Integrated Corporate Finance Approach

Outcome-based financial products are attractive because they provide general-purpose financing to support companies’ SDG strategies. Outcome-based finance should apply to the entire capital structure and support a company’s overall SDG strategy and all of its SDG investments. The eventual goal is to move away from a product-based approach and link all of a company’s financial products to SDG metrics, just as all debt products are tied to the same credit metrics.

Ultimately, companies could reshape their entire capital structure to be SDG-linked.
Federated Hermes

Alignment with SDG Strategy

Outcome-based financial products are linked to targets related to sustainability risks and opportunities. Such products are intended for general-purpose financing; therefore, they must be aligned with the main strategy of the issuer.

Similarly, KPIs and targets used for outcome-based finance should be derived directly from a company’s internal SDG strategy. Internally, it is useful to have only one set of KPIs and targets to monitor and audit. For investors, it is also important that SDG targets in bonds are aligned with a company’s overall strategy, raising the probability that indicators will last during the life of the bond.

The current sustainability-linked financial market shows a clear link between the issuer strategy and the transaction. This is summarized in clear KPIs representing the necessary metrics to evaluate the nonfinancial outcome of the instrument.
CFO Insights

As seen in the Blueprint for Principle 1, the ability of issuers to develop a credible SDG impact thesis revolves around the design of a strategic plan for material SDGs and metrics to monitor performance and impact. Leveraging these metrics to issue SDG-linked finance creates an even stronger link among material SDG factors for the business, funding needs, capital allocation, value creation, and positive impact generated by the issuer.

Link to Material Targets and KPIs

In general, outcome-based finance should make reference to KPIs and targets that are related to the company’s material SDG impact and that are used as part of its overall strategy. KPIs shouldn’t be developed exclusively for financing purposes but as a clear monitoring tool for strategy implementation. Similarly, setting targets on these KPIs should be consistent with the strategy and reflect where the company wants to arrive—in terms of performance—in the future.

Indicators should live beyond the life of the financial instrument, demonstrating how the selection, assessment, and monitoring of the metric is tied to the issuer’s business.
CFO Insights

However, investor preferences, the high-level of standardization of publicly-traded bonds, and the need for the highest quality data suggest that only a subset of flagship metrics should be used for pricing and covenants in specific financial products, especially for publicly listed products like SDG-linked bonds.

Out of 11 KPI in our sustainability index, only three had the requirements for financial markets: carbon, diversity, and training. For capital markets, the large number of transactions require a few clear and simple KPIs. For banks, it can more customized.
Schneider Electric

An analysis of KPIs used in Sustainability-Linked Bonds by industry sectors (see Resource) shows that companies general use only couple of KPIs, often highly quantifiable metrics around climate and industry-specific impacts.

The validation process for selected metrics for a financial instrument involves intermediaries, second-party opinion providers, and investors and is aimed at enhancing the accountability of the issuer in various aspects of its SDG impact thesis. Insuch an approval process, issuers may see some resistance from other actors in the financial value chain regarding the use of a larger set of KPIs.

While the identification and development of multiple KPIs is critical and pivotal for the issuer to understand its performance on SDG-related metrics, sustainability-linked financial products tend to focus on a very small set of “flagship” KPIs to represent the sustainability performance of the core business.
CFO Insights

The characteristics of good KPIs and targets for outcome-based finance include:

objective, quantitative, able to be benchmarked
reflect materiality matrix of the company
investors understand the goal
can be audited and reported

Supporting a broad range of SDG Investments – Not just Capex

As outcome-based finance is general-purpose financing not earmarked for a taxonomy-compliant set of investments, it can support a broad range of SDG investments that companies need to make to support their SDG strategies and drive performance on their SDG targets. These include not only capital expenditures (Capex) but also research and development (R&D), operating expenses (Opex), and other investments that support long-term value creation for multiple capitals—human, natural, and intellectual. By extension, this broadens the market to allow less capital-intensive and more people-centric companies that make intangible investments to contribute to the SDGs.

Leverage Corporate Governance to Monitor Performance

Outcome-based finance is centered around the credibility of SDG KPIs and targets and the way they are measured and reported.

The continued growth of sustainable corporate finance is based on setting targets on material sustainability issues, monitoring them, and reporting on performance.
CFO Insights

Just as the KPIs and the target selection of financial products should be part of the overall company strategy, the measurement, monitoring, and reporting of performance on those KPIs and the target should be part of the company’s overall corporate governance and follow the same model as the measurement, monitoring, and reporting of financial information. This includes board oversight, internal controls and risk management related to the accounting, and the verification and disclosure of performance data on sustainability strategies and investments.

The role of CFOs is critical, in this respect,to elevate the measurement of sustainability performance to the same level as financial performance.

The ability of the issuer to effectively track outcomes is essential in providing credibility to the SDG-to-capital link, and issuers can leverage their experience in tracking metrics before thinking about linking these to a financial instrument.
CFO Insights

KPIs should emerge from sets of indicators used internally to track performance that are verified and certified by second-party-opinion providers and external assurers, assessing the relevance of the KPIs to the issuer. Therefore, the ability to provide accountability and consistency by issuers and show a track record of measurements is essential to issuing a credible outcome-based product.
CFO Insights

Capturing Performance on Social Matters

The general-purpose nature of outcome-based finance makes it a good fit for social issues – like gender diversity and digital inclusion – that require less capital investments, and more investments in people and communities. This is reflected in the increasing diversity of industries participating in the sustainability-linked bond (SLB) market, including people-intensive industries.

However, despite access to a broader universe of companies, very few SLBs use targets and KPIs related to social issues. Instead, as the chart below shows, most targets and KPIs in outcome-based finance products are related to greenhouse gas (GHG) emissions and other environmental issues.

*Number of KPIs by broad category. Majority of KPIs are associated with GHG emissions reduction*

Source: Moody's ESG Solutions, Environmental Finance Bond Database and company reports

This lack of social KPIs in the SLB market suggests a potential mismatch between companies’ material issues and where they choose to invest. It could also limit the potential of outcome-based finance to support social investments at scale.

To overcome this challenge, companies should strive to develop credible targets and KPIs for less quantifiable social matters in a way that reflects material issues and links to value creation. For example, for access to and affordability and reliability of telecom services, the following KPIs can be used:

number of homes reached in impoverished area
discount provided on essential products and services
amount of extra broadband for the same price

One of the main challenges of effectively monitoring performance is to justify specific KPIs for long-term strategies that won’t show results for a few years. In addressing this issue, the existence of a structure and a clear commitment to analyzing and monitoring sustainability performance are the pivotal aspects to justify long-term targets.
CFO Insights