Sustainability-Linked Bonds

24 April 2023

The ESG finance market continues to develop and grow as interest and demand for environmentally and socially conscious investments becomes more and more important to investors around the world.

ESG use of proceeds bonds have traditionally been the focus of the ESG finance market.  These bonds are issued to fund a particular project or activity with an ESG focus. 

Sustainability-Linked Bonds (SLBs) are a more recent product to emerge in the market, and an important difference between SLBs and use of proceeds bonds is that SLBs are general purpose bonds and do not necessarily have to be used to fund ESG-related activity.  Instead, the sustainability element comes from a link in the characteristic of the bond (usually pricing) to specified ESG metrics, and the bond will be adjusted to recognise an issuer's good, or poor, performance in relation to its goals.

This opens the market up to issuers who may not have a particular ESG-focused project in mind, or may not operate in a traditionally sustainable sector, but do want to transition towards a more sustainable position.   These instruments are forward looking, and act as a commitment by an issuer to meet certain sustainability targets within specified timeframes. 

The SLB Principles, voluntary principles published by the International Capital Market Association, are as follows:

  1. Selection of Key Performance Indicator (KPI), which should be material to the issuer's sustainability strategy and measurable. Examples of KPIs include level of water consumption, or particular diversity and inclusion targets.
  2. Calibration of the Sustainability Performance Targets (SPTs), which should be ambitious and represent a material improvement to the issuer's position, rather than a 'business as usual' trajectory. Examples of STPs for the KPIs mentioned above include a reduction in water consumption to a particular volume, or reaching a certain percentage of diversity and inclusion targets within a workplace, for example the number of women on a board.
  3. Bond characteristics, being the impact on the bond once a certain trigger event has occurred, for example an increase in the bond coupon if the SPT has not been met. This should be a meaningful change to the original bond characteristics, so that if the bond were to change, there would be a real impact on the issuer.
  4. Reporting on performance of the SPTs, which should be transparent and frequent, and accessible to investors.
  5. Verification, which should be external and independent, measure the issuer's performance as against the SPTs and made publicly available.Pre-issue verification is recommended and verification post-issuance is mandatory.

Although voluntary, an issuer's adherence with the SLB Principles can give investors a level of comfort that the investment is in fact sustainable, and the requirement for external verification is a helpful tool against greenwashing.  As mentioned above, the emergence of SLBs has resulted in more issuers being able to participate in the ESG finance market.  However, they do come with challenges which need to be kept in mind. A key challenge is the general use of proceeds, which means, unlike green bonds, proceeds from SLB issuances can be allocated towards projects or expenses that do not necessarily align with ESG goals.  This means investors may need to conduct more due diligence on issuers to be comfortable before investing.  In addition, if the KPIs are not material to the issuer's business or the SPTs are not ambitious enough, then the sustainable nature of the bond itself can be questioned. 

As the SLB market develops, we may see a shift in the level of regulation to address these challenges.  The EU has recently announced a proposed EU Green Bond standard, which would impose certain requirements on issuers to issue EU Green Bonds.  According to reporting from Environmental Finance, the EU has also agreed to bring in regulation for SLBs within the next three years1.

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