Chile’s decision to become the first sovereign borrower to issue a sustainability-linked bond takes it far ahead of the pack of other governments in sustainable finance.
It is a bold move for several reasons. Despite Russia’s invasion of Ukraine, and the extreme volatility and uncertainty that has dogged markets since, the sovereign has taken the plunge and launched a dollar deal that is expected to be priced on Wednesday, March 2.
Some market participants have been warning that market conditions are too weak for such a novel venture, particularly as it involves issuing long dated bonds — a 20 year dollar security, followed perhaps on Thursday by a 15 year euro.
The structure is also a tough one for sovereigns to get right, given its complexity and novelty. But when the market volatility dies down, there should be a good chance that the country may come to be seen as a pioneer, for introducing this fast-growing financing technique to national governments.
The deal will not be the first from the public sector. In late January, Sweden’s City of Helsingborg issued what is thought to be the first SLB by a government issuer, and more is expected from municipalities.
Chile is far from the first nation to consider SLBs, either. Uruguay began working on a project in October 2019, very soon after Enel, the Italian power and gas company, introduced the structure to the market. Chile, on the other hand, has been working on it only from the second half of last year.
But if Chile can establish a convincing precedent, which other nations are tempted to follow, it could open up a vast issuer base to the product. In so doing it would also bring in a new set of investors — official monetary institutions — to this new, powerful form of ESG finance.
Market mushrooms
The SLB and its older sister the sustainability-linked loan have been success stories over the last three years. Volumes have rocketed — $96bn of SLBs were issued last year, up from just $6.8bn in 2020, while $604bn of SLLs were signed in 2021 against $162bn in 2020.
The instruments have found fertile ground among both sustainable finance investors and — so far almost entirely corporate — issuers.
They offer a different approach to sustainable finance from green and social bonds. Use of proceeds bonds continue to have their fans among investors, who like the feeling that their particular money is used for specific beneficial purposes. But despite 10 years of superb marketing for all those that have issued, arranged and invested in them, they have rarely proved to be truly additive, by financing activities that were not already going to receive funding.
SLBs do not offer the one-to-one attribution of proceeds to specific projects, but commit the whole organisation to achieving certain targets of improvement. For their supporters, this is a more holistic and some would say a more powerful way to steer the issuer towards sustainability.
Proponents of both structures argue that they enable issuers to finance real, positive change. Both can enable issuers to garner improved pricing and a wider investor base.
Certainly, ESG-linked bonds and loans are a nifty way for borrowers — green or, perhaps more importantly, grey, as well as those in between — to tie their financings directly to their sustainability ambitions, enabling them to very publicly convey their strategies.
The types of key performance indicators to which bonds and loans are being tied is extremely varied and growing all the time, ranging from greenhouse gas reduction and increasing the use of renewable energy — as Chile intends — to energy efficiency, recycling waste, water consumption, women’s empowerment in the workforce and even distributing medicines in developing countries.
Barriers to expansion
But the product has stayed almost entirely within the confines of the corporate sector. Berlin Hyp, the German mortgage bank, ventured out in April last year with the first SLB from a financial institution, a €500m 0.375% 10 year preferred senior bond. The coupon will rise by 25bp if Berlin Hyp fails to cut the carbon intensity of its loan book by 40% by 2031.
Despite the deal’s success, many believe it might be the last from that sector after the European Banking Authority poured cold water on the structure for banks.
It objected that coupon step-ups, especially if associated with call options, would conflict with the eligibility criteria for regulatory debt. Step-ups could act as an incentive for an issuer to redeem its debt, which is outlawed under EU capital standards.
The other big sector that has been missing out is sovereigns, supranationals and agencies, which led the way in green bonds a decade ago.
For supras and agencies, there are two clear reasons. Most of them are banks, meaning it is fairly straightforward and transparent for them to issue green bonds tied to specific green loans.
Their governance could also make it difficult. They have to follow policies set by their shareholders, national governments and groups of nations. It might be difficult for them to engage in a financial instrument which would entail paying a penalty rate if their policies later change.
Hostages to fortune
For sovereigns, the obstacles are more complex and nuanced, but nevertheless significant.
They may worry about muddying the waters for their very conservative investor base, which have only just got to grips with new-fangled use of proceeds bonds. After all, Germany and Denmark took a long time to issue green bonds because they were anxious not to fragment the liquidity of their debt curves.
But a more significant objection is likely to be the sustainability targets themselves.
Governments are of course free to decide their own actions. But they face aggressive scrutiny — from the public, the media and political opponents, as well as investors.
Tying a bond’s interest rate to sustainability targets means the state runs the risk of missing the targets and embarrassing itself in front of the electorate (cue social uproar) and investor base (cue potential selling — no ESG-conscious fund is going to like a borrower missing sustainability pledges).
Even before the targets have been hit or missed, the government could be attacked for being too unambitious, or for tying the hands of a future government, imposing a potential future cost on taxpayers if policies change. Fifteen and 20 years, in Chile’s case, is a long time.
These drawbacks could be neutralised if governments could demonstrate that the bonds priced at new issue substantially tighter than their ordinary debt — but such a greenium would need to be of a decent size, and proving any such advantage is always difficult.
The fact that Uruguay has not yet managed to bring its deal to market is testament to the thorniness of achieving political support for such a transaction.
For all these reasons, Chile’s move is a genuinely bold and exciting one.
An alluring prize
It may take a while for other sovereigns to emulate it. But in time, the structure is likely to attract adherents, for the same reason Chile wants to use the instrument.
It makes a crystal clear statement about the country’s sustainability ambitions. Chile has committed to reducing its absolute greenhouse gas emissions by 15.4% between 2018 and 2030, to 95m tonnes of carbon dioxide-equivalent, and not to exceed 1,100 tonnes of total emissions this decade.
Secondly, Chile has pledged to have half its electricity generation come from non-conventional renewable energy sources by 2028, and to hit 60% by 2032.
Critics of SLBs often argue that the targets are not ambitious enough, and that the instruments are not additive because the issuers were aiming for the targets already.
Certainly, Chile had already set itself these goals. But SLBs are an unusually powerful way for a government to proclaim that it believes in its targets and in its own ability to meet them.
For confident governments that want to convince the world they believe in sustainability, the instrument is likely to be attractive. Sustainability-linked finance is a real chance for sovereigns to back up the rhetoric of their politicians with real financial incentives.
Eventually, when momentum builds, they could become a must-have, as green bonds now are.
If Chile can get its bond away successfully, its president and finance minister will be the only ones at COP27 able to walk the ESG finance walk in Sharm El-Sheikh.