Building back better: Linking sovereign bond payments to sustainability targets
Countries should not just label bonds as sustainable; they should actively tie coupon payments to sustainability targets, such as achieving its Nationally Determined Contributions on emissions.
In the midst of the greatest global economic downturn in nearly a century, governments around the world are facing an unenviable challenge — how to fund COVID-19 stimulus and relief packages while also addressing environmental degradation and climate change.
It’s not something going very well at the moment, given one new report which found that only 12% of the $14.9 trillion in global Covid stimulus financing so far is going to green projects.
Finding a solution will require outside of-the-box, innovative thinking. That’s why we at CountryRisk.io, along with a growing number of economists, investors, and policy makers, believe that sustainability-linked sovereign bonds offer an interesting opportunity for countries to build back better coming out of the global pandemic and to align the incentives of key stakeholders: governments, multilateral development banks and private sector capital.
Linking sovereign bond payments to sustainability targets
As we begin to see the light at the end of the tunnel for the Covid-19 pandemic, governments looking to stimulate green growth would be wise to consider using sustainability-linked bonds to finance a green recovery.
Sustainability-linked bonds are another financial innovation in addition to sustainability-labelled bonds. However, a key difference between the two, is that in the case of sustainability-labelled bonds (e.g. green or social bonds) the use of proceeds from the bond sale are tied to specific government expenditure (e.g. financing renewable energy power plants). In January 2020, Ecuador issued the world’s first sovereign social bond dedicated to social housing projects. The issue came with a guarantee from the Inter-American Development Bank that reduced the financing costs for Ecuador significantly.
Sustainability-linked bonds are different (to sustainability-labelled bonds) as they are issued for general budget spending but key bond features (i.e. coupon payments) are tied to sustainability targets. The International Capital Market Association’s guidance paper details process guidelines for structuring features, disclosure, and reporting of sustainability-linked bonds. We at CountryRisk.io believe this is a better approach, since a country could issue a sustainability-labelled bond for a renewable energy project and at the same time fund coal power plants with the general budget.
Obvious choices for targets are countries’ Nationally Determined Contributions (NDCs) to the Paris Agreement, particularly as nations are readjusting their NDCs this year, five years on from the signing of the Paris Agreement and ahead of the COP26 UN Climate Change Conference in November. The World Banks’ Anderson Caputo Silva and Fiona Stewart have been advocates of this approach. Other possible targets might be linked to biodiversity or social goals.
“Investors really want to push countries to be ambitious and in addition, include ways in which consequences are attached to meet targets. Sovereign linked sustainable bonds are an interesting potential way to do this.”
Fiona Stewart (Global Lead Insurance and Pensions at the World Bank Group)
Pricing sustainability-linked bonds
Issuers will also need to consider how to link sustainability performance to the bond’s coupon. One framework could feature coupon step-ups, where a higher coupon is paid by the issuer if key performance indicators (KPIs) are not achieved.
Another option could be that a multilateral development bank (MDB) like the World Bank, pays part of the coupon if the country meets the KPIs. The bond holder would always receive the same coupon, but the country’s debt servicing costs would be reduced if sustainability targets are achieved. MDBs have ample experience with such set ups and it would leverage the financial means of the MDBs through bringing in private capital.
Learning from Argentina’s GDP warrants
While “sustainability-linked bonds” is a sexy new label, these bonds could be considered plain vanilla structures with some covenants related to sustainability targets. Corporate bonds — especially the lower rated segments — have always included clauses that stipulate if a company fails to reach certain targets (e.g. debt to equity ratio needs to stay below a certain threshold), the investor receives a higher coupon, or in more extreme cases, the investor can demand early repayment of the principal.
There are some sovereign bonds with embedded options that allow the investor to demand early repayment, but the more interesting bond structure to draw parallels to sustainability-linked bonds is Argentina’s GDP-indexed warrants.
Simply speaking, these warrants are structured so that the investor receives a coupon payment if the real GDP level and growth rate exceed certain threshold values. By extension, the price of the warrant reflects investors’ assessment of Argentina’s growth outlook. If investors think that the economy will grow faster, then the price of the warrant will go up. Or put differently, the price of the warrant reflects a certain future growth path.
If we were to apply this concept to sustainability-linked bonds, the market would provide information on the probability of a sustainability target being reached. For instance, we could extract from bond prices the probability of a country achieving its emission targets. One should add “in theory” as it would require quite a liquide market.
Certainly, the Argentinian warrants case highlights the challenges of defining the target and thresholds, as well as the difficulty in monitoring their performance over time. Additionally, there is precedence for inflation-linked government bonds where the coupon payment is linked to the inflation rate. Further, the market’s trust in inflation statistics varies from country to country. But these challenges are surmountable; the market can have some disciplining effect. If investors deem the KPIs issued by the authorities unreliable, demand for such bonds will be very low.
We believe that the multilateral development banks — first and foremost the World Bank — or an organisation within the United Nations, are well positioned to take the role of monitoring agents. They have ample experience in keeping track of social and environmental outcomes from decades of project financing and also have established relationships with sovereign states. Transparency regarding a country’s performance in relation to the sustainability-targets and the initial goal-setting will be crucial. So will the level of ambition. The KPIs for the bond need to be stretch targets that lead to significant advancement of sustainable development goals. This, by extension, means that the issuers and MDBs need to have high ambitions when it comes to sustainability goal-setting. Certainly, it is easy to see how politics could prevent sustainability-linked bonds from driving the positive change they are intended to bring.
Conceptionally, we view sustainability-linked bonds as more intriguing than sustainability-labelled bonds and we hope that they will also gain traction in the sovereign space. There have already been a few cases of sustainability-linked bonds at the corporate level and now the time has come for sovereigns to break new ground. Let’s wish sustainability-linked bonds roaring success!
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