Airline sustainability-linked finance to pick up from a low level, expects credit ratings agency

Global credit ratings business DBRS Morningstar says airlines have raised only $5 billion in sustainability-linked finance since 2018 but expects this to pick up as the aviation sector needs to invest around $175 billion annually to achieve net zero by 2050. In addition to the possible increase in funding, benefits of raising sustainable financing include enhancing ESG credibility and the potential to lower the cost of funding, explains DBRS in a client report. It says sustainability-linked bonds (SLBs) and transition bonds are likely to emerge as the key instruments of choice for the sector. However, airlines’ key performance indicators (KPIs) under their SLBs are likely to get more aggressive over the coming years as the market matures. “Although we do not expect material long-term impact in terms of credit implications, a failure by airlines to meaningfully tap the sustainable financing market could have consequences for liquidity and ratings in the long term,” notes Rohit Kumar, Assistant Vice President, Diversified Industries at DBRS.

The report says that given few avenues are available to decarbonise aviation in the short term, the chances of any material financial burden being imposed by regulators on airlines are limited. However, it warns, over the medium to long term, airlines that fail to meaningfully tap the sustainable financing market and/or adequately focus on new technologies could suffer from liquidity challenges and possible negative rating actions.

To date, the airline sector has completed only 16 sustainable finance transactions, according to DBRS (see table below), representing only a fraction of the overall financing needs of airlines, which globally raised $250 billion and $340 billion in 2020 and 2021 respectively. This low activity is partly because green bonds, which traditionally have been the most common form of sustainable finance, do not often fit airlines’ business model as the use of net proceeds is restricted to environmentally friendly projects, while airlines mostly raise funds to finance aircraft purchases.

“SLBs fall in the sweet spot as they do not restrict the use of net proceeds but rather link the financing cost to ESG targets. Transition bonds, which were introduced even more recently than SLBs, are also a viable option for high carbon-emitting industries like airlines, as they support projects that reduce the carbon footprint, such as fleet modernisation,” says the report.

“Going forward, we think SLB and transition bond activity is likely to grow from current modest levels. As a capital intensive industry, airlines need to maintain access to capital at a time when investors are becoming increasingly focused towards sustainability.”

DBRS believes sustainable financing can help airlines’ credit profile in a number of ways:

1. As investors put more emphasis on ESG, an increased focus on sustainable financing might help the sector maintain access to a wider pool of capital.
2. Airlines linking their climate goals with financing agreements enjoy more credibility on their targets.
3. Funding costs will likely decrease as yields may be lower on SLBs compared with non-sustainable instruments.
4. Airlines that are proactive in cutting emissions as part of their corporate-wide operating KPIs in their SLBs could benefit if regulators take more aggressive actions to accelerate decarbonisation.

However, DBRS is concerned that the medium-term climate targets set by airlines, and the KPIs under SLB transactions, are not always ambitious enough to achieve the long-term objective of net zero. While targets under some SLBs are set to reduce emissions intensity – emissions per revenue passenger kilometre (RPK) – the expected growth in travel activity could more than offset the attempt to reduce net emissions.

“For example, a target of 30% reduction in emissions intensity by 2030 compared with a 2019 baseline would still result in around 8% higher net emissions in 2030, assuming a 4% CAGR in RPK activity,” says the report. “Therefore we think airlines’ KPIs are likely to get more aggressive in the coming years and regulators may step in to tighten the framework under SLBs to prevent any greenwashing.”

The credit ratings agency foresees significant decarbonisation challenges for the aviation sector, such as the high cost of production of sustainable aviation fuels and the heavy investment requirements, plus the technological hurdles of electric and hydrogen powered aircraft, which are at least 10 years away from wide-scale adoption.

“Without sufficient global support from governments to offset the high costs, it might be challenging for the sector to build viable alternatives,” it concludes.

Sustainable finance transactions in the airline industry:

Note: Scope 1 covers emissions from sources that an organisation owns or controls directly; Scope 2 are emissions that a company causes indirectly through the energy it purchases and uses; Scope 3 encompasses emissions that are produced by other entities that the company is indirectly responsible for, up and down its value chain.
Sources: DBRS Morningstar, Ishka

Photo: Air France-KLM raised just over $1 billion through a SLB in January 2023

Christopher Surgenor

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