Small miss for Enel, big step for the sector

Following yesterday’s release of Italian energy company Enel's 2023 annual sustainability report, it was confirmed that they had failed to meet the emissions reduction key performance indicator (KPI) linked to a number of their sustainability linked bonds (SLBs). As a result, the largest issuer of SLBs will see the coupon increase on 10 of its bonds, marking the most significant penalty trigger to date in the SLB market.

As a reminder, green bond proceeds are tied to specific assets or projects, as are social and sustainability bonds. In contrast, sustainability-linked bonds raise capital for general corporate purposes, with the company's overall ESG performance linked to certain KPIs. If the issuer fails to meet these KPIs, the bond's coupon rate will increase.

The labelled bond market has experienced significant growth over the past five years, driven by strong macroeconomic factors following pandemic-related stimulus efforts and increased investor focus on ESG issues globally, particularly in Europe. While green bonds have dominated this growth, sustainability-linked bonds have struggled to gain traction with investors, who are often cautious due to the perceived lack of ambition in issuer KPIs, the challenge of envisioning scenarios where the coupon step-up mechanism would be triggered, and whether this warrants the cheaper funding ESG labelled bonds typically offer.

Enel missed its 2023 carbon intensity target, citing higher-than-expected coal-based electricity generation due to the Russian invasion of Ukraine and the subsequent disruption in European gas supplies. Specifically, Enel fell short of its target to reduce its scope 1 carbon intensity to 148 gCO2eq/kWh for 2023, with actual intensity recorded at 160 gCO2eq/kWh. To put these figures in context, Enel’s scope 1 intensity in 2017 was 365 gCO2eq/kWh and 229 gCO2eq/kWh in 2022. While the drop in 2023 was not what management had hoped for, it still represents a material decline: a reduction of 56% over a six-year period and 30% over one year.

As a result, 10 bonds (5 Euro and 5 USD) will be impacted and will see their coupon increase by 25 basis points (bps) or 0.25%. This increase in interest costs amounts to around €83m over the remaining life of these bonds; a significant number but not enough to materially impact Enel’s credit profile in our view.

The market reaction has been muted to marginally positive. While the coupon step-up was largely expected, it was not fully priced in. This led Enel’s SLB to see their spreads tighten 5-10 bps yesterday, outperforming their non-SLB counterparts. Additionally, there hasn’t been any negative reaction to Enel’s ESG profile due to the circumstances surrounding its KPI miss. Ultimately this failure was due to external factors and cannot be attributed to a lack of sustainability investments; Enel continue to be a leading utility in the shift away from fossil fuels, which is evident in their decline in scope 1 emission intensity.

While this event may not mark a seismic moment for the sector, we do think this is a positive development and adds credibility to an instrument often criticised. It demonstrates the structure working where falling short of targets leads to a financial penalty and highlights that there are plausible scenarios in which KPIs can be missed. We continue to like the SLB format as it focuses on the ESG profile and journey of the company as a whole rather than a specific green project, and importantly, the financial penalty holds management accountable. While this event is unlikely to trigger rapid growth within the sector, we do think it may change the negative perception of many investors.