A new tool in the sustainable finance toolkit – the Sustainability-Linked Bond Principles

The International Capital Market Association (ICMA) has recently published the Sustainability-Linked Bond Principles (SLBPs). The SLBPs are intended to further develop the role that the bond market can play in the transition towards a sustainable global economy, by creating a framework for structuring features, disclosure and reporting in relation to sustainability-linked bonds (SLBs).

What are SLBs?

SLBs are forward-looking performance based instruments, similar to sustainability-linked loans (SLLs), which have been gaining in popularity in recent years.

The SLBPs are voluntary guidelines, that are broadly applicable to all types of issuers and any type of bond instrument. Similar to SLLs, the financial and/or structural characteristics of an SLB can vary depending on whether the issuer achieves pre-determined sustainability/ESG performance objectives.

What are the key features of SLBPs?

The SLBPs focus on five core components.

1. Selection of key performance indicators (KPIs), which are predefined, quantifiable metrics that are used to measure the performance of selected indicators. KPIs should be relevant, core and material to an issuer’s business, and of strategic significance to an issuer’s operations; objectively measurable and verifiable; and able to be benchmarked.
2. Calibration of sustainability performance targets (SPTs). SPTs are measurable improvements in KPIs, which an issuer commits to over a predefined timeline. SPTs should be ambitious and represent a material improvement in the relevant KPIs; be compared to a benchmark or an external reference (where possible); be consistent with an issuer’s overall strategic sustainability/ESG strategy; and be determined on a predefined timeline.
3. A variation in the bond’s financial and/or structural characteristics if the selected KPIs reach (or fail to reach) the predefined SPTs. This is a key feature of a SLB, and will usually result in a step-up or step-down in the coupon (but other financial and/or structural variations are also possible).
4. Reporting on the performance of KPIs relative to the SPTs should be regular (at least annual).
5. Verification is a key requirement. Independent and external verification of performance in the KPIs against the SPTs, by a qualified external reviewer with relevant expertise, is required at least annually up until the last SPT trigger event of the bond is reached. The verification report should be made publicly available.

Are there any similarities between SLBs and SLLs?

SLBs (like SLLs) are a highly flexible product, as the SPTs can be aligned to an issuer’s own sustainability goals. There are also similarities in terms of use of proceeds. The proceeds of a SLB or SLL issuance may be used for general purposes (in contrast to green, social and sustainability bonds, which require funds to be used for specific sustainable projects, with associated on-going tracking of the funds). Similar to SLLs, SLBs are likely to include margin ratchet mechanisms aligned to performance against SPTs. As is generally the case for SLLs, we do not expect failure to meet SPTs to trigger an event of default under SLBs.

Are there any differences between SLBs and SLLs?

The SLBPs broadly reflect the Sustainability-Linked Loan Principles (SLLPs) published by the Loan Market Association. The primary difference between the SLBPs and the SLLPs is their approach to verification. Post issuance external verification by a qualified external reviewer is a necessary element of an SLB, whereas it is an optional element under the SLLPs and negotiated on a deal-by-deal basis. The SLLPs recommend that a borrower seeks external review where information relating to SPTs is not made publicly available or otherwise accompanied by an audit/assurance statement.

Disclosure and transparency requirements are also slightly different as between the SLBPs and the SLLPs, primarily due to the public nature of listed SLBs as opposed to the private nature of SLLs. However, both the SLBPs and the SLLPs encourage issuers to be as transparent as possible, to promote issuer accountability and to enable investors to evaluate their sustainable investments. We expect issuers to embrace the transparency related elements of the SLBPs, as a way to publicly demonstrate their commitment to sustainability/ESG.

What else does an issuer of SLBs need to consider?

From a documentation perspective, the issue documents for an SLB will be broadly similar in format and structure to a typical bond issue. However, an issuer of SLBs will also need to consider:

• the inclusion of fallback mechanisms, in case the SPTs cannot be calculated or observed in a satisfactory manner;
• the inclusion of explicit and defined conditions under which the issuer may be allowed to update or amend SPTs to account for exceptional events such as significant M&A activities, extreme events, and/or drastic changes in the regulatory environment;
• the need for additional representations and warranties in the subscription agreement to support underwriter diligence in respect of the sustainable nature of the bond; and
• whether the SLBs involve information that could be considered market sensitive, and if so, how to handle such information.

The cost of external verification will also be a consideration, if this is not already part of the issuer’s on-going sustainability reporting.

What next?

The impact of the COVID-19 pandemic has meant that sustainability is currently a key issue on boardroom agendas. The SLB market is still at a nascent stage, but the publication of the SLBPs will be instrumental to the development of this nascent market as a coherent market. We expect SLBs to become an increasingly popular addition to an issuer’s sustainable finance toolkit.