The manner in which the bonds are structured effectively provides an issuer with an "exit route if it expects to miss its target," Maia Godemer, a sustainable finance analyst at BNEF in London, wrote in the report.
Such clauses aren't the only weakness identified in the BNEF study, which looked at 111 SLBs. Ms. Godemer also found examples of flexibility clauses, which let companies adjust their ESG targets after the bond has been issued. And in general, SLBs often entail weak financial penalties for an issuer that doesn't live up to its targets, she said.
Investors are already cooling to the SLB market. The debt form has started to attract criticism from asset managers, with a number of the world's largest ESG bond investors refusing to buy the bonds. And early proponents have since voiced concerns that the market risks losing credibility.
After seeing an almost tenfold increase in sales between 2020 and 2021, the SLB market has since seen a dramatic slowdown. In the year through May, sales of sustainability-linked bonds were down roughly 28% from the same period in 2022, according to Bloomberg Intelligence data. The securities have lagged behind green bonds in popularity amid persistent greenwashing concerns.
SLBs are "riddled with exit clauses, toothless terms and conditions, vague timelines and opaque targets — all designed to protect issuers," Ms. Godemer said. "But correcting course could unlock trillions of dollars of investment, shepherding decarbonization in ways no other financial instrument can."
Unlike green bonds, whose proceeds are earmarked for environmental projects, SLB issuers can use the funds they raise for any corner of their business. Researchers at the Federal Reserve have even noted that SLBs could be more effective than green bonds at connecting investors with firms making systemic green investments.
Ms. Godemer said examples of good practice in the SLB market include linking coupon payments to an issuer's ability to align emissions targets with the Paris Agreement on climate change. Issuers also should set a clear and credible pathway that shows investors how they'll meet their targets.
And since the market for SLBs remains unregulated, it's up to investors to police issuers, she said.
"Sustainability-linked bonds could be a powerful engagement tool to incentivize companies to walk their sustainability talk," Ms. Godemer said. "But due to structural flaws, this potential remains untapped."