Climate penalties to be built in to more debt issuances

More countries are exploring issuing new innovative bonds that penalise them for failing to meet climate change targets, in an effort to win over investors wary of issuers’ commitment to sustainability.

A number of governments appear ready to follow Chile and Uruguay, which issued $2bn and $1.5bn in sustainability-linked bonds, respectively, last year, a world first. Such bonds offer higher payouts to investors if issuers fail to deliver on their nationally determined emission cuts under the Paris climate agreement.

Adding such a green ‘slap on the wrist’ to national debt issuances could help ease fears that countries plan to backtrack on decarbonisation pledges, say analysts, and also widen the pool of capital available to sovereigns with poor track records on sustainability.

“We are having regular discussions with quite a few of our sovereign clients on the sovereign sustainability-linked bonds,” said Stéphane Marciel, head of sustainable bond, debt capital markets at Societe Generale, which acted as joint structuring adviser and joint bookrunner in Chile’s bond last year.

Following Uruguay’s inclusion of a deforestation target in its issuance in October, Brazil’s recently elected leftwing president Luiz Inácio Lula da Silva, who has pledged to reduce logging to zero in the Amazon, could be next in line to try to issue an SLB, said Alvaro Vivanco, head of emerging markets strategy at NatWest Markets.

And a banker who helped structure Uruguay’s bond last year said he was advising a number of countries that were preparing to issue in 2023. “When your neighbour buys a veranda, you start asking yourself if you are going to put one in as well,” he said.

Growing interest in the new flavour of debt also reflects concern that green bonds — a separate type of financing which can only be used for specific projects — have no bearing on a country’s overarching sustainability performance. They can also prove frustrating for Treasuries which must ringfence the cash.

The Netherlands has said it would consider issuing sustainability-linked bonds in future. Other countries are also holding exploratory talks.

In its bond, Uruguay introduced a 0.15 percentage point coupon “step down”, which would make its debt cheaper to service if it stays true to its word on the climate.

“These steps up or downs . . . are signals the issuers are sending that they are serious, and in most cases genuinely want to do something to improve their footprints,” Vivanco said.

But doubts remain. Having once been touted as the future of green investing in the corporate sector, interest is now flagging among such issuers, because investors are not convinced that the penalties for failure are sufficiently stringent.

Corporates issued around $60bn of SLBs last year, fewer than in 2022, amid concern that issuers were not choosing strong enough targets.

“We need a rigorous approach. Three-quarters of the corporate side have been crap historically,” said Sean Kidney, head of the Climate Bonds Initiative, a non-profit organisation.

Analysts also question whether the deals by Chile and Uruguay, two politically stable countries with low debt levels, can be replicated in less developed markets, which need more capital to reach energy transition goals but have a smaller pool of possible investors.

While emerging markets like Rwanda are seen as possible issuers, an SLB clause by itself is unlikely to make small countries in debt distress more attractive to lenders. “If you’re an investor trying to make a difference you have to be comfortable with the sovereign credit risk that comes with that,” Vivanco added.

Another problem is that investors could find a coupon step-up unpalatable, even though they would benefit financially, because of the perception that higher repayment rates on national debt would punish taxpayers.

Ozgur Altun, associate director of sustainable finance at the International Capital Markets Association, a Zurich-based trade body, said growing interest in SLBs was a response to anxieties that an issuer’s climate profile could damage creditors’ reputation. “Investors don’t only look at how green the bond is but how it fits within the sustainability and environmental strategy of this issuer . . . you need to score well on both sides.”

Issuers should aim to set a target “well below two degrees of warming”, across all categories of carbon emissions, and in the most polluting sectors, according to standards for corporate sustainability bonds worked out by the industry. It plans to issue similar standards for sovereigns later this year.

Some in the market predict softer deals known as “debt for nature swaps”, debt repackaging deals with biodiversity commitments attached. Belize’s stock of external commercial debt was restructured by Credit Suisse and The Nature Conservancy last year in exchange for a promise by the central American country that it would spend more on marine conservation.

Simon Zadek, chair of an initiative by the Swiss non-profit Nature Finance to promote sustainability-linked sovereign debt, said this type of deal was an “experiment”, likely to be replicated elsewhere this year.

SocGen’s Marciel said sovereign SLBs were difficult to implement and their rollout would take time. “It’s a big commitment and a highly political decision,” he said, noting that the energy crisis triggered by Russia’s invasion of Ukraine had created pressure on some countries to increase fossil fuel plans.