps to recruit and retain talent. It also helps to build customer loyalty and makes customers less sensitive to bad news. This was revealed, among other things, by the recent health crisis.
Choosing a specific goal helps to rally teams around a project that everyone can easily understand and share. Employee engagement is a powerful driver of productivity that also promotesinnovation.
Investors also have everything to gain from these new instruments. A responsible company is more likely to take a long-term view, be more cautious, and be less likely to default financially. This is an attractive feature for debt holders. The lower interest rate that the company has to pay reflects its lower risk of default.
Investment funds can in turn demonstrate their responsible nature by holding securities associated with clearly identified sustainable development objectives. At a time when savers are increasingly concerned about the future of the planet and keen to invest their money responsibly, these sustainable development bonds have all the advantages to be widely adopted.
A promising instrument
The company has considerable freedom in choosing its objectives: they may relate to the materials (raw materials, liquids, energy, etc.) entering the production cycle, the waste (solid waste, effluents, greenhouse gases, etc.) leaving it, or the company's operations (proportion of women in the management team, proportion of disabled workers, etc.).. This prioritization will depend on the company's sector of activity and the communication channels it intends to focus on.
We can therefore expect EDF or Engie to issue bonds sooner or later linked to a promise to increase the share of renewables in their electricity production, as their Italian competitor Enel has already done.
In the steel and cement industries, which are among the largest emitters ofCO2, the main challenge is reducing emissions. LafargeHolcim based its bond issue on this criterion, raising €850 million last November. The target set was considered ambitious by the ISS rating agency in view of the cement manufacturer's past performance, which highlights the effort it will have to make.
Other companies will commit to increasing the proportion of recycled or sustainably sourced materials in their products.
With green bonds, whose use of funds is strictly regulated but which do not impose any specific targets on the issuer, sustainable development bonds are a useful addition to the range of financing tools designed to encourage companies to act more responsibly. We can bet that they will very quickly take center stage in the financial landscape of tomorrow.
Pascal Nguyen, Professor of Finance, University of Montpellier
This article is republished from The Conversation under a Creative Commons license. Readthe original article.