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Cost of Capital - Case Study: Enel

The Thesis

The main assertion of this research series is that Environmental, Social, and Governance (ESG) investing will soon become mainstream and that it will have a significant impact on prices of all asset classes and their related cost of capital. ESG investing crossed a major inflection point in 2019 and momentum will accelerate in 2020 and beyond, in our view. There is a tendency to view this from a superficial and cynical lens from all corners of our current polarized political and socioeconomic factions, but one will do this at their own peril.

Ironically, the almost inevitable unifying conclusion regarding ESG is that no one is going to be happy. Those on one side will believe that not enough is being done and/or current efforts are just corporate greenwashing and lip service. Those on the other side will believe that this is an unnecessary infringement on one’s sovereignty. The reality is that economic players are just responding to the demands of “consumers,” and that capital is already fully aware that there are enormous opportunities that will be available during this massive industrial evolution that our global economy will undergo in the coming decades. And thus, at the end of the day, we all might be fine despite ourselves, in our view.

We envision this research series to be an intellectually honest vehicle on which to better understand the macro and micro impact of all things ESG from the perspectives of various diverse stakeholders and from a critical economic and capital markets point of view.

Cost of Capital

The current focus among institutional investors and the like is on definition, categorization, quantification and framework. How do we measure ESG? How do we force/compel companies to behave “correctly”? What disclosures should be required? These questions are all well and good; however, tackling this from strictly a regulatory and box-ticking perspective will most likely result in a suboptimal outcome. Also, there are a bevy of ratings agency types that have rose to serve this need. We question some of the validity of this type of ratings approach, but we do appreciate the effort. It’s a start, but it feels a bit like ESG 1.0.

Additionally, researchers have lauded the view that more ESG-friendly companies’ stocks have outperformed their peers and relative benchmarks (i.e. doing good is good business). That’s wonderful; however, we question these types of conclusions from the age-old causality vs. correlation perspective – our oligopolistic economic champions (with correspondingly better performing stock prices) tend to be in greener industries and thus it’s unclear which is the dog, and which is the tail, analytically speaking. And never mind the fact that we’re almost solely focused on the E in ESG. One could argue that the S and the G could be equally or more important at the end of the day from a more comprehensive, holistic perspective.

Enter cost of capital. Being an old Wall Street hand, the thought of a simplified metric such as cost of capital is appealing. A free market mechanism definitely has its benefits and shortcomings, and we’re not blind to either. However, a market’s ability for price discovery is its most basic function and it’s pretty good at it – with all the pitfalls that come with this – it’s just price discovery; nothing more, nothing less.

Rather than get into a long and eternally boring discussion on this topic that has been covered ad nauseum elsewhere and everywhere, perhaps it may make more sense to look at a brief case study that illustrates how companies have seized on this opportunity to lower their cost of capital (for the layperson, cost of capital is just the price of money) that also advantageously aligns with their overall strategy – and that unambiguously creates ESG and resultant equity value.

Enel: The Evolution from Green Bonds to SDG-Linked Bonds

Enel is Italy’s largest company by market capitalization, the largest European utility, and is the world’s largest renewables provider with 46 gigawatts (GW) of installed capacity. As an aside, the company has a unique approach to ESG that is based on shared values that we believe is the future of corporate strategy and culture that ultimately will drive healthy, long term excess idiosyncratic equity value. It’s a potentially significant competitive advantage in our emerging ESG economy. We will analyze this aspect of Enel in greater detail in the coming months.

In terms of cost of capital, Enel has initiated a capital markets strategy that will perhaps redefine what a green/climate bond is and in turn could significantly change the market for these types of products going forward. A green/climate bond is what it sounds like. It is a bond that is strictly for use for climate and environmentally friendly projects (i.e. most typically a wind or solar power generation project). While the ESG benefits of this type of financial product appear to be straightforward, the reality is a bit more complicated.

Some of the potential shortfalls of green/climate bonds are as follows:

  • The financing of a specific green project could be aiding a company that is generally a “bad” actor, so this could be an example of one step forward, two steps backward.

  • There are many other projects worth investing in that might not fit neatly in the definition of green/climate bond (i.e. grid modernization, technology, management and employee training, etc.).

  • Green/climate bonds do not incorporate the S and the G in ESG which could have more net impact than investments that focus purely on environmental benefit.

  • These and other shortcomings are the reasons why the global green/climate bond market has yet to gain scale and illiquidity.

Enel’s proposed evolution of this market was to introduce a Sustainable Developmental Goal (SDG) linked bond in September 2019 that holds the company accountable for achieving 55% or greater renewable installed capacity by year end 2021. This specifically addresses SDG 7, which is “Affordable and Clean Energy.” For the lay person, the U.N. adopted seventeen integrated SDGs in 2015 to ensure that all people enjoy peace and prosperity by 2030 (no poverty, zero hunger, good health and well-being, quality education, etc.). These SDGs have become a general framework on which the ESG investment approach is being built.

Why is Enel’s SDG-linked approach so notable? It is subtle, but profound. Most importantly, this approach moves away from “project” financing to “general-purpose” financing. Some critics would contend that this lets the issuer potentially “get away” with non-climate friendly actions since the bond is not strictly tied to a specific green project. We think this as a misguided, myopic point of view. By tying money to a specific project, it misses the point of how companies have to broadly and comprehensively invest to truly move the needle on key SDGs. This criticism is a clear example of “the road to ruin that is paved with good intentions”, in our view. There is accountability in a specific key performance indicator (KPI) target of achieving a specific renewable target verified by an external party. This SDG-linked approach preserves the spirit of the intended goal of a green/climate bond while at the same time increases the marketability, size, and liquidity of this financial instrument, in our view.

And lastly, Enel was able to place €4 billion of these 5-year SDG-linked bonds at an approximate 15bps discount relative to a conventional bond. Interestingly, there is a penalty of a one-time 25bps adjustment if the company does not achieve the >55% of renewables installed capacity target by year end 2021. The big takeaway is that Enel is essentially creating a new market of sorts for sustainable financing with the end goal of creating greater access to a larger pool of capital and greater liquidity. This is the direction where the world is headed, in our view.

The upcoming EU Action Plan on Sustainable Finance will put in place a regulatory taxonomy that will surely impact the capital markets in unprecedent ways. We do not believe that even sophisticated market participants are fully aware of this potential impact. We will analyze this in greater detail throughout the year. Companies who are ahead of the curve such as Enel will likely have a competitive advantage in this new environment and will likely benefit from a lower cost of capital and, mostly importantly, a corresponding higher equity valuation (i.e. higher multiples). This will incentivize companies to get on board the ESG train and change behavior faster than any other variable, in our view.


This is the most exciting area of global finance and we believe it will fundamentally redefine our global economy and capital markets for the foreseeable future. It is truly a new industrial revolution. ESG 1.0 has been defined by a comparative analysis approach using existing systems and thought processes to erect an initial crude framework. While conceptually valid, it prevents us from truly maximizing the potential of this massive financial and economic change that is literally happening right before our eyes.

The irony is that the capital markets will likely have more of a profound social impact than any other entity just due to the fact that it wields enormous power regarding corporate behavior. This is ultimately driven by individuals’ values and morality on a collective global basis (i.e. consumers, voters, individual and institutional investors, etc.). These types of ambiguous and non-quantifiable concepts are unfamiliar and uncomfortable to the capital markets generally speaking, but these factors will be the critical independent variables that will determine cost and access to capital, and resultant valuations.

It is no longer going to be as simple of figuring out revenue, earnings, and EPS growth for investors. A P/E based or any multiple based investment approach will be even less relevant that it is today, in our view. We will need a constantly iterative analytical approach to understand these rapidly evolving ESG factors, and we believe that we’re just scratching the surface of the extent of the change of how the market will price assets and determine cost of capital. We’re excited to be on this journey with you as this transformation develops.

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