Miss an emissions target? More people want your green bonds, apparently
Miss a sustainability target, attract more ESG investors?
Companies can’t be trusted to do good for the world if left solely to their own profit-hungry devices, or so the wisdom of “ESG” investing goes. What would governments know about regulating businesses to protect people and the planet? The invisible hand of private markets can save us instead, if we made it push a little harder on corporate leaders to have “impact”. Yet if this really works, why would a sustainability-linked investment product get more valuable if a company misses their emissions targets?
“ESG” stands for Environmental, Social and Governance. ESG investors consider “doing good” factors when allocating capital or voting at shareholder meetings, not just financial performance. These companies are rewarded with friendlier shareholders and a lower cost of capital, but in practice, this grading system doesn’t always work.
This concoction of considerations goes together like a child preparing a meal of their favourite foods – they might serve up a strangely delicious but ultimately revolting blend of chocolate, chicken nuggets and spaghetti hoops. Companies like Tesla are leaders in decarbonising transportation but might have horrible ESG ratings because of errant tweets from their founders. “Well governed” oil companies could be ranked highly on ESG, even though they might have an uninspiring carbon emissions record. Investors trying to target emissions reduction might erroneously back the wrong companies if relying solely on ESG composite metrics.
ESG investors have also introduced “Sustainability-Linked Bonds”, or SLBs, to more directly influence behaviour. Companies could be rewarded with reduced interest rates for meeting ESG targets, or higher rates for missing them. Herein lies the bigger issue with ESG investing: profits simply matter more.
This week, Enel missed a carbon emissions reduction target that was linked to ~€10 billion of debt, triggering an €83 million increase in interest payments. This is the largest penalty ever incurred by an SLB. Bizarrely, this was lauded as a “success” for the SLB market and an indication that it “shows that targets can be ambitious”. The fact that Enel blew up their target shows quite the opposite.
Despite having a commitment to reduce carbon emissions, Enel used the European energy crisis as their excuse to miss the mark. Energy crisis or not, the SLB penalty represents a tiny portion of their costs – the €83 million increase represents a mere 2% of 2023’s interest expenses, or 1% of pre-tax profits. It is utterly predictable that this financial slap on the wrist would not drive major business decisions to cut emissions.
Furthermore, investors actually bought more of the Enel SLBs after they missed their sustainability target.
All else equal, a bond that suddenly starts paying more interest is worth more, so more people buy it and its price goes up. However, when a company misses a financial target and triggers a penalty on its debt, this can signal distress and often investors sell off the bond. Even though its interest payments went up, it indicates that the company may be unable to pay it in future.
In Enel’s case, since nothing had fundamentally changed about the business, investors started paying more for the bond because of its higher coupon. They were not scared away by Enel missing its emissions goals but doubled down. Perhaps they never believed they would meet them 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 using government money, given that private financial markets are significantly larger. We also should want companies to consider climate change and act responsibly, as it is probably in theirs and our long-term interest to do so.
However, placing our faith in financial actors to act isn’t enough, if they are unwilling to actually punish or motivate companies to change behaviour. Why not instead use the centuries-old tools we already have for goading corporations to price in externalities that benefit society: policy, regulation and laws.
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Thank you to an anonymous reader with a passion for highlighting the flaws in ESG investing, who sent me the Enel article.