_“Does the date of the sustainable targets and potential financial incentive/penalty occur early enough in the bond’s life to be material and before relevant call dates? If not, this could be a red flag as the issuer may, in reality, have no material financial incentive and/or could call the bonds before they are held accountable to hit the sustainability targets and avoid facing the financial penalty_ .” (AEGON Asset Management, 2022).

This paper attempts to shed light on two of these structural loopholes and related issues. It does not analyze the first of the three potential structural loopholes. Kölbel and Lambillon (2022) examine this issue and find that the average SLB premium exceeds the average penalty, suggesting that penalties are set too low. Instead, our paper focuses on the remaining two structural aspects which have not been studied yet: setting of target dates and inclusion of call provisions. Setting a late target date is a simple way for an issuer to reduce the total number of higher coupon penalty payments arising from a failure to achieve sustainability targets. Similarly, calling a bond before maturity relieves the issuer from remaining coupon payments in the bond’s life, allowing it to minimize or even completely avoid penalties.

Our sample includes all SLBs issued till the end of 2021, across all markets. Data is derived primarily from Thomson Reuters (Refinitiv) and BloombergNEF. To examine the setting of target dates, we hypothesize that in order to minimize penalties, SLBs with step-up penalties are likely to have later target dates while the opposite is true for step-down incentives (i.e., decrease in coupon rate if targets met). We find that step-up penalties are indeed associated with significantly later target dates, set on average at approximately 57.2 percent of the bond’s tenor compared to step-downs for which it is set closer to the one-third (36 percent) mark. We further explore the relationship between target dates and step-up penalty amounts, as there is greater incentive to minimize penalties if the penalty payout is higher. We find a positive and significant relationship, with the target date being set later by 11 percent of the tenor period for a 25-basis point penalty increase.

To study the inclusion of call provisions, we make a distinction between call options with potential to minimize penalties and all others (such as clean-up calls and make-whole calls). We also consider potential penalties imposed on early call of an SLB. We find such penalties to be more lenient for SLBs with step-up penalties, averaging only 15.4 bps compared to the average penalty of 31.2 bps. These are substantially more stringent for SLBs with other types of penalties, making these less attractive for early call. This makes SLBs with step-up penalties a prime candidate for such call options. We present evidence that this is indeed the case and that such call options are typically structured to allow minimizing of total penalty payout by setting the call date close to the target date.

Additionally, the paper explores the type of issuers likely to resort to these two structural loopholes. In particular, we are interested in how an issuer’s sustainability performance (proxied by past CO2 emissions) is related to late target dates and penalty-minimizing call options. If past sustainability performance is a reflection of an issuer’s motivation to pursue sustainability efforts, we expect high polluters to be more likely to exploit structural loopholes as an act of insurance against future failure to achieve pre-set SLB targets. We find this to be the case for setting of late target dates but not call provisions, which instead tend to be favored 3