Structuring a sustainable KPI-linked instrument

More than a decade after the first Green Bond issuance, use-of-proceeds debt instruments – such as green or social bonds are dominating the sustainable finance market.

While the first ever KPI-linked bond, issued by energy company ENEL, raised some questions about the credibility of such a bond, which uses the proceeds for general purposes, the format has gained legitimacy in the market since ICMA published the Sustainability-Linked Bond Principles (SLBP) in June this year. Likewise, the Loan Markets Association (LMA) has published the LMA Sustainability-Linked Loan Principles (SLLP) to promote the development of such loans and underpin their integrity.

This article explains the characteristics of sustainability-linked bonds and loans and what issuers need to do to ensure the successful use of these instruments.

Jargon Buster

ICMA: The International Capital Markets Association (ICMA) brings together over 600 members from all sectors of the wholesale and retail debt securities markets in 62 countries to inform its work on regulatory and market practice issues, which impact all aspects of international market functioning.

LMA: Founded in 1996, the Loan Markets Association (LMA) with its 650 member organisations aims to improve liquidity, efficiency and transparency in the primary and secondary syndicated loan markets in Europe, the Middle East and Africa.

What are sustainability-linked bonds (SLB) and sustainability-linked loans (SLL)?

The cornerstone of a SLB is that the bond’s financial and/or structural characteristics can vary depending on whether or not the selected Key Performance Indicators (KPIs) reach the predefined Sustainability Performance Targets (SPTs). The variation of the bond’s coupon – lowered if the issuer achieves the SPTs or increased if the SPTs are not being met  – is the most common example for SLBs.

By linking the achievement of sustainability targets to a financial incentive or ‘punishment’, issuers are committing explicitly to future improvements in sustainability outcomes within a predefined timeline. Meanwhile, the proceeds of SLBs can be used for general purposes (hence also referred to as general corporate purposes bonds).

Sustainability-linked loans are structured in a similar way: typically, lenders and borrowers agree a “two-way” pricing mechanism. If targets are met, the borrower receives a margin discount, normally up to 2.5 basis points. If targets are not met, then an equivalent margin premium will be added.

High level process and timeline for sustainability-linked bonds:

Selection of Key Performance Indicators (KPIs) determines issuer and lender credibility

The credibility of an SLB and SLL rests on the selection of one or more KPIs. The SLBP state that the KPIs should be material to the issuer’s core sustainability and business strategy and address relevant environmental, social and/or governance challenges of the industry sector; and be under management’s control.

Furthermore, the principles advise that the KPIs should be:

  • relevant, core and material to the issuer’s overall business, and of high strategic significance to the issuer’s current and/or future operations;
  • measurable or quantifiable on a consistent methodological basis;
  • externally verifiable; and
  • able to be benchmarked, i.e. as much as possible using an external reference or definitions to facilitate the assessment of the SPT’s level of ambition.

The SLBP encourage issuers to select KPIs that they’ve already included in their previous annual reports, sustainability reports or other non-financial reporting disclosures to allow investors to evaluate historical performance of the KPIs selected.

Similarly, the underlying KPIs for SLLs need to be aligned with the borrowers’ overall sustainable objectives and agenda. Typically, companies choose between one to five KPIs. While borrowers want to use KPIs, which are quantifiable and where the management feels confident they can meet the targets, it is important to formulate ambitious, ‘stretching’ KPIs, in line with the LMA Sustainability Linked Loan Principles.

Setting Sustainability Performance Targets

Calibrating one or more SPTs per KPI marks the second crucial step in structuring an SLB or SLL. The SLBP (and equally the SLLP) state the targets should be:

  • consistent with the issuers’ overall strategic sustainability/environmental, social and governance (ESG) strategy,
  • where possible be compared to a benchmark or an external reference, and
  • be determined on a predefined timeline, set before (or concurrently with) the issuance of the bond.
  • also, the issuer should disclose strategic information that may decisively impact the achievement of the SPTs.

Furthermore, the principles recommend that issuers set ambitious targets that, for example, represent a material improvement in the respective KPIs and be beyond a “business as usual” trajectory.

Detailing how the target setting exercise should be based on a combination of benchmarking approaches, the SLBP suggest to use:

  • the issuer’s own performance over time (with a minimum of 3 years of measurement track record on the selected KPIs),
  • the SPT’s relative positioning versus its peers’ where available (average performance, best-in-class performance) and comparable, or versus current industry or sector standards,
  • reference to the science, i.e., systematic reference to science-based scenarios, or absolute levels (e.g. carbon budgets), or to official country/regional/international targets (Paris Agreement on Climate Change and net zero goals, Sustainable Development Goals (SDGs), etc.) or to recognised Best-Available-Technologies or other proxies to determine relevant targets across environmental and social themes.

Sustainability-linked bonds and loans to follow the same reporting standard and external verification process as use-of-proceeds bonds

Not surprisingly, as in nature a bond or loan, the SLBP and SLLP reflect the same expectations towards the reporting standard post issuance of a SLB and SLL as outlined in the GBP and SBP. Equally, the SLBP and SLLP advise issuers to seek external verification for their KPIs and SPTs.

Corporate clients who would like to discuss this topic further should contact:

Varun Sarda, Head of ESG Advisory

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