October 25, 2023
The understated benefits of sovereign sustainability-linked bonds
What could influence a country's Debt Management Office (DMO) to choose a sustainability-linked bond (SLB) over a vanilla bond? Previous blogs have explored the relative costs and benefits of sovereign SLBs and data and governance requirements of SLBs, leading to this exploration of the understated benefits of SLBs.
On the one hand there are challenges and transaction costs of SLBs in terms of budget, time, and political capital, and the questions surrounding their pricing benefit.
On the other hand, SLB issuance can initiate and accelerate urgently needed changes in both macro-fiscal policy making and public financial management regardless of whether the bond is issued or not. This is because the “back end” of an SLB — the data systems and governance processes underpinning the bond — can have multiple applications beyond the “front end” sustainability framework that specifies the targets and KPIs.
The narrow focus of the front-end can provide a focal point to spur collective action towards climate-nature alignment, while the challenge of quickly building a robust back end lends itself ideally to innovation techniques such as an accelerator. These features of an SLB therefore have the potential to unlock meaningful savings in the form of:
- Lower cost of funding through credit enhancement and signaling effects;
- Economies of scope by spreading back-end installation costs across various policy use cases, not just debt financing;
- Economies of scale from spreading transaction costs over multiple issuances.
Rising nature-climate risks and mounting pressure from markets and civil society to implement sustainability commitments render the institutional changes and technological upgrades described above unavoidable. In other words, governments are likely to incur the costs regardless of whether the SLB is issued or not.
Sovereign issuers are facing growing calls for enhanced sustainability reporting, which are being driven by the growth of environmental, social, and governance (ESG) investing as well as increasing sensitivities to the macro-fiscal risks emanating from climate shocks and biodiversity loss. The task-forces for climate- and nature-related financial disclosures (TCFD and TNFD) are being rolled out to corporates and have received strong endorsement by investors. It is only a matter of time before they are applied to sovereigns.
Even the credit rating agencies are incorporating these considerations into their methodologies, albeit slowly and belatedly. Sovereign fiscal policies, financing plans, and bond disclosures will be increasingly scrutinised for measures to mitigate climate and nature risks. Those sovereigns that fail to disclose or take action to address emerging risks in their Public Financial Management (PFM) frameworks and systems will likely face penalties in the form of higher borrowing costs or, in the worst case, lockouts from international capital markets.
As climate and nature risks crystallise, the risk premia demanded by investors will rise commensurately. Those that fail to produce credible plans, present dubious data, or demonstrate misalignment in key climate/nature policy functions may also incur a credibility discount in the price of their bonds.
Taking these trends to their logical conclusion, it is not hard to envision a scenario wherein emerging and developing economies (EMDEs) are effectively decoupled from international bond markets. The rising refinancing risks at a time when sovereigns face a wall of maturities in 2024 to 2025 clearly implies an escalating debt crisis. Rounding out the doom loop, that means less funding for climate adaptation/resilience and biodiversity conservation, increasing vulnerability climate shocks and nature loss, and worsening credit fundamentals.
Figure 1. EMDE general government bond maturities
Source: World Bank International Debt Statistics
Multilateral development banks (MDBs) and development finance institutions (DFIs) can plug some of this shortfall, but only to an extent. They are already falling short on meaningfully closing the existing development financing gaps, let alone extra capital to rollover maturing obligations. Even if this funding were forthcoming, under current rules, most MDBs and DFIs can only provide budget support loans that are tied to policy conditionality — in effect, targets and KPIs imposed by the creditor.
Furthermore, budget support is based on an assessment of the government’s institutional and policy framework and its commitment to and ownership of the reform program. Meanwhile, the lumbering pace of capital adequacy framework (CAF) reform means that the volume of policy-based loans (PBL) is likely insufficient to meet immediate financing needs. They are also an inefficient mechanism to channel private capital from advanced economy institutional investors to EMDEs, given that MDB issued bonds themselves are in limited supply.
A more efficient mechanism would be for MDBs and DFIs to issue credit guarantees on SLBs covering all or part of the issuer default risk. De-risking would result in a credit rating uplift on the instrument and render them more attractive to risk-averse investors, thereby crowding in the substantially larger pools of capital and countering the threat of EMDE decoupling.
As argued in this blog, SLBs general use of proceeds provision allows for refinancing conventional debt. It therefore need not increase the stock of debt — indeed, if they are used to buy back heavily discounted vanilla bonds, they can produce a reduction in the debt burden. By lowering the average weighted cost of borrowing, a guaranteed SLB would also have a beneficial impact on the issuer’s debt dynamics.
Furthermore, issuers have “ownership” in so far as they select the targets, while commitment is established through the incentive and performance tracking mechanisms embedded in the bond contract. Since the MDBs/DFIs can achieve similar outcomes via a PBL or a guaranteed SLB, but can mobilise more capital with the latter, the case for issuing more bond guarantees for SLBs is arguably stronger.
Even without credit enhancement, SLBs can lead to higher perceived creditworthiness — and by extension lower credit spreads — to the extent that it signals greater ‘policy effectiveness’ and reduced susceptibility to ‘event risk.’ Policy effectiveness is a concept that features prominently in sovereign risk models.
For instance, both Moody’s and Fitch assign significant weight in their respective sovereign rating scorecards and models to the World Bank’s Worldwide Governance Indicator (WGI), of which ‘policy effectiveness’ is core pillar. All agencies make qualitative adjustments to reflect policy coherence and predictability, as well as exposure to contingent liabilities. An SLB can hit all of these notes if it is properly structured.
Aside from direct savings on the cost of borrowing, an SLB can also defray the cost of setting up a sustainability policy framework and data architecture with multiple use cases across government. Climate change and biodiversity loss are complex public policy problems that cut across virtually all policy domains, and the sustainability targets and KPIs in the bonds are likely to be shared across multiple government agencies, even if they differ in focus and emphasis.
For example, a robust forest cover monitoring system has numerous uses well beyond biodiversity conservation, including water resource management, wildfire management, silviculture, land use planning, drug enforcement, and more. By selecting a few specific, time-bound targets and clear set of KPIs to coalesce around, the SLBs can act as a focal point for inter-ministerial collective action. The market scrutiny surrounding these KPIs also ensures that the foundation is up to standard. Where it is not, an SLB can provide the impetus for getting it there.
The cost of adding new targets and data streams can fall significantly once a technological and institutional foundation is laid down. Likewise, once the system and governance arrangements are in place, they can be used for subsequent offerings, even if the targets are new and substantively different from those before.
Many of the extra processes entailed in an SLB, as described in Figure 2 below, are one-time, upfront expenses that can be amortised over time.
Figure 2. Actors and actions in a conventional vs SLB issuance
The key actors in the issuance process as well as prospective investors in SLBs will have been familiarized with the concept of performance-based financing, and presumably require less socialization, via road shows and the like second time around. For example, it took Chile more than two years to structure the first SLB that was placed in March 2022. The second SLB issuance took place a year later and included a gender equality KPI. Therefore, if the data architecture is open and modular, then adding new modules and application should be relatively straightforward.
This approach of piecemeal construction based on specific solutions to immediate problems is in keeping with the logic of “agile” development, whereby innovative systems are built quickly via an iterative process of learning by doing, as opposed to charting out a detailed path in advance. This is also the thrust of the accelerator we examine in our next blog ‘Accelerating sovereign SLB transactions: Building the ecosystem’.