The appeal of sustainability-linked bonds for investors is largely based on the contractual leverage they provide to ensure that companies will deliver on their commitments. However, this only works if companies adopt targets and KPIs that are ambitious enough, both from a relative standpoint, based on competitors’ practices, and from an absolute standpoint, based on their contribution to global goals and thresholds.
Benchmarking Ambitions and Targets
The type and level of ambition of SDG targets in outcome-based finance should take into account investor expectations and the targets of other companies in the same industry. Such market benchmarking will play a key role during the life of the bond, putting pressure on companies to deliver on their targets and potentially raise their sustainability ambitions over time.
In benchmarking SDG targets, consideration should be given to the level of maturity of companies, as performance may get exponentially harder as companies ascend the curve to reach more ambitious targets. Also, not all companies can achieve the same impact, based on their industry, geographical location, and legacy.
When public benchmarks are not available, benchmarking for the issuer may be about triangulating past performance based on goals set, industry peers, and the market standards. In that case, companies should work with intermediaries to gauge the credibility and competitiveness of their ambition.
Alignment with Global Goals and Thresholds
While SDG targets and KPIs used in outcome-based finance should be linked to the most material SDG impacts of the company, they should also have a clear connection to the global sustainability goals and the thresholds of the SDGs and the Paris Agreement. Such alignment allows investors to assess whether companies are on the right trajectory toward sustainable development.
Managing Dynamic Sustainability Targets
Often, companies will need to step up their SDG commitment and targets over time to reflect their overall evolving strategy, the changing nature of sustainability issues, or competition in the rest of the market. Alternately, some companies will overperform on their targets or meet them early.
In that case, new issuance of outcome-based finance products can reflect new or higher targets. However, existing products with covenants based on expired targets may trade at a discount compared with products with more competitive targets, either from the same issuer or its competitors. This does not directly impact the issuer as the bonds are traded in the secondary market, unless the market conditions suggest that a bond with the new targets would trade at a higher price and a lower yield. In that case, companies could refinance to reflect the new targets and benefit from the lower cost of capital on existing debt.
To create more flexibility and a better connection between dynamic sustainability targets and fixed bond structures, companies can also issue bonds with various maturities to address issues (and targets) with various maturities. Alternately, companies can use various tranches within the same bond to address various maturities.
When dealing with long-term targets, issuers can also use progressive milestones to ensure progress throughout the life of the bond. Issuers can also use dynamic sustainability targets up front in conversation with investors and intermediaries to adapt to the changing context and remain on a sustainable path.
Lastly, issuers can use ongoing investor communication to keep investors informed about a company’s latestsustainability targets and encourage investors to trade the company’s bonds andloans based on the new target.
