October 25, 2023
A sober assessment of the sovereign sustainability-linked bond value proposition
The value proposition of sustainability-linked bonds (SLBs) for sovereigns, compared to conventional bonds as presented in public discourse to date, has generally rested on three core features of the instrument:
- They can command a lower cost of funding because they appeal to larger pools of investors with environmental, social, and governance (ESG) mandates;
- They incentivise government action towards ESG objectives through step-downs or step-ups in the coupon rate, depending on whether key performance indicators (KPIs) achieve predetermined targets or not;
- They lock in sustainability commitments through the political cycle by embedding commitments into long-term and legally binding financial contracts.
There are still too few data points to say conclusively whether SLBs deliver these benefits.
Neither Chile nor Uruguay’s SLBs generated a discernible ‘greenium’ at issuance. The strength of their incentives is also questionable since the coupon step-ups and step-downs of between 5 and 50 basis points do not present material outlays or savings in debt-service if they were triggered under current conditions. Although issuers may still wish to avoid the reputational hit of missing a sustainability target, they may nevertheless weigh the political costs of abiding by the commitments to be greater than paying the financial penalty or retiring the SLB early.
On the costs side of the ledger, the additional actions and actors involved with an SLB implies a heavier lift for debt management offices (DMOs) compared to vanilla bonds (see Figure 1). For investors to have confidence in the performance tracking mechanisms when evaluating an SLB offering, they need to be assured that the data pipelines feeding the Key Performance Indicators (KPIs) are tamper proof, durable, and open to scrutiny.
This in turn requires a robust governance framework that ensures all stakeholders are committed and capacitated to perform their duties under the terms of the SLB. Where data is collected from other line ministries or third parties, data sharing arrangements need to be cemented for the life of the bonds, with clear protocols governing data capture, processing, storage and reporting. Second opinion providers need to be carefully vetted and locked in, and contingency arrangements need to be put in place for the event that any part of the pipeline breaks down.
Figure 1. Actors and actions in a conventional vs. SLB issuance
The set-up and maintenance costs of these systems and processes are not trivial.
For Key Performance Indicators (KPIs) based on alternative or unstructured data (such as geospatial imagery or text mining) more complex workflows and advanced storage solutions might be needed, raising information technology (IT) costs of the transaction.
The data architecture of governments tends to be highly fragmented, with siloed databases and non-interoperable exchange protocols. Likewise, the decision-making authority that covers cross-cutting policy objectives – such as combating climate change and safeguarding biodiversity - tends to be dispersed across multiple agencies, making them susceptible to coordination failures and bureaucratic politics.
The technological and institutional groundwork can therefore add up to significant transaction costs and lengthy structuring timelines, possibly skewing the calculus of a debt manager over whether to pursue a conventional (“vanilla”) or sustainability-linked issuance in favor of the former.
The challenges to scaling up SLBs are therefore formidable, but they are not insurmountable.
The current version of the SLB structure is just the first iteration of an evolving design, and current shortcomings can be addressed through a variety of enhancements. We will explore these in our final blog series.
In this series, we examine ways to defray the extra transaction costs of an SLB versus a vanilla bond, which is partly a matter of framing. If a bond embeds sustainability pledges that a government would pursue irrespective of the financing instrument underlying it, then many of the upgrades entailed by an SLB ought to happen anyway – provided the commitments are genuine. In this view, SLBs are simply a mechanism to operationalise sustainability commitments and render them more credible.
This series of blogs will take you through ‘Data and governance requirements’ of SLBs, followed by ‘The understated benefits of SLBs’ and a final piece on ‘Accelerating SLB transactions, building the ecosystem’, which considers techniques for how SLB upgrades can be accelerated to cut costs and time to market.
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