A new financial tool to encourage companies to be more environmentally responsible
In the face of global social and environmental challenges, and in particular the threat of global warming, the financial sector has an indispensable role to play. To this end, it has recently gained a new tool:sustainability-linked bonds, first used in September 2019 by Enel, the Italian energy giant, with a $1.5 billion issuance.
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. If it fails to meet this target, it is required to pay a penalty in the form of a higher loan repayment.
This requirement thus allows companies to demonstrate their commitment to these issues by agreeing to face penalties in the event of even a partial breach of these promises.
An incentive role
In practice, the penalty is fairly small. On average, it amounts to 0.5% of the bond’s face value. For a five-year bond, this additional cost amounts to an increase of 0.1% in the annual coupon rate. Not exactly enough to give a CFO a cold sweat.
However, the impact on the company’s reputation will be far greater if it fails to deliver on its promises. In addition to the financial penalty, its credibility risks being seriously damaged. This will only become apparent in the long run, when progress is compared to the goals set at the outset.
Given that sustainable performance leads to higher valuations, it is likely that any perceived failure will result in a decline in the company’s value. Consequently, the company can be expected to make a genuine effort to deliver on its promises.
These bonds could therefore serve as an incentive for companies to pursue more sustainable development.
At first glance, such an approach is not self-evident. On the contrary, the pursuit of non-financial goals is often seen as incompatible with financial performance. Recall the famous remark by Milton Friedman, winner of the Nobel Prize in Economics, in his 1970 op-ed in The New York Times: “The sole objective of a corporation should be to create value for shareholders.”
In fact, the world today would not be marked by deep social inequalities and severe environmental degradation if companies were to voluntarily take into account the social and environmental impact of their activities.
By facing the threat of penalties that could tarnish their reputation, companies are effectively encouraged to serve the interests of stakeholders other than just their shareholders.
Schneider Electric is getting in on the action
In most cases, the goals to be achieved are actually very demanding.
This is the case with the bond issued by Schneider Electric in November of this year. The goal is to raise the company’s rating on certain key indicators from the current score of 3 out of 10 to 9 out of 10. This represents a significant improvement that the company is committed to achieving. Specifically, Schneider aims to nearly triple the reduction inCO2 emissions associated with the use of its products within five years and to train four times as many low-income households on how to lower their energy bills.
Similarly, the Australian company Wesfarmers, which employs nearly 220,000 people in the retail sector, has committed to the economic integration of Aboriginal communities 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) combined with ambitious commitments reinforces the reputation of companies already recognized for their best practices.
That is precisely why these companies take on such challenges, even at the risk of paying penalties: the benefits they gain from doing so are far from negligible.
Beneficial for issuers and investors
For starters, a company’s social reputation helps attract and retain talent. It also helps build customer loyalty and makes customers less susceptible to bad news. This is one of the lessons learned from the recent health crisis.
Setting a specific goal helps rally teams around a project that everyone can easily understand and get behind. Employee engagement is a powerful driver of productivity that also fostersinnovation.
Investors also stand to gain significantly from these new instruments. A responsible company is better positioned to adopt a long-term perspective, operates more prudently, and is less likely to default financially. This is a valuable characteristic for holders of debt securities. The lower interest rate the company must pay reflects, incidentally, its lower risk of default.
Investment funds, in turn, can demonstrate their commitment to sustainability by holding securities linked to clearly defined sustainable development goals. At a time when investors are increasingly concerned about the future of the planet and eager to invest their money responsibly, these sustainable development bonds have everything it takes to gain widespread adoption.
A promising tool
The company has considerable freedom in choosing its objectives: these may relate to the inputs (materials, liquids, energy, etc.) entering the production cycle, the outputs (solid waste, effluents, greenhouse gases, etc.) leaving it, or the company’s operations (proportion of women in the management team, proportion of workers with disabilities, etc.). This prioritization will depend on the company’s industry and the communication priorities it intends to emphasize.
It is therefore likely that EDF or Engie will eventually issue bonds tied to a commitment to increase the share of renewables in their electricity generation, as their Italian competitor Enel has already done.
In the steel and cement industries—which are among the largest emitters ofCO2—the main challenge, for example, is reducing emissions. It was on this criterion that LafargeHolcim based the bond that enabled it to raise €850 million last November. The target set was deemed ambitious by the rating agency ISS given the cement manufacturer’s past performance, underscoring the effort it will need to make.
Other companies will commit to increasing the proportion of recycled or sustainably sourced materials in their products.
While green bonds strictly regulate how funds are used but do not impose any specific targets on the issuer, sustainability-linked bonds usefully complement the range of financing tools designed to encourage companies to act more responsibly. We can expect them to quickly take center stage in the financial landscape of the future.
Pascal Nguyen, Professor of Finance, University of Montpellier
This article is republished from The Conversation under a Creative Commons license. Readthe original article.