Sustainability-linked bonds (SLBs) represent an innovative step in the realm of environmental, social, and governance (ESG) investments. Distinguished by their unique structure, SLBs increase their coupon rates if issuers fail to meet predetermined sustainability targets. This mechanism sets them apart from traditional Green, Social, and Sustainability (GSS) bonds, providing an alternative for companies committed to sustainability without restricting the use of proceeds to specific projects.

The Rise of SLBs

Italian utility Enel pioneered the SLB market in 2019, setting a precedent with a bond whose coupon would increase by 0.25 percentage points (pp) if the company failed to achieve a 55% share of renewable capacity by 2021. Since meeting this target, Enel has issued nearly $25 billion in SLBs, pledging to rely solely on sustainability-linked debt moving forward. The flexibility of SLBs—unlike GSS bonds, whose proceeds are earmarked for specific green or social projects—allows issuers to use funds for broader purposes, such as acquisitions, working capital, or general corporate needs. This flexibility has driven rapid growth in SLB issuance, from $6 billion in 2019 to over $100 billion in 2022.

Assessing the Efficacy of SLBs

Despite their potential, not all SLBs are created equal. Our evaluation framework for SLBs considers the materiality of the key performance indicators (KPIs) chosen by the issuer, the ambition of the targets, and the transparency of progress reporting. Additionally, we scrutinize the structural features of SLBs, such as the appropriateness of target dates relative to the bond’s tenor and the financial impact of coupon step-ups. Weaknesses in any of these areas can render an SLB no more impactful than traditional bonds.

The Benefits and Drawbacks of SLBs

A well-structured SLB reinforces an issuer’s commitment to sustainability by tying financing costs to achieving environmental or social targets. However, the market has seen varying degrees of rigor in SLB structures. For instance, while a metals and mining company's SLB featured ambitious emission reduction targets, the financial penalty for missing these targets was minimal, undermining its effectiveness.

Conversely, some SLBs fail to meet basic standards for materiality and ambition. A recent SLB from a food producer linked a 0.25 pp coupon step-up to reducing Scope 1 and 2 emissions, despite over 96% of the company’s emissions stemming from upstream Scope 3 sources. This discrepancy highlights the need for more meaningful and comprehensive KPIs.

Challenges and the Path Forward

The potential downside of SLBs lies in their ability to distract from inadequate transition plans or dissuade issuers from setting ambitious targets due to the fear of public failure. Ensuring that KPIs are material, ambitious, measurable, transparent, and integrated into a broader sustainability strategy is crucial for SLBs to achieve their intended impact.

While SLBs have a role in the ESG-labeled debt market, their current impact is limited. To realize their full potential, the market must evolve to address these shortcomings, fostering a more robust and credible framework for sustainability-linked investments.

Conclusion

Sustainability-linked bonds offer a promising avenue for issuers to enhance their sustainability credentials and appeal to ESG-focused investors. However, their effectiveness hinges on the rigor of their KPIs and structural features. As the market for SLBs matures, it is essential for issuers, investors, and regulators to collaborate in establishing higher standards to ensure these instruments genuinely contribute to sustainable development.