Liz Cain, head of debt origination at Pension Insurance Corporation, discusses how reform to Solvency II rules in the UK could open the sustainability-linked bond market to insurers, and the benefits of such instruments in a responsible investment strategy.
The sustainability-linked bond market has received mixed reviews over the last few years, what are your views on this market?
We are definitely seeing more issuance of loans or bonds that have coupons step up or step down linked to ESG KPIs.
In a number of sectors - utilities, project finance, social housing, transportation - it's quite popular with borrowers, particularly ones that are trying to diversify their funding base.
For investors, it's a good way of integrating ESG into the portfolio, and help to track their own journey to net-zero.
However, for insurance investors, like ourselves, our assets fall under the Solvency II regulatory framework. At the moment that's very much focused on fixity of cash flow, having certainty of cash flows to match our liabilities. And therefore where you've got variability in the coupon, as in the case of SLBs, it can sometimes be challenging for insurers to invest in those instruments.
We are hoping that will change when we move to Solvency UK, with the focus shifting to highly predictable cash flows rather than fixed cash flows.
SLBs feel like obvious assets that would fall into the highly predictable bucket. Because, although you might have some variability in the coupon, it will be within a range, and that range will be known from the outset.
So, for us at the moment, we can invest in some SLBs. In particular those where the coupons step up if they don't meet target. That is generally easier under current Solvency II treatment, because you can assume the starting coupon.
The most common type of SLB in the market usually have step down coupons if they meet certain targets - so the carrot rather than the stick. And these at the moment are pretty challenging for us, because you have to assume the lowest coupon from the outset, so it starts to hurt economics.
Why are bonds with a step up coupon easier?
With a coupon step up, we can just assume from day one that it doesn't step up. So we can take the day one coupon and ignore any potential upside through the lifecycle of the debt. With a step down, you can't really do that and have to recognize the lower coupon that it might be. You are losing the benefits of the economics you are getting on day one.
Those bonds had a bad reputation when they first emerged, but now this seems to have gone away. When did you start investing in those? And did you share those worries about those instruments?
We've only done a handful, due to the regulatory constraints we've just discussed. But something we're mindful of is obviously greenwashing. And that's where a lot of the criticism has stemmed from. Just because something has an ESG-linked coupon, in isolation isn't a compelling reason to invest. It might be a target that's not particularly difficult to attain, it might be that it doesn't actually have a good overall ESG story. You definitely have to be mindful of greenwashing when you're looking at these, and that applies to SLBs as much as green bonds.
Key questions to consider are: how relevant are the targets? How easy are they to measure? Past criticisms were around the lack of transparency over what the KPIs were, how they're benchmarked and monitored.
There are now frameworks that borrowers are signing up to which help with that. So, borrowers are certainly taking this seriously and looking to integrate it into their borrowing platforms.
As an investor, how are you assessing the likelihood of the borrower meeting the targets?
At the moment we are looking at it more holistically because we haven't been able to do many of these investments. More holistically in our overall credit due diligence, in terms of: how does it feed into our overall ESG assessment of a name? Is it a good ESG story, even if it's perhaps not in a clean industry? How committed are management to their net-zero plans?
But if it gets more recognition as part of the Solvency II reform, we are going to need further views on what our best estimate cash flows are for that asset. That will require a deeper dive into what those targets are, and how achievable they are.
You mentioned greenwashing and regulation as hurdles to invest in SLBs, what are the other challenges?
Another challenge is the quality of the monitoring and benchmarking of these bonds. If you're going to have your economics impacted by it, you want to be sure that those KPIs are being calculated correctly against sensible industry benchmarks. That requires better reporting on the part of the borrowers and some third-party assurance.
Isn't one challenge that these instruments are highly customised and that KPIs vary greatly between issuers?
Potentially, but you will start to see more convergence within sectors. We're not there yet, but we will reach a point where you have more sector standard KPIs. At the moment you have a handful of issuers at the forefront of it, and some that haven't even thought about it, with quite a range in between. As we go forward, and more companies have got to report on their own net-zero targets and think about how they get to those, you will start to see more standard sets of sector-specific metrics.
How are you making the case for the regulatory changes to the regulator and policy makers?
By demonstrating that these are highly predictable cashflows within a known range. Any coupons that step up or step down will have a cap on how much it steps up or steps down.
How the documentation is worded is important as well, is it a permanent step up/down? Or can it move around depending on ongoing KPI performance?
It's easier to make a case where you have certain measurement dates, and then it steps up or steps down, and then stay at that level.
With all the discussions with regulators around highly predictable cash flows, it's about talking through examples and demonstrating that it's range-bound and, although there a bit of variability, we're not talking huge variability relative to the total coupon that they will pay. And then when you overlay that with an insurance portfolio, this is only ever going to be a small portion of the portfolio. So, it's very much in the spirit of what the regulator is trying to achieve from these reforms.
Assuming the regulation changes in that sense, will it have a snowball effect in your conversations with investee companies on the structure of those bonds?
It's more about an increase in the deals we will be able to do as well as the quality of the reporting. We definitely see deals at the moment we can't do because of these features. So, this change would bring these assets in, which we would have otherwise already liked to buy from a credit perspective, but just this structure point didn't work for us.
And then it's more that it will result in a better alignment for the borrower and investor on ESG and reporting. Giving investors a clearer look through to when they might achieve net-zero or when they might have achieved certain KPIs.
You mentioned green bonds earlier, what are the benefits of SLBs vis-à-vis other instruments?
They both have a role to play. With green bonds, the use of proceeds is tightly regulated, so if you are a borrower that's one tool in your toolkit of borrowing options.
With SLBs, use of proceeds is not regulated and it's more a business-wide covenant or commitment to meet specific targets.
So, the usefulness for the borrower is quite different.
And from an investor perspective, how do you see the two fit in your sustainability goals?
Taking a step back, our primary purpose is very much to pay our policyholders their pension. And a core part of that strategy is investing in long-term assets that generate social value for future generations. Whilst we are not a 'green investor', we see purposeful investment as providing stable cash flows to match our liabilities.
So, we see green bonds and SLBs as very relevant instruments to drive investments in core sectors such as renewables, social housing, regeneration etc.
Are you able to share examples of some of the SLBs you have invested in?
In November 2022, we invested €57m into a 12-year sustainability-linked private placement with Umicore, a leading multinational sustainable technology company. They committed to achieving net-zero GHG emissions by 2035, with intermediate milestones of a 20% reduction by 2025 and 50% reduction by 2030 versus a 2019 baseline. And the bond has a coupon adjustment if the targets are not achieved. We were able to invest in that bond because it was structured in a way that was suitably Solvency II friendly.
Are the KPIs of SLBs you've seen – regardless of whether you can or can't invest in them at the moment – consistent across the different bonds? Is it very much focused on carbon or climate, or do you see a wide diversity and range of KPIs?
I don't think we have enough data yet internally to really say. We definitely see a common theme being co2 emissions, as something that anybody could set a meaningful target on if they put their mind to it, and report on it.
Once you get into more sector-specific KPIs, they will look quite different within the ESG umbrella.
For example, social housing – what portion of your properties have a high EPC score. Then if you look at utilities you probably have KPIs around pollution and spillages. For the rail sector you can have things like noise pollution or passenger satisfaction.
Companies:Pension Insurance Corporation
People:Liz Cain