Preparing investors for new sustainable bond standards using AI

Ciaran Raymer

August 23, 2024

•

min read

min watch

Preparing investors for new sustainable bond standards using AI

Ciaran Raymer

August 23, 2024

•

min read

min watch

The changing face of the sustainable bonds market

Sustainable bonds, one of the fastest growing segments of the debt capital market, are used globally as a financing source for a wide range of issuers, including green renewable energy companies, sovereigns and supranationals, and brown corporate issuers seeking to transition some or all of their business operations.

More than 8,000 sustainable bonds worth over $1 trillion are set to mature by the end of 2026, according to Environmental Finance Data. This suggests that the $5 trillion market is likely to see heightened issuance volumes from existing issuers looking to refinance. However, many of these issuers may need to update their frameworks to meet the evolving expectations of investors or revert to more traditional 'plain vanilla' bonds if they cannot align with the latest sustainable finance standards.

By 31st March 2024, Climate Bonds recorded cumulative volume of USD4.7tn in aligned green, social, sustainability, and sustainability-linked (SLBs) bonds, (collectively GSS+)

A significant trend within this space is the increasing complexity and specificity of sustainable bond frameworks. Investors are demanding more rigorous standards and greater transparency in reporting the impact of these bonds. This shift is driven by a broader awareness of the risks associated with greenwashing and the need for measurable, verifiable outcomes tied to sustainable finance. Consequently, issuers are expected to adopt more sophisticated frameworks that align with evolving global standards, such as the International Capital Market Association’s (ICMA) Green Bond Principles, to ensure continued access to capital.

Another trend is the diversification of sustainable bond types beyond traditional green bonds. Social bonds, sustainability-linked bonds (SLBs), and transition bonds are gaining traction as issuers seek to finance a broader array of environmental and social projects. This diversification allows issuers to cater to a wider investor base and address various aspects of sustainability, from carbon reduction to social equity. As these instruments become more prevalent, they also introduce new complexities in terms of impact measurement and reporting, which issuers and investors must navigate.

Sustainable bonds - the modern challenges

In response to investor demand, guidelines such as the Green Bond Principles (GBPs) and Social Bond Principles (SBPs) have been developed to support issuers in financing projects that are environmentally sound, sustainable, and socially beneficial. GBPs focus on fostering a net-zero emissions economy and protecting the environment, providing transparent green credentials alongside an investment opportunity. Similarly, SBPs offer transparent social credentials, ensuring that investments contribute to greater social benefits. Additionally, the Climate Bonds Initiative has introduced principles for a just transition, establishing a Transition label that helps investors identify climate-proof investments and mitigate the risk of greenwashing criticism.

When it comes to mitigation and transition efforts, sustainability bonds have significant potential. However, the market is fraught with challenges, including greenwashing, transparency and metric reporting issues, and a lack of pricing incentives for investors. Greenwashing, in particular, remains a critical concern, as it undermines the credibility of the entire market by allowing companies to present a facade of environmental responsibility without making substantive changes to their operations. Transparency and the quality of reporting are also persistent challenges. Investors often struggle to obtain clear, consistent, and comparable data on the impact of the projects funded by sustainability bonds, which complicates the assessment of these investments.

Furthermore, the market faces a pricing conundrum. Despite the strong demand for green bonds, there is a growing lack of a pricing advantage for issuers compared to conventional bonds. This recent lack of a 'greenium'—a premium for green bonds—can discourage issuers from pursuing green projects if they do not see a tangible financial benefit.

Over the last year, greeniums, and the share of bonds showing positive greeniums, have declined and currently show no meaningful difference to standard corporate bonds. We think that a number of factors have influenced the trend toward lower greeniums, including new environmental, social and governance (ESG) regulations and greater attention to greenwashing, which has negatively impacted inflows into ESG funds, as well as tighter overall spread levels and rising supply. These factors have made investors more selective with investments and have negatively impacted greeniums.

Investors are addressing these issues through a combination of more stringent due diligence, increased reliance on third-party certifications, and active engagement with issuers. Enhanced due diligence involves a deeper dive into the specific projects funded by green bonds, with a focus on understanding the social and environmental impacts, the credibility of the issuer’s sustainability claims, and the robustness of the reporting framework. Investors are increasingly demanding that sustainability bonds undergo external reviews or receive certifications from recognised bodies to validate their benefits and ensure compliance with international standards.

In addition, investors are engaging more actively with issuers to encourage better transparency and reporting. This includes pushing for more detailed disclosures on the use of proceeds, the environmental and social impact of the funded projects, and the methodologies used for impact assessment. By holding issuers accountable and fostering a dialogue around best practices, investors aim to reduce the risks associated with greenwashing and improve the overall integrity of the sustainability bond market.

Given the complexity and the evolving nature of these issues, how can investors navigate the challenges posed by sustainable bond frameworks while ensuring alignment with their investment goals?

Opportunity for investors - leveraging AI

As sustainability bond frameworks evolve, so do the guidelines and frameworks governing their use. This presents yet another challenge for investors who need to understand how new sustainability bonds will differ from those set to mature, and what implications the new bonds will have for sustainability reporting.

To address this issue, AI tools and machine learning algorithms are increasingly being leveraged to analyse and assess sustainable bonds. These technologies can help investors navigate the complexity of sustainability reporting by automating the evaluation of vast amounts of data, identifying patterns, and predicting outcomes based on historical and real-time information. By integrating AI into their investment processes, investors can enhance their ability to assess the credibility of sustainability claims, monitor compliance with frameworks like the Green Bond Principles, and anticipate potential risks associated with new issuances.

Keen to explore the potential of AI in this context, we conducted a basic screening exercise using the Responsible Capital assessments tool to evaluate a sustainability bond prospectus issued by the ENEL Group - a 258 page document detailing the structure of the bond, the types of projects it intends to fund, and and the standards the bond adheres to. The aim of this exercise was to create an evaluation tool that could be used as a starting point for assessing the robustness of sustainability bonds across different issuers and sectors.

To guide this assessment, we established a set of 25 questions to assess the bond in terms of reporting and transparency, involvement of stakeholders in bond-funded initiatives, social and environmental impact, and alignment with recognised sustainability frameworks such as those set by ICMA and the Climate Bonds Initiative mentioned prior.

The results

Question	RC Result
Does the company use a formal Sustainability Bond Framework?	TRUE
What recognised standards is the company's bond framework aligned with?	The organisation's bond framework is aligned with the Sustainability-Linked Bonds Principles 2023 (SLBP) administered by the International Capital Markets Association (ICMA) and the Sustainability-Linked Loan Principles 2023 (SLLP) administered by the Loan Market Association (LMA).
Has the company acknowledged any risks that might affect its business operations?	TRUE
What risks have the company acknowledged that might arise from their sustainability bonds?	The documents provided cover specific risks that Enel SpA has acknowledged that might affect its business operations. These risks include interruptions in service at its facilities, disruptions in information technology and cyber attacks, risks related to recent and potential future acquisitions and sales of participations, risks related to climate change and transition to sustainable development, risks related to political, social, or economic instability in countries where the group operates, and risks related to exchange rate fluctuations and creditworthiness of counterparties.
What specific projects or activities are funded by the bond proceeds?	There is information available on the specific projects or activities funded by the bond proceeds of Enel SpA. The organisation issues "Green Bonds" to finance Renewable Energy Projects, Transmission, Distribution, Smart Grid Projects, and Innovative Infrastructural Projects that meet environmental and social criteria. These projects are approved by relevant parties and made available on Enel's website.
Do the specific projects or activities funded by the bond proceeds align with the company's overall sustainability goals?	TRUE
How are the expected environmental benefits quantified?	The organisation quantifies the expected environmental benefits of projects funded by bond proceeds through Key Performance Indicators (KPIs) such as Scope 1 and 3 GHG emissions intensity, renewable installed capacity percentage, and proportion of CAPEX aligned to the EU Taxonomy. These KPIs measure factors like greenhouse gas emissions, renewable energy capacity, and sustainable capital expenditure to assess environmental impact.
What criteria does the company use to select projects eligible for bond funding?	The organisation selects projects eligible for bond funding based on criteria outlined in the International Capital Market Association Green Bond Principles. Eligible projects include Renewable Energy Projects, Transmission, Distribution, Smart Grid Projects, and Innovative Infrastructural Projects that meet environmental and social criteria, approved by the Issuer, Guarantor, and Second Party Opinion Provider.
Who is responsible for selecting projects eligible for bond funding?/td>	The responsibility for selecting projects eligible for bond funding at Enel SpA lies with the relevant Issuer and, where applicable, the Guarantor. Eligible Green Projects must meet specific environmental and social criteria and are approved prior to the relevant Issue Date. This process ensures that only projects that align with the International Capital Market Association's Green Bond Principles are financed.
Has the bond been externally reviewed or certified by third parties?	The organisation's bonds have been externally reviewed and certified by third parties, specifically through the issuance of Green Bond Second-party Opinions. These opinions provide assessments on the eligibility of projects funded by the bonds according to established green standards.
Have the underlying projects been externally reviewed or certified by third parties?	The projects funded by Enel SpA's bonds have been externally reviewed and certified by third parties. Moody Investor Service provided a second-party opinion on the relevance and scope of the selected key performance indicators and sustainability performance targets, confirming alignment with the Sustainability-Linked Bonds Principles
Does the company provide regular, transparent reporting on the use of proceeds?	The organisation Enel SpA does provide transparent reporting on the use of proceeds from their bonds, specifically mentioning the issuance of "Green Bonds" where the net proceeds are intended for Eligible Green Projects. They also have a Sustainability-Linked Financing Framework in place, reviewed by Moody Investor Service, to ensure alignment with sustainability principles
Does the company provide regular, transparent reporting on environmental impacts?	The organisation provides regular and transparent reporting on the use of proceeds, as indicated in the base prospectus document. The underwriters have been involved in this process, ensuring accountability and transparency in the allocation of funds.
Does the company provide regular, transparent reporting on progress toward sustainability goals?	The organisation does provide regular and transparent reporting on progress toward sustainability goals. The documents mention the monitoring of sustainability-related issues, examination of sustainability plans and materiality matrix, and reporting on key performance indicators annually. This demonstrates a commitment to transparency and accountability in achieving sustainability objectives
What key performance indicators (KPIs) are used to measure the success of the projects funded by the bond?	The KPIs include Scope 1 and 3 GHG Emissions Intensity, Absolute Scope 3 GHG Emissions, Renewable Installed Capacity Percentage, and Proportion of CAPEX aligned to the EU Taxonomy. These metrics are crucial for evaluating the environmental impact and sustainability of the projects financed by the bond.
How are these KPIs monitored and reported?	There is detailed information in the prospectus outlining specific targets, conditions, margins, and verification procedures for KPIs related to GHG emissions intensity, renewable installed capacity, and CAPEX alignment with the EU Taxonomy. Each KPI is calculated based on defined methodologies and reported in their Sustainability Report, Non-Financial Statement and/or Annual Report, ensuring transparency and alignment with EU sustainability criteria.
Are there any penalties or financial incentives tied to the achievement or failure to meet specified sustainability targets?	Failure to satisfy sustainability-linked note conditions could result in increased interest payments and harm to Enel's reputation. Additionally, failure to meet sustainability targets may impact the market price of sustainability-linked notes and expose the organisation to reputational risks
How does the company assess and manage ESG risks associated with the projects funded by the bond?	The organisation assesses and manages ESG risks associated with projects funded by the bond through frameworks like the Sustainability-Linked Financing Framework, which includes key performance indicators and sustainability performance targets reviewed by Moody Investor Service. They also engage external verifiers to provide assurance reports on sustainability-linked notes. Additionally, they have a Green Bond Framework and a commitment to allocate Green Bonds to sustainable activities only.
How does the issuance of the bond align with the company’s broader corporate sustainability strategy and long-term goals?	The issuance of the bond aligns with Enel's broader corporate sustainability strategy and long-term goals by integrating sustainability factors into their debt profile, improving credit metrics, and influencing the cost of debt positively. Enel's commitment to meeting the objectives of the Paris Agreement and creating sustainable value over the long term is reflected in their strategic planning and risk management efforts.
How are stakeholders involved in the planning, execution, and monitoring of the bond-funded initiatives?	The stakeholders are involved in the planning, execution, and monitoring of bond-funded initiatives through processes such as examining sustainability-related issues, assessing achievement of sustainability objectives, and supervising the implementation of sustainability policies. They also play a role in ensuring the alignment of the company with sustainability indexes and international events on sustainability matters.
Does the company publicly disclose the specific allocation of green bond proceeds?	The net proceeds from each issue of green bonds are intended to finance or refinance Eligible Green Projects, as defined by the International Capital Market Association Green Bond Principles. Additionally, Enel has issued multiple Green Bonds for sustainable activities, aligning with their commitment to allocate Green Bonds to renewables, infrastructures, and network projects.
Does the company publicly disclose the amounts allocated to each project and any unallocated funds?	The organisation discloses the specific use of proceeds from each issue of green bonds, detailing whether they are for general corporate purposes or for financing Eligible Green Projects.
Are the intended social and environmental outcomes for the bond based on science?	The intended social and environmental outcomes for the organisation's bond projects are based on scientific criteria. The organisation has a Sustainability-Linked Financing Framework that aligns with the Sustainability-Linked Bonds Principles 2023 and incorporates key performance indicators and sustainability performance targets reviewed by Moody Investor Service. This framework aims to foster best market practices and present a unified suite of sustainability-linked financing instruments.
Does the prospectus align with the IMCA Green Bond and Social Bond Principles?	The prospectus for Enel SpA's bond aligns with the ICMA Green Bond and Social Bond Principles, as it specifies the issuance of "Green Bonds" for financing Eligible Green Projects in accordance with ICMA GBP, and mentions the Sustainability-Linked Financing Framework reviewed by Moody Investor Service, confirming alignment with the SLBP and SLLP. The framework includes sustainability strategy and targets, demonstrating a commitment to best market practices in sustainable financing.

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The assessment provided a comprehensive screening of the document's alignment with sustainability criteria, particularly focusing on the formal frameworks, recognised standards, and potential risks associated with the bond. It indicates that the bond framework is aligned with recognised standards, and acknowledges risks that might affect the bond's sustainability claims. Additionally, the specific projects or activities funded by the bond are detailed, highlighting the bond's adherence to established guidelines for sustainable finance. The exercise was run in just under an hour - from collecting documents and specifying questions, to analysing the results.

While the assessment is thorough in addressing key aspects relevant to sustainability bonds, some responses in the results are quite generalised, which may suggest a need for further specificity when dealing with complex financial information. Nonetheless, Responsible Capital effectively identified and summarised critical information for the modern investor, making it a valuable tool for initial screenings.

Benchmarking results

To test the strength and accuracy of the screening results, we spot checked a random selection of assessment questions against an open source large language model. While the open sourced model performed admirably, many of the answers lacked the level of detail we were seeking in our answers.

Question	Open Source Model	Responsible Capital
How are the expected environmental benefits quantified?	The document does not provide specific details on how the environmental benefits are quantified. However, the projects must meet a set of environmental and social criteria, which suggests that there are measures in place for assessing these benefits.	The organisation quantifies the expected environmental benefits of projects funded by bond proceeds through Key Performance Indicators (KPIs) such as Scope 1 and 3 GHG emissions intensity, renewable installed capacity percentage, and proportion of CAPEX aligned to the EU Taxonomy. These KPIs measure factors like greenhouse gas emissions, renewable energy capacity, and sustainable capital expenditure to assess environmental impact.
Have the underlying projects been externally reviewed or certified by third parties?	The document mentions that projects will be approved by a Second Party Opinion Provider, implying that external review or certification of projects is part of the process.	The projects funded by Enel SpA's bonds have been externally reviewed and certified by third parties. Moody Investor Service provided a second-party opinion on the relevance and scope of the selected key performance indicators and sustainability performance targets, confirming alignment with the Sustainability-Linked Bonds Principles.
Does the company publicly disclose the specific allocation of green bond proceeds?	The document mentions the allocation of proceeds to Eligible Green Projects but does not explicitly state if the specific allocations are publicly disclosed.	The net proceeds from each issue of green bonds are intended to finance or refinance Eligible Green Projects, as defined by the International Capital Market Association Green Bond Principles. Additionally, Enel has issued multiple Green Bonds for sustainable activities, aligning with their commitment to allocate Green Bonds to renewables, infrastructures, and network projects.
Does the company publicly disclose the amounts allocated to each project and any unallocated funds?	The document does not explicitly mention the disclosure of amounts allocated to each project or any unallocated funds.	The organisation discloses the specific use of proceeds from each issue of green bonds, detailing whether they are for general corporate purposes or for financing Eligible Green Projects.
Does the prospectus align with the IMCA Green Bond and Social Bond Principles?	Yes, the prospectus aligns with the IMCA Green Bond and Social Bond Principles.	The prospectus for Enel SpA's bond aligns with the ICMA Green Bond and Social Bond Principles, as it specifies the issuance of "Green Bonds" for financing Eligible Green Projects in accordance with ICMA GBP, and mentions the Sustainability-Linked Financing Framework reviewed by Moody Investor Service, confirming alignment with the SLBP and SLLP. The framework includes sustainability strategy and targets, demonstrating a commitment to best market practices in sustainable financing.

The comparison between the two models revealed significant differences in the level of detail and transparency provided by each approach. The answers provided by the open source model tended to be more general and sometimes vague, such as mentioning that details are "not explicitly" provided or only broadly aligning with certain standards. This lack of specificity could be a limitation in assessing the actual impact or compliance of the projects, as it leaves room for interpretation and may not fully capture the nuances of environmental and sustainability metrics.

In contrast, Responsible Capital demonstrated a more robust and detailed approach by, for instance, quantifying expected environmental benefits and providing evidence of external review for underlying projects. This higher level of detail likely contributes to a more comprehensive and trustworthy evaluation of the projects, which could be particularly valuable for investors and stakeholders looking to make informed decisions based on rigorous sustainability criteria.

Conclusion

By leveraging AI to automate the collection and analysis of data related to these questions, investors can significantly enhance their due diligence processes. AI-driven assessments can provide real-time insights into the performance of bond-funded projects, flag potential issues such as discrepancies in reporting, and suggest areas for further investigation. The emphasis on transparency and specificity in the Responsible Capital tool sets it apart as a more effective instrument for screening and evaluating projects according to ESG standards. As a result, investors can make more informed decisions, reduce the risk of greenwashing, and better align their portfolios with their sustainability objectives.

If you'd like to run your own assessment, try Responsible Capital for free today at responsiblecapital.io