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 indispensable role to play. To this end, it has recently introduced a new instrument:sustainability-linked bonds, which will be used for the first time in September 2019 by Enel, the transalpine energy giant, with an issue of $1.5 billion.

Pascal Nguyen, University of Montpellier

Enrique del Barrio - stock.adobe.com

This instrument is characterized by the fact that the issuer sets itself a precise target, linked to one or more of the United Nations' sustainable development goals. If it fails to do so, it is required to pay a penalty in the form of a higher loan repayment.

The obligation thus enables companies to demonstrate their commitment in this area, by agreeing to expose themselves to a penalty in the event of any breach, even partial, of these promises.

An incentive role

In practice, the penalty is quite low. On average, it corresponds to 0.5% of the bond's face value. In the case of a five-year bond, this additional cost is equivalent to increasing the annual coupon by 0.1%. Not exactly enough to make a CFO break out in a cold sweat.

However, the impact on a company's reputation will be greater if it fails to deliver on its promises. In addition to the penalty, the company's credibility could be seriously damaged. This will only become apparent at the end of the project, when progress is compared with the ambitions set at the outset.

Given that sustainable performance translates into higher valuations, it is likely that failure will lead to a depreciation in the company's value. We can therefore expect the company to make a real effort to deliver on its promises.

The bonds in question could therefore act as an incentive for more sustainable development on the part of companies.

At first sight, such an approach is not self-evident. On the contrary, the pursuit of extra-financial goals is often seen as incompatible with financial performance. As Milton Friedman, winner of the Nobel Prize in Economics, famously remarked in an article published in the New York Times in 1970: "The sole purpose of business should be to create shareholder value".

Indeed, today's world 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 a penalty that could tarnish their image, companies are encouraged to put themselves at the service of stakeholders other than their shareholders.

Schneider Electric gets involved

In most cases, the goals are very demanding indeed.

Such is the case with the bond issued in November this year by Schneider Electric. The aim is to raise the company's rating on certain key indicators from the current 3/10 to 9/10. This is a considerable improvement that the company is committed to achieving. In particular, over the next five years Schneider intends to almost triple the reduction inCO2 emissions linked to the use of its products, and to train four times as many underprivileged households to reduce their energy bills.

Similarly, the Australian company Wesfarmers, which employs almost 220,000 people in the distribution sector, has committed itself to the economic integration of Aboriginal people by increasing the proportion of this disadvantaged minority among its employees from 1.7% to 3%. The loan (a loan rather than a bond) taken out with Commonwealth Bank (CBA) last March provides for lower interest rates if the company manages to exceed its targets, and higher rates if it fails to do so.

In both examples, debt (bank or bond) combined with ambitious commitments reinforces the image of companies already recognized for their good practices.

That's why these companies take on such challenges, at the risk of paying penalties: the benefits are far from negligible.

Beneficial for issuers and investors

For a start, a company's social reputation helps to recruit and retain talent. It also builds customer loyalty and makes them less sensitive to bad news. This is what the recent health crisis revealed, among other things.

The choice of a precise objective makes it possible to mobilize teams around a project that everyone can easily understand and share. Employee commitment is a powerful driver of productivity, which also encouragesinnovation.

Investors also stand to gain from these new instruments. A responsible company is more likely to have a long-term perspective, to be more cautious, and to be less likely to default financially. This is a valuable feature for the holder of a debt security. The lower interest rate the company has to pay reflects its lower risk of default.

In turn, investment funds can signal their responsible nature by holding securities associated with clearly identified sustainability objectives. At a time when savers are becoming increasingly concerned about the future of the planet, and are keen to invest their money responsibly, these sustainable development bonds have everything it takes to be widely adopted.

A promising instrument

The company has a great deal of freedom in the choice of its objectives: they may concern the materials (materials, liquids, energy, etc.) entering the production cycle, the discharges (solid waste, effluents, greenhouse gases, etc.) leaving it, or the way the company operates (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 lines of communication it intends to focus on.

So, sooner or later, we can expect EDF or Engie to issue bonds linked to the 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, for example, which are among the biggestCO2 emitters, the main challenge is to reduce emissions. This was the criterion on which LafargeHolcim based the bond that enabled it to raise 850 million euros last November. The course set was judged bold by the ISS rating agency in view of the cement maker's past performance, underlining the effort it will have to make.

Other companies will commit to increasing the proportion of recycled or sustainably sourced materials in their products.

Along with green bonds, whose use of funds is strictly regulated but which do not impose any specific objectives on the issuer, sustainability bonds are a useful addition to the range of financing tools designed to encourage companies to act more responsibly. We're confident that they will very soon occupy a prominent place in tomorrow's financial landscape.The Conversation

Pascal Nguyen, Professor of Finance, University of Montpellier

This article is republished from The Conversation under a Creative Commons license. Read theoriginal article.