ESG finance: When missing an emissions target makes your “sustainability bonds” more valuable

A cynical take on modern capitalism identifies a tension between making profits and ‘doing good’. Enter the innovation of Environmental, Social and Governance (ESG) investing. ESG investing intends to direct the invisible hand of the private markets to hold companies to higher ethical standards, rather than leaving this just to governments. In practice, this does not necessarily work, as was the case with Enel’s sustainability bond ‘default’ last month.

When assessing companies, ESG investors consider factors beyond just financial performance. The idea is that companies doing well on ESG metrics are rewarded with friendlier investors and lower capital costs. Thanks to their good behaviour, real or perceived, their securities are expected to outperform, at least long-term. Yet this approach can also have perverse outcomes.

This concoction of financial, environmental, social and governance considerations sometimes resembles a child preparing a meal of their favourite foods. They might serve up a strangely delicious but nevertheless revolting blend of chocolate, chicken nuggets and spaghetti.

Tesla is a leader in decarbonising transportation but has relatively low ESG ratings because of Elon Musk’s errant tweets. Supposedly well-governed oil companies can be found highly ranked on ESG factors, despite their uninspiring carbon emissions records. Investors targeting emissions reductions might erroneously back the wrong companies if they rely solely on ESG composite metrics.

Another recent illustration of how ESG investing can be inconsistent with its purpose is how Sustainability-Linked Bonds (SLBs) incentivise behaviour. SLBs reward companies with reduced interest rates for meeting agreed ESG targets, or rate rises for missing them. The problem is that short-term profits simply seem to matter more than being sustainable.

Enel, a multinational energy major and one of the largest carbon emitters globally, missed a carbon emissions target last month by 8%. This target is linked to €10 billion of SLBs, and triggered an €83 million increase in interest payments - the largest ever penalty incurred by SLBs.

Bizarrely, this was lauded as a success for the SLB market, “showing that targets can be ambitious” as published in Bloomberg. The fact that Enel breezily missed the mark in favour of paying more interest shows quite the opposite.

Despite making a commitment to reduce carbon emissions, Enel used the European energy crisis as cover to delay the necessary business changes to meet their targets. Energy crisis or not, the SLB penalty represents a tiny portion of their costs. The €83 million increase is a mere 2% of 2023 interest expenses (€3.5b), or 1% of pre-tax profits (€7.4b). It is utterly predictable that this financial slap on the wrist would not drive major business decisions to cut emissions.

Furthermore, investors bought more of the Enel SLBs after they missed their sustainability goal.

All else being equal, a bond that unexpectedly starts paying more interest becomes more valuable, increasing its price. However, when a company misses a financial target that triggers a debt penalty, this typically signals distress to investors. Despite the higher interest payments, demand for bonds often decreases in this situation, because investors may doubt whether a company can comfortably pay its interest or principal in future. The bond becomes a riskier investment, typically reducing its price.

In Enel’s case, nothing fundamentally changed about the business, and investors’ SLB demand increased because of its higher coupon. They were not fearful of Enel’s missed targets and what that might mean for the environment or the company’s viability. Instead, they doubled down. Perhaps they never cared whether Enel would meet those targets in the first place. 

SLBs are an imperfect wrench in the ESG investor’s dysfunctional toolkit. It’s tempting to hope that influencing companies through investment will have more societal impact than through the government, as private markets are significantly larger and move faster. Of course, we should want companies to consider climate change and act responsibly, as this is undoubtedly in everyone’s interest.

However, ESG investors seem unwilling to materially punish or motivate corporate behaviour to meet sustainability goals. Placing our faith in the private sector to act on ESG values doesn’t appear to be enough to induce change. ESG investors’ carrots either need to be tastier, or their sticks should hurt more. Instead of ceding the government’s role to the private markets, we should also implement important ESG objectives with the traditional, more coercive methods of the state: better policy, laws and regulation.