When Italian energy giant Enel announced in April that it had failed to meet the carbon emissions reduction goals in a third of its sustainability linked bonds (SLB), it exposed significant deficiencies in a once-coveted form of loan aimed at reining in climate-altering carbon emissions.
It also raised concerns about whether companies such as Enel and the banks that underwrite the sustainability linked bonds were truly interested in combating climate change or in merely making misleading claims of being environmentally friendly, a practice known as greenwashing.
Enel was the first and largest corporate issuer of sustainability linked bonds, which are a form of green bonds that raise capital for general corporate purposes rather than for specific renewable energy projects. With SLBs, a discounted rate of about 10%-15% is tied to reaching certain sustainability indicators, such as decarbonization metrics, renewable energy consumption or generation, and the volume of recycled materials.
At their debut in 2019, sustainability linked bonds were welcomed as a way for industrial companies and banks to show that they were taking steps to achieving net-zero emissions by 2050. With the bonds, climate change could even be addressed by heavy polluters, such as automakers or steel manufacturers, which otherwise might not have projects eligible for traditional green bonds.
Initially, the sustainability linked bond market grew rapidly, soaring to over $100 billion in global volume in 2021. But since then the market has hit a wall. In the first quarter of 2024, the global SLB volume peaked at $3.1 billion, down 37% from the same period the prior year. Experts attribute the steep drop to growing investor concerns that the bonds are failing to induce any real reductions in carbon emissions.
Enel missed its target for direct emissions by about 8%, a deficiency that triggered an automatic 0.25% increase in the interest rate on the affected bonds. The financial hit was relatively minor, amounting to around $100 million over the remaining life of the bonds for a company whose annual revenue was $103 billion last year.
Enel attributed the shortfall to higher-than-expected coal-based electricity generation, in part mandated by the Italian government in the wake of the Russian invasion of Ukraine and the subsequent disruption in European gas supplies. But that explanation did not temper reactions in the sustainability linked bond market. Enel had embraced SLBs as part of a well-publicized strategy to develop a business model in line with the Paris Agreement to limit the average global temperature increase to 1.5 degrees Celsius.
In the wake of Enel’s failure to meet its emission goals, concerns grew that if the sustainability linked bonds were insufficient to ensure that Enel’s highly motivated sustainability program reached its goals, what were the odds the bonds would have a consequential impact on the decarbonization efforts of a less committed bond issuer?
Moreover, investors and underwriters supporting the sustainability linked bond market—a group that in Enel’s case included major financial players such as BNP Paribas, Crédit Agricole, Citigroup, Commerzbank, Goldman Sachs, JP Morgan, and Societe Generale—often did so to claim these instruments as part of their “green” portfolios.
“SLBs can be a valuable climate change tool, a difference maker, but two things are necessary: The target goals must be ambitious, offering a credible decarbonization pathway, and the consequences of failing to meet those goals must be a deterrent to falling short,” said Kevin Leung, a sustainable finance analyst at the Institute for Energy Economics and Financial Analysis.
Despite the high hopes for sustainability linked bonds, about 86% of the 800 bonds that so far have been issued lack adequate greenhouse gas reduction targets to achieve global climate change goals, according to Climate Bonds Initiative, which analyzes the green bond marketplace.
In general, the bonds’ sustainability indicators are either too ambiguous or too shortsighted to align with science-based carbon abatement solutions or their monitoring protocols are not sufficiently robust or transparent—shortcomings often ignored by investors. As a result, a Climate Bonds analysis of more than 150 bonds from top issuers through November 2023 found that in about half of the cases, companies are not on track to meet their climate goals or have failed to provide evidence of their progress. Only 25% appear to be on target to reach their goals.
French oil and gas major TotalEnergies provides an apt illustration of the gap between the purpose of sustainability linked bonds and their results. In 2021, Total announced that all its future debt would be issued as SLBs, linked to its climate targets. To kick off this strategy, in January 2021 Total issued about $3.2 billion in SLB-style bonds with an average interest rate of 1.875%, in part to further its development of nonfossil fuel energy sources, the company said. Total reveled in the discounted cost of capital, describing it as “comparable to that of pure players in renewables.”
To get this advantageous rate, Total did the minimum, offering only generic claims about its sustainability initiatives, including the promise of a mere 20% reduction in the carbon intensity of its oil products by 2030, when most companies would aim for a more robust reduction. Total also stated, without any guarantees, that a transition to renewable energy was its unwavering priority. No scheduled metrics for monitoring the organization’s performance was included in the loan.
By contrast, a more robust goal was laid down by Kinetik, a U.S.-based natural gas company that issued nearly $4 billion in sustainability-linked bonds in 2022 and 2023. The company has targeted a 35% reduction in greenhouse-gas emissions from its operations by 2030.
Even Total’s vague assurances appear to run counter to Total’s actual plans. In 2030, two-thirds of Total’s capital expenditures will still be earmarked for oil and gas with nearly half for new fields, according to an analysis by Oil Change International. By that time, oil and gas will account for 80% of Total’s energy mix, compared with 95% in 2021, which actually means that Total’s fossil fuel production will increase by about 3%, a separate report by Reclaim Finance found.
But if Total has become a symbol of how sustainability linked bonds can be misused and rendered toothless, the company’s lenders have not been put off. During shareholder votes about Total’s decarbonization policies, investment managers Amundi and AXA said that by merely vowing to focus on energy transition,Total has proved its intention to adopt more ambitious climate targets over time. And BlackRock said it was satisfied that Total’s “stated carbon neutrality strategy meets our expectations of a company committed to the energy transition.”
In fact, global asset manager BlackRock believed that Total’s enthusiastic embrace of sustainability linked bonds was evidence enough that it would ultimately achieve net zero goals. That justification for supporting Total’s debt has not aged well: In April, three years after announcing its SLB strategy and issuing debt at discounted interest rates, Total said it was abandoning the approach. According to one analyst who follows SLBs closely but asked to remain anonymous because of his relationship with other companies he does business with, Total’s investors told him they had become less willing to give the company discounted loans for empty promises and little headway towards addressing climate change.
Most sustainability linked bonds are more explicit about targeted outcomes than Total’s bonds. But that only highlights a fundamental flaw in this type of debt. Generally, the issuers meet or come close to their goals only because their metrics are not particularly difficult to achieve—in some cases, reflecting results reached prior to the bond issuance—or are not connected to the way a particular company can impact climate change.
Compounding matters, some of the most crucial measurements of decarbonization are often absent from sustainability linked bond goals. Scope 3 emissions, those that occur outside an organization’s direct control and usually account for the largest source of a company’s carbon output, aren’t covered in 70% of sustainability linked bonds underwritten by top issuers. Estimating Scope 3 emissions is difficult, but there are ways to cover these greenhouse gases, such as metrics that measure the share of renewable energy in a supply chain, or the percentage of a company’s products recycled by consumers.
On the demand side of sustainability linked bonds, the pricing and penalties mechanisms are also contributing to the deficient key performance indicators (KPI), the metrics used to measure environmental performance.
“The major problem here is that the link between KPIs and the interest rate paid in the loan is weak,” said Joachim Klement, a London-based investment strategist. He and others believe that the discounts of a few basis points that issuers receive are not large enough to entice companies to undertake an expensive and potentially disruptive decarbonization program. Moreover, the penalties for not meeting climate change goals—generally a 0.25% increase in interest rates—are too weak to deter missed targets, especially for big companies like Enel. Since sustainability goals take time to reach, companies can often enjoy interest discounts for several years before paying a step-up for a short period until the bond matures.
Unless sustainability linked bonds (and other green bonds) begin to play a perceptible role in addressing climate change, net zero and global temperature goals are likely impractical and out of reach. And to a large degree, that puts the onus on financial backers and underwriters to set the SLB market straight, demanding meaningful and carefully defined environmental improvements in return for real and advantageous interest rate discounts—and to require strict and scientific monitoring protocols to certify the key performance indicators are met.
Additionally, if SLB shortcomings are not addressed, regulators may ultimately determine that these bonds should not even be categorized as green investments. That possibility has already made sustainability linked bonds less attractive to some investors, say experts.
Still, many climate change investment supporters are hopeful that SLBs can play a constructive role in corporate decarbonization and provide a venue for credible green investments. It is somewhat fitting, perhaps, that it took bond defaults by Enel, a true believer in using lending as a cudgel against climate change, to inspire a reckoning about sustainability linked bonds.
— Jeffrey Rothfeder, Capital & Main
This piece was originally published by Capital & Main, which reports from California on economic, political, and social issues.