Sustainability-Linked Bonds: Incentivising Future Performance

What is a Sustainability-Linked Bond?

A sustainability-linked bond (SLB) is a forward-looking performance-based debt instrument where the financial characteristics can vary depending on whether the issuer achieves predefined sustainability objectives. Unlike green, social, or sustainability bonds that focus on how proceeds will be used, SLBs focus on how the issuer performs against specific sustainability targets—creating direct financial consequences for success or failure.

The definition of a sustainability-linked bond has been formalised by the International Capital Market Association (ICMA) in its Sustainability-Linked Bond Principles. According to ICMA, SLBs are "any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined Sustainability/ESG objectives. In that sense, issuers are thereby committing explicitly (including in the bond documentation) to future improvements in sustainability outcome(s) within a predefined timeline."

These objectives are measured through Key Performance Indicators (KPIs) and assessed against Sustainability Performance Targets (SPTs), creating a mechanism that directly aligns financing costs with sustainability performance.

The Sustainability-Linked Bond Fundamentals

Unlike other labelled bonds that focus on financing specific projects, SLBs establish a direct link between an organisation's overall sustainability ambitions and its financing arrangements.

Financial Structure

Sustainability-linked bonds maintain most of the standard financial characteristics of traditional bonds, but with one critical distinction:

• Fixed interest rates that can increase (or occasionally decrease) based on whether sustainability targets are met
• Predetermined maturity dates
• Typically structured as senior unsecured debt (though secured structures are possible)
• Credit ratings based on the issuer's financial standing
• Secondary market trading similar to conventional bonds

The key innovation is the inclusion of a "step-up" mechanism (or occasionally "step-down") that adjusts the coupon rate if the issuer fails to achieve its sustainability targets. This creates a direct financial incentive for the issuer to meet its sustainability commitments, transforming sustainability performance into a financial consideration.

Core Framework Components

Following guidance from the ICMA Sustainability-Linked Bond Principles, SLBs adhere to five essential elements:

1. Selection of Key Performance Indicators (KPIs): Relevant, core, and material to the issuer's overall business and sustainability strategy
2. Calibration of Sustainability Performance Targets (SPTs): Ambitious, material, specific, measurable, and aligned with the issuer's overall sustainability strategy
3. Bond Characteristics: Inclusion of financial and/or structural impact when targets are met or missed
4. Reporting: Regular and accessible performance reporting on the selected KPIs
5. Verification: Independent external verification of performance against each target

These components create a robust framework ensuring that SLBs maintain credibility and impact while providing flexibility for diverse issuers across various sectors and sustainability challenges.

Self-Labelled Nature

Like other labelled bonds, sustainability-linked bonds operate on a self-labelled basis. The issuer determines whether its bond qualifies as an "SLB" based on alignment with the SLB Principles. This flexibility allows issuers to tailor their approach, while creating the need for:

• External reviews to confirm alignment with principles
• Clear articulation of KPIs, targets, and step-up mechanisms
• Enhanced scrutiny from investors regarding target ambition and materiality

The self-regulation approach provides for innovation while maintaining credibility through market-based accountability mechanisms.

The Evolution of Sustainability-Linked Bonds

While green bonds dominated the sustainable finance landscape for over a decade, the introduction of sustainability-linked structures represented a paradigm shift. The market has grown rapidly since the first corporate SLB was issued by Italian utility Enel in 2019:

• From a niche innovation to a recognised market segment with hundreds of billions in issuance
• Expansion across diverse sectors, including high-emitting industries that may struggle to issue traditional green bonds
• Growing acceptance among investors seeking to support comprehensive corporate sustainability transformations
• Increasing alignment with science-based targets and net-zero commitments

This evolution reflects market recognition that financing the sustainability transition requires tools that address organisational transformation alongside specific green projects.

Types of Sustainability-Linked Bond Structures

The market has developed various approaches to sustainability-linked bonds, offering flexibility for different issuer needs:

1. Coupon Step-Up: The most common structure, where coupon rates increase if targets are missed, creating a financial penalty for underperformance
2. Coupon Step-Down: Less common structure where coupon rates decrease if targets are met, rewarding successful performance
3. Dual-Direction: Combines both mechanisms, with rates that can either increase or decrease depending on performance
4. Redemption Premium: Requires additional payment at maturity if targets are missed
5. Bullet Payment: Includes one-time payment if targets are missed, rather than adjusted coupon rates

These variations enable issuers to select structures that align with their specific financial objectives and investor expectations, while maintaining the core principle of linking financial outcomes to sustainability performance.

KPI Selection and Target Setting

The credibility of sustainability-linked bonds rests fundamentally on the quality of the selected KPIs and the ambition level of the targets:

Key Performance Indicators

Effective KPIs for sustainability-linked bonds should be:

• Material to the issuer's core sustainability and business strategy
• Addressing relevant environmental, social, and/or governance challenges
• Measurable and verifiable on a consistent methodological basis
• Capable of being benchmarked against external references or standards
• Consistent with the issuer's overall sustainability strategy

Common KPI categories include greenhouse gas emissions reductions, renewable energy adoption, water usage, waste management, biodiversity impact, gender equality, worker safety, and access to essential services.

Sustainability Performance Targets

Credible SPTs must be:

• Ambitious beyond "business as usual" improvement trajectories
• Material to the issuer's overall sustainability strategy
• Benchmarked against peers, industry standards, or science-based pathways
• Set on a predefined timeline that creates accountability
• Verified by independent external parties

The 2024 edition of the SLBP emphasises that target-setting should combine multiple benchmarking approaches, including the issuer's own performance over time, peer comparison, and reference to science-based scenarios or official targets.

The Sustainability-Linked Bond Principles

The ICMA Sustainability-Linked Bond Principles (SLBP) serve as the primary market standard, providing voluntary guidelines focused on transparency, disclosure, and promoting market integrity. The SLBP framework emphasises:

1. KPI Selection: Ensuring relevance, materiality, and reliability of indicators
2. Target Calibration: Setting ambitious, meaningful performance targets based on benchmarking
3. Bond Characteristics: Incorporating meaningful financial consequences for performance
4. Reporting: Providing regular, transparent performance updates
5. Verification: Requiring independent external verification of results

The June 2024 edition of the SLBP includes additional guidance on KPI selection, encouraging issuers to refer to ICMA's KPI Registry as sector guidance and distinguish between core and secondary KPIs to support selection of the most material metrics.

Impact and Importance of Sustainability-Linked Bonds

Sustainability Impact

Sustainability-linked bonds can drive meaningful organisational transformation:

• Creating direct financial incentives for company-wide sustainability improvements
• Extending sustainable finance beyond "green" sectors to transitioning or hard-to-abate industries
• Establishing science-based performance benchmarks that align with global sustainability goals
• Encouraging long-term strategic commitment to sustainability rather than project-by-project approaches
• Integrating sustainability considerations into core financial decision-making

The forward-looking nature of SLBs makes them particularly valuable for supporting ambitious long-term transitions that require significant organisational change.

Market Impact

Beyond individual issuers, sustainability-linked bonds have catalysed broader market developments:

• Creating frameworks for measuring and rewarding sustainability performance
• Establishing benchmarks for what constitutes "ambitious" targets across sectors
• Building investor capabilities for assessing sustainability strategy credibility
• Developing verification methodologies for robust performance assessment
• Complementing use-of-proceeds bonds with performance-based alternatives

These instruments have expanded the sustainable finance toolkit, enabling more diverse participation across sectors and sustainability objectives.

Benefits for Issuers

Organisations issue sustainability-linked bonds for numerous strategic reasons:

• Holistic approach: Aligning financing with organisation-wide sustainability strategy rather than specific projects
• Transition financing: Accessing sustainable finance options for industries where eligible green projects may be limited
• Strategic signalling: Demonstrating commitment to measurable sustainability outcomes
• Investor engagement: Creating dialogue around company-wide transformation strategies
• Accountability mechanism: Creating external verification of sustainability performance
• Diversification: Accessing sustainability-focused investors for general corporate purposes

Common Questions About Sustainability-Linked Bonds

What is the difference between a sustainability-linked bond and a green bond?

This represents the most fundamental distinction in the sustainable bond market:

• Green bonds follow a "use of proceeds" model where funds are dedicated to specific eligible green projects, with no change to the bond's financial characteristics based on performance.
• Sustainability-linked bonds follow a "performance-based" model where funds can be used for general corporate purposes, but the bond's financial characteristics change depending on whether the issuer achieves predetermined sustainability targets.

In essence, green bonds focus on what the money finances, while SLBs focus on how the organisation performs. Green bonds are ideal for issuers with defined green project pipelines, while SLBs are suited for issuers seeking to transform overall operations and performance.

Do sustainability-linked bonds allow "business as usual" with minimal penalties?

A common criticism of early SLBs was that some featured unambitious targets or minimal financial penalties for missing targets. However, market standards have evolved to address these concerns:

• The SLBP emphasises that targets must be "ambitious" and represent "material improvement" beyond business as usual
• Investor scrutiny and external reviews increasingly focus on target ambition levels
• The market expectation for "meaningful" financial step-ups has increased over time
• Best practice includes benchmarking targets against science-based pathways and peer performance
• KPIs increasingly focus on absolute metrics (like total emissions) rather than just intensity metrics

The quality and ambition of sustainability-linked bonds vary, making careful assessment of KPIs, targets, and step-up mechanisms essential for investors seeking true impact.

How are sustainability performance targets verified?

Robust verification is a cornerstone of SLB credibility. The verification process typically includes:

1. Pre-issuance review: Second-party opinion assessing the relevance of KPIs and ambition of targets
2. Regular reporting: Issuer disclosure of performance data against targets
3. Post-issuance verification: Independent third-party verification of performance against targets
4. Trigger event confirmation: Formal determination of whether targets were met and financial consequences
5. Annual updates: Ongoing verification until all target observation dates have passed

The SLBP specifically requires post-issuance verification as a mandatory component, unlike green bonds where it is recommended but not required. This verification must be conducted by qualified external reviewers with relevant expertise, such as auditors or sustainability consultants.

Why would issuers accept higher costs if they miss targets?

The willingness to risk higher financing costs demonstrates several strategic considerations:

• The cost increase (typically 25-50 basis points) is material enough to create incentives but modest compared to overall sustainability strategy benefits
• Meeting ambitious targets often creates business advantages that outweigh the potential step-up costs
• The reputational benefits of sustainability commitments provide value beyond direct financing costs
• Investor relations advantages, including access to ESG-focused investors, create long-term financing benefits
• Internal accountability mechanisms help drive organisational focus on sustainability objectives
• The step-up mechanism creates a quantifiable financial risk that helps justify sustainability investments

This risk-taking signals credibility to investors and stakeholders, demonstrating that the issuer has sufficient confidence in its ability to meet targets and recognises the business value of sustainability performance.

Can sustainability-linked bonds be combined with use-of-proceeds structures?

Yes, the sustainable bond market has begun to develop hybrid structures that combine elements of both approaches:

• Sustainability-linked green bonds: Use proceeds for eligible green projects while also including step-up mechanisms tied to sustainability performance
• Partially linked bonds: Dedicate a portion of proceeds to eligible projects while including performance targets
• Transition bonds with sustainability-linked features: Finance specific transition projects while incorporating broader company performance metrics

The SLBP explicitly acknowledges that "issuers may choose to combine the GBP/SBP approach with the SLBP." These hybrid structures can be particularly valuable for issuers seeking to finance specific projects while also committing to broader organisational transformation.

How do sustainability-linked bonds fit into net-zero transition strategies?

SLBs have emerged as a key financing tool for organisations with net-zero commitments:

• They enable financing of company-wide transition strategies rather than just specific green projects
• Performance targets can be directly linked to science-based emissions reduction pathways
• They can incorporate interim milestones for long-term net-zero goals
• Hard-to-abate sectors can access sustainable finance while working on multi-decade transitions
• They create accountability mechanisms for public net-zero commitments
• They can incorporate just transition considerations through social and governance KPIs

When targets are science-based and aligned with credible transition frameworks, SLBs can provide financial incentives that help organisations maintain steady progress toward long-term climate goals.

The Future of Sustainability-Linked Bonds

The sustainability-linked bond market continues to evolve in several important directions:

• Standardisation of KPIs: Development of sector-specific standardised KPIs to improve comparability
• Science-based target alignment: Stronger integration with science-based pathways and methodologies
• Regulatory developments: Increasing alignment with emerging sustainable finance taxonomies and disclosure requirements
• Market innovation: New structures that combine performance-based approaches with other financing mechanisms
• Biodiversity and nature metrics: Expansion beyond climate to include emerging nature-related performance indicators
• Social and just transition KPIs: Greater incorporation of social metrics alongside environmental indicators

As sustainable finance evolves, sustainability-linked bonds will remain an essential instrument for connecting capital markets to organisational sustainability performance, complementing use-of-proceeds bonds in driving the transition to a more sustainable economy.

This article is the fourth in our series exploring the labelled bond universe. Read our first article on green bonds and second article on sustainability bonds, and third article on social bonds, and watch for our upcoming feature on transition bonds.