Sustainable finance is becoming a reality, with standardised terminology and greater assurance over investments. Sonia Shah looks at sustainability-linked bonds and the key principles that guide them.
Over the last few years, sustainable finance has become a significant concern for investors. It's evolved from a trend to a core element of a diverse portfolio. Used effectively, sustainable financial products reduce the impact of the climate crisis and support overall environmental, social and governance (ESG) objectives. One option for investors is buying sustainability-linked bonds.
What are sustainability-linked bonds?
Sustainability-linked bonds allow investments in any type of fund, but the characteristics of the bonds are linked to the sustainability key performance indicators (KPI). This is different from sustainability bonds, which require the proceeds to directly support environmentally-friendly initiatives.
Sustainability-linked bonds aim to hold issuers accountable for improving ESG standards and provide investors with more information to make informed choices. An issuer will set a number of ESG objectives, and the financial or structural characteristics of the bond will vary according to how well they meet those targets. For example, issuers underperforming against their targets may pay a higher coupon interest rate.
The International Capital Market Association has produced voluntary guidelines for firms issuing sustainability-linked bonds so that the basic principles can be clearly interpreted.
These sustainability-linked bond principles are one of many activities in the financial sector to standardise terminology, reduce greenwashing and help investors make informed decisions. Other initiatives include the EU Taxonomy, the Sustainable Finance Disclosure Regulation, a proposed IFRS foundation Sustainability Standards Board, an ISO sustainable finance standard and a British Standard Institute (BSI) sustainable finance framework. Evidencing sustainability is essential for protecting consumers, and issuers who cannot back up their claims could be liable for mis-selling in the future.
What are the five principles of sustainability-linked bonds?
Identifying key performance indicators
Issuers will select some key performance indicators in line with their sustainability strategy and wider business goals, such as reducing carbon emissions. Ideally, these KPIs will align to ESG goals outlined in previous financial reports or disclosures, or if this isn’t possible, issuers are encouraged to share relevant metrics for the previous three years. This is to help investors gauge the progress made to date and the potential improvements ahead.
Well-chosen KPIs are central to the overall business, quantifiable by a consistent methodology, benchmarkable, and verifiable by a third party. Transparency in definitions, selection and calculation methodology is imperative. Investors will also benefit from rationale on relevance, the materiality of the KPIs' and wider information on the organisations overall ESG ambitions.
Sustainability performance targets
Structuring sustainability-linked bonds relies on creating sustainability performance targets (SPTs) to track each KPI. Targets will reflect long term ESG goals, be ambitious, and go beyond the anticipated trajectory. Ideally, they will be comparable to some kind of external benchmark such as the firms’ previous performance, peer achievements, industry standards, or scientific metrics. The targets must be set at bond issuance, if not before, with a clear timeline for achieving the KPIs and when structural or financial characteristics will change.
When disclosing these targets, key considerations for issuers include:
Timelines for observing and checking the target, including any triggers to change the bond characteristics
The initial baseline or starting point for each KPI, including any information on reassessing the baseline if necessary
An outline of how issuers will achieve each KPI through their ESG strategy and supporting activity
Details of anything that may potentially prevent issuers from achieving their KPIs
It is important to gain assurance over this part of the process, either internally or from an external provider. This will give the board and senior management confidence that the methodology is appropriate, targets are relevant and benchmarks are reliable.
The characteristics of the sustainability-linked bond will change depending on whether or not the issuer meets its sustainability performance targets. This will most likely be a change in the interest payment to the bondholder, and outcomes will bear meaningful relation to the original terms of the bond.
Sustainability-linked bonds must include a fall-back mechanism in case the issuer cannot measure performance against a given ESG target. This would only happen in exceptional circumstances, such as a significant regulatory change or the need to adjust the baseline performance target or due to a merger or acquisition.
Transparency around sustainability-linked bonds is vital, and publishing (at least) annual reports on the KPIs and associated targets will keep investors and other stakeholders up to date. This will include the latest performance data on the KPIs and other information to allow investors to monitor the targets. Most importantly, the report should outline progress against the issuer’s ESG sustainability performance targets, any updates to the strategy or relevant changes in ESG governance.
Independent verification of target performance against each KPI will determine if key triggers for the bond mechanism have been met. This will be shared publicly to improve transparency and give bondholders assurance over the product.
The future of sustainability-linked bonds
These principles provide issuers with a framework for creating consistent standards for sustainability-linked bonds, improving investor confidence. While they do not drive direct investment in green projects, they are an innovative and practical way to improve ESG standards. Ambitious targets, combined with absolute transparency, is vital for making sustainability-linked bonds a fair and attractive proposition for investors.
Achieving this will rely on a clear bond structure and mechanism for change, good use of metrics and effective reporting. While third-party verification is an integral element of the process, assurance over the bond structure, KPI and target selection, and reporting processes can give investors greater confidence when buying sustainability-linked bonds.
Contact Sonia Shah for more information on sustainability-linked bonds, including assurance and verification processes.