Recently Aditya Birla’s Ultratech has launched Sustainability-Linked Bonds (SLBs) for the first time in India. All types of issuers in the debt market can issue the SLBs. SLB are market instruments to reward borrowers for meeting sustainability targets. Major Financial Companies quote Sustainability-Linked bonds to exceed $150 billion by the end of the year, with a growth rate of about 49%.  To define the concept of SLB, consist of environmental, Social and governance related key performance indicators and financial characteristic vary depending upon whether the issuer has met the sustainability objectives within the time period. It is a forward-looking performance-based instrument.

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Usually, issuers take inspiration from the regulatory standards to design the KPIs, for example the Paris Agreements or Sustainability Development Goals of 2030. Targets should be based on science-based scenarios or absolute levels for example in case of carbon budgets based on Best Available Targets. Some of the targets include for example availability of water and sanitation to all (SDG goal 6), Sustainable energy to all (SDG goal 7), Cities should be safe, resilient and sustainable (SDG Goal 11), Sustainable consumption and production (SDG goal 12), Tackle climate change (SDG Goal 13), Biodiversity and territorial loss (SDG Goal 15). Issuer can use already available tools to map the KPI’s to SDG goals like UNDP Impact Practices standards, WBCSD’s SDG compass or PIMCO’s Best Practices Guidelines for Sustainable Bond Issuance.  

Sustainability bonds consist of use of proceeds bonds consisting of Social, Sustainability and Green bonds. Green bonds consist of Water, Adoption bonds (Climate related) and Transition (Energy Transition). Sustainability linked bonds consist of Social KPIs, Mix of social and green KPIs or even Green KPIs.

That is, they aim to incentivize the barrower for the sustainability achievements. Compared to green bonds, SLB bonds are not ring fenced against sustainability use alone, that is SLB can be used for general purposes within an organization, however, are linked with Sustainability Key performance indicators and targets. Sometimes green bonds and sustainability bonds can be combined. These targets require to be made public and needed to be verified.

For the purpose of the KPI selection and usage, various existing Guidelines like Global Reporting Initiative’s guidelines, Sustainability Accounting Standards, International Reporting council’s framework and Accountability Materiality framework are suggested by ICMA. The materiality chosen for the bond issuance or KPI selection are suggested to meet the company core, significant business activity. The calculations used for KPI are suggested to follow recognized reporting standards namely GRI, GHG Protocol or EU ETS etc. As Europe Central Bank, Eurosystem considers SPTs to be acceptable only if they refer to targets in a publicly available issuance document. The issuer is required to publish information on the KPIs, verification assurance report and bond tenor and sustainability strategy. The reporting should be published at least annually.

Financial characteristics of the bond namely, coupon maturity, repayment, interest rate etc, vary depending upon the KPI met or not met. However, the scenario is in early stages and it needs to get to a consensus. The key features of SLBs include Commitment regarding issuers ESG performance with questionable impact reporting capabilities. The applicable instruments include loans, convertible, bonds. Further the bonds have investor protection in case of green default and financial incentive for the issuers.

The Sustainability-Linked Bonds have five core components. i. Selection of Key Performance Indicators ii. Calibration of Sustainability Performance Targets iii. Bond Characteristics iv. Reporting and v. Verification.

Selection of the KPI: – The Success of credibility of the SLB depends on the chosen KPI. As highlighted above KPI should be selected based on organizations core sustainability strategy. It should be relevant, measurable, can be verified externally and be bench marked. KPIs should be chosen from their previous sustainability or annual reports.

Calibration of Sustainability Performance Targets (SPTs): The target should be based on bench marking which suggested to take ambitious i.e., go beyond business-as-usual scenario. It should be based on minimum 3 years of measurement track of KPIs, Peer targets, science-based target setting. These targets refer to timelines to achieve, baseline reference points, recalculation criteria and confidentiality considerations etc.  

Bond Characteristics: As highlighted earlier Bond characteristic like Coupon. Failure to meet the target triggers an escalation of the coupon.  Such detailed information or structural characteristics is required to be clearly mentioned in the bond documentation and any deviation to the calculated or observed SPTs needs to be communicated.

Reporting: – Reporting is needed to communicate the performance information of the select KPIs, verification assurance information and update on sustainability strategy. These reports should be published at least once in a year.

Verification: An independent external verification is suggested for the verification of the KPIs against the SPTs. An environmental consultant is required to verify the records to assess the performance targets. The records are required to be made publicly available.

The SLB issuance checklist consist of post issuance and pre issuance check list. The pre issuance checklist consists of General segment highlighting Rationale, Selection of KPIs consists of description of KPIs, rationale for selecting the KPIs, Calibration section highlighting Rationale behind the KPIs, Historical externality values, Description etc. Bond characteristics section highlights the various calculation methodologies, Detailed description of various calculation variances, back up mechanism if any. Reporting commitments highlights the content around location and frequency of reporting, intended scope. The final segment of pre-issuance section highlighting second party opinion consisting of any pre-issuance external review.

Post issuance section consists of Report review, quarterly qualitative explanation of the contribution, verification information.

To conclude, Sustainability Linked Bonds are suggested to be very promising instruments in meeting the sustainability as the bonds not ear marked only for sustainability activity, that is it is not required to be invested only in green markets making the diversification possibility; making it also a disadvantage as it is not fully ear marked. Compared to green bonds which require green assets to release the bonds, SLBs do not warrant such requirement which helps in many issuers working on such initiatives, These SLBs are aimed at organization with overall corporate sustainability goals help in managing the performance. The challenge is how best the SLB or budget is allocated to the sustainability, which need not be disclosed in financial reports, further the KPIs chosen needs to be science-based approach might aim at setting too low to meet the target i.e., they are not ambitious. Some marketing challenges are quoted by some financial firms like ECB step – up requirements.

Thanks

Jayakumar

References: –

  1. ultratech-cement-to-raise-first-sustainable-offshore-bonds-for-400-mn – Economic Times
  2. ICMA – Sustainability Linked Bond Principles
  3. ECB Guidance on Sustainability-linked bonds

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