April 16, 2021

Bond… Green Bond

Like many of you, I anxiously await the release of the new James Bond film No Time to Die. Sadly, this will be Daniel Craig’s final turn at the role, who in my opinion has been the finest Bond ever. It may also be the last time we see Bond’s stunning Aston Martin DB5. Although after the car’s total destruction in Skyfall, Q did rebuild it for the subsequent Spectre, so maybe there is hope.

One bond that isn’t going away is the sustainability-linked bond (SLB) – at least according to JPMorgan Chase. Last month, Marilyn Ceci, global head of the bank’s ESG developed capital markets (DCM) group offered this prediction:

The SLB market will grow from $6.9 billion (the volume for January-March 2021) to $100 – $130 billion before the end of 2021. She expects the global issuance of green bonds generally to grow almost 50% – to around $690 billion – in 2021 alone.

Shortly after Marilyn made that comment, BlackRock announced a $400 million expansion of a $4 billion revolving credit facility in which it pays slightly lower fees & interest if it meets targets for women in senior leadership and Black and Latino employees in its workforce. The filed amendment contains specifics. We don’t know whether it was BlackRock or its lenders who wanted to add these terms to the debt deal – it helps both sides show that they’re making commitments to ESG, and it could add momentum to the SLB trend.

The first SLB was issued in 2019, meaning SLBs are a newer subset of the broad category of green bonds. SLBs are an interesting animal, offering both carrots and a stick to issuers.

The carrots: SLB proceeds can be used for general corporate purposes rather than being limited to a specific green or social project, and the issuer gets a reputational bump for offering a sustainability instrument.

The stick: if the issuer misses the sustainability goals/performance metrics, they must pay bondholders a premium that is established at issuance. Some are saying this is a different shade of “say-on-climate” – with bondholders determining whether the metrics are appropriate and whether they’ve been satisfied.

Another unique aspect is the economic certainty of SLBs. When evaluating green upsides, much uncertainty is built into predictions – global market conditions, mercurial consumer behavior, pricing dynamics, supply chain risk. It can be difficult to demonstrate the ROI on expenditures related to sustainability performance monitoring or not achieving the sustainability goals. SLB covenants, on the other hand, specifically define the real cost of missing the mark – pre-emptively answering certain “what if?” questions and making an ROI calculation for project monitoring costs more defensible than other green investments.

What You Can Do

If you have the opportunity to raise capital through SLBs, how can you make sure you can verify that you’ve hit your targets? First, knowing the cost of missing SLB sustainability goals in advance should make it easy to justify monitoring and assurance efforts – but here are some wrinkles that could arise:

– Is the company using emissions offsets to achieve at least part of its GHG reduction commitments? There are meaningful risks associated with offsets (see my blog below!) – therefore, additional monitoring activities are warranted.

– Are SLB targets related to social or workplace condition improvements in the company’s supply chain? Companies should consider augmenting industry-wide supplier audit/monitoring programs by either participating directly or engaging qualified third parties to conduct supplier evaluations in parallel with – or as a replacement to – industry programs.

– How is raw data concerning the goals collected and verified? Automated systems such as meters and probes are great, but they are not flawless and need ongoing maintenance. Procedures to detect errors or failure should be put into place and it may be optimal for those to be manual to some extent.

Carbon Offsets: Widespread “Sustainability” Practice is Under Internal Review

Liz blogged a few weeks ago about investors specifically discouraging portfolio companies from using carbon offsets to achieve net zero goals.  As reported in this piece by World Oil, the Nature Conservancy is also launching an internal review of its carbon offset & trading projects and procedures.  Offsets have a long history of controversy, misuse and fraud, yet play an outsized role in corporate Net-Zero pledges and strategies.

This is big news, as WorldOil points out:

The internal review is a sign that it’s [The Nature Conservancy] at least questioning some practices that have become widespread in the environmental world, and could carry implications for the broader market for carbon credits.

Carbon offsets can be a viable tool in corporate greenhouse gas reduction plans. It’s tempting to wave a hand, write a check and not give it much consideration.  Yet offsets carry a large amount of risk in the mid to long term – both on a project-specific basis and in terms of maintaining a credible market.

To be valid, offsets are supposed to be “additional” – meaning that they arise from an activity that would not have occurred otherwise.  As an example, offsets for not cutting trees that were intended to be harvested meets the “additionality” definition. But if those trees were never to be harvested, offsets cannot be claimed for doing nothing. Also, plant-based offsetting assets such as trees can disappear before their “job” is done, meaning the expected – and contracted – carbon uptake is incomplete. Forest fires, droughts, infestations, regulatory changes, nationalization/imminent domain and illegal harvesting are very real threats to their ability to absorb the promised amount of CO2 over the decades typically needed.

The article states that “in 2020, companies purchased more than 93 million carbon credits,” and the emissions trading market is expected to exceed $100 billion in the coming decades. That is a lot of hot air needing global credibility.

What You Can Do

If you’re using carbon offsets as part of your net-zero strategy, it’s good to be aware that they’re not a full solution – and that they’re coming under additional scrutiny right now. It’s not a bad idea to work with your internal risk management group to conduct a risk assessment exercise. Among the potential perils:

– Reputational risk

– Contract breach

– Customer mandate non-conformance

– Loan and bond covenant breach

– Regulatory non-compliance

– Materiality disclosure non-compliance

– Third-party exposure

Once the risk picture is in focus, you can develop specific mitigation strategies – such as:

– Risk transfer (such as insurance and contractual terms)

– Verifying project assumptions, calculations, controls and technologies

– Direct involvement in project verification, monitoring and auditing

– Contingency plans for offset losses

– Rebalancing the mix of tools used to achieve reductions

– Reconsideration of greenhouse gas commitments or strategy

Biden Infrastructure Plan May Pay to Avoid Emissions

Speaking of carbon offsets, here is an interesting thought. Biden’s Infrastructure Plan announced March 31 includes a proposal to

reform and expand the bipartisan Section 45Q tax credit, making it direct pay and easier to use for hard-to-decarbonize industrial applications, direct air capture, and retrofits of existing power plants.

For a short refresher, Section 45Q values a metric ton of qualified avoided CO2 emissions at $50 (for geologic capture/sequestration) or $35 (for other methods of capture/sequestration). As a tax credit, it only applies to the owner of the carbon capture/sequestration equipment or user of the captured CO2.

But changing to a “direct pay” model could open the doors to innovative revenue sharing arrangements between electricity producers, capture/sequestration technology providers and even other parties.

After all, Q is all about innovations for Bond.

Lawrence Heim