Earlier this year, we described how the global pandemic is drawing renewed attention to the interlocking challenges of rising sovereign debt levels, climate change and environmental degradation. Addressing these problems will require unprecedented levels of investment, and policy makers are looking for ways to link the solutions.
The corporate sector has already started making these connections through sustainability-linked loans and bonds (SLBs), which tie the interest paid to investors to the issuer’s ability to meet key performance indicators (KPIs) on environmental or social policies. Unlike sustainable debt, such as green or blue bonds, an SLB has no restrictions on the use of proceeds. Instead, it is designed to promote sustainability while providing general-use liquidity to the issuer.
About $10 billion of these bonds were issued in 2020, and Moody’s estimates that number could rise to $100 billion in 2021. This asset class has yielded some early lessons. Corporate issues have been mainly structured with “step-up” coupons, where the issuer agrees to pay a higher rate (25 basis points on average) if it fails to meet its KPIs. Investors have shown willingness to pay some discount to incentivize results (and for potential upside).
Now, several countries are considering issuing sovereign debt that follows this model. These bonds would allow nations to raise debt to deal with immediate COVID-related costs and general-purpose budget finance needs while signaling commitments to medium-term sustainable development goals that contribute to sustainable development and reduce potential financial risks.
The debt could be linked to policy, program or project objectives. In addition, it would avoid costly budget tagging and project identification because the proceeds would be used for general-purpose financing and would provide capital incentives for governments prepared to commit to ambitious targets. The SLBs might also contribute to debt sustainability by reducing the cost of capital, though they wouldn’t be debt swaps or debt restructuring instruments. Countries’ overall debt levels could be maintained by rolling over existing obligations to lower cost issuance.
Sovereign SLBs would likely be structured differently from their corporate counterparts. They would be more likely to use “step-down” structures that reward issuing countries for implementing ambitious targets on climate, the environment and sustainable development. So, who would pay when these targets are met? Most likely, the performance cost would be borne by a combination of investors supported by some concessional, philanthropic funding.
We have also been working in conjunction with partners, including the Potomac Group, to explore how to make these payments work, while keeping the design of the instrument as close to regular sovereign bonds as possible to make pricing easier, avoid the fragmentation of small markets and allow for replication and scale.