Meaningful Reward for Performance

The promise of outcome-based finance is that capital markets will reward company performance on SDG targets and promote competition for the most effective sustainability solutions. In the long run, as investors continue to improve their understanding of how sustainability impacts financial analysis, the efficient market theory suggests that markets will “price” sustainability performance in the market for corporate bonds and equity. In the meantime, step-ups in the interest rates have been introduced to ensure that companies are sufficiently incentivized to meet their targets.

The credibility of an issuer’s commitment is enhanced by detailing the intermediate steps that will allow the issuer to get to the goal: what specific deliverables will be met and what the medium- to long-term goals are.
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Arbitrage in the Secondary Market

Over time, bond (and equity) prices on the secondary market should reflect performance on material SDG targets. With the right incentives and information and the participation of all actors in the investment value chain, the bond market should reward performance key SDG metrics, just as it rewards performance on key business or financial metrics. If a company performs in line with its SDG targets, pricing would be in line with its credit rating. Higher performance would lead to higher bond prices and lower yield; under performance would lead to lower bond prices and higher yield.

Without adjustment mechanisms in the financial product itself, performance on SDG targets would not immediately impact the cost of a company’s outstanding debt. However, it would impact the cost of refinancing that debt or obtaining new financing.

The entire investment value chain, including accountants, financial analysis, and credit rating agencies, must play the role of benchmarking and rewarding performance.
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Case Study: How Market Forces Can Price Sustainability Performance

When bonds are traded in the secondary market, their price reflect the interest rate environment and the issuer’s credit profile. If interest rates go up, or the issuer’s credit profile worsens, bond prices will go down (and yields will go up), reflecting a lower demand for the bond. Inversely, a lower interest rate environment, or an improvement of the issuer’s credit will lead to a price increase, and lower yield for the bond.

If sustainability targets are fixed at the issuance of a sustainability-linked bond (SLB), bond prices could also play an arbitrage role if there is a change in the issuer’s performance or if the overall market changes. For this to happen, two things are necessary: • an independent assessment of a company’s sustainability performance against its target (the equivalent of a CRA) • a sense of the market level of sustainability performance in specific issues or industries

Note: Step-ups have been introduced temporarily to address the issue of a change in the issuer’s performance. However, eventually this function could also be served by pricing arbitrage.

How would it work?
Company A issues a five-year bond in Year One, with two SDG targets and intermediate milestones: • GHG emissions reductions of 50 percent in Year Five (maturity), with a straight-line decrease over time • Between 45 percent and 55 percent of women in management and board positions in Year Five (maturity), with a straight-line increase over time

Scenario 1: Issuer Underperforms
At the end of Year Two, the issuer is on track to meet its GHG emissions target, having decreased its emissions by 20 percent, but it is lagging on diversity targets with only 23 percent of management positions filled by women. Board diversity also lags at 37 percent, and neither the board nor management has satisfactorily addressed underperformance on diversity targets.

Based on this performance, a credit rating agency lowers the rating of the company and signals to the markets that the sustainability quality of the issuer has fallen and therefore the bond—all other credit consideration being equal—should trade at a discount.

While the lower price of the bond does not affect the issuer directly (since it is being traded on the secondary market), it does impact the pricing of new bond issuance and therefore the cost of capital.

Corrective actions by the board and management to catch up with the trend line, documented by the rating agency, would bring the bond’s prices back up to, or close to, their par value, all other credit factors being equal.

Scenario 2: Change in Market Conditions
At the end of Year Two, the issuer is on trend to achieve its five-year targets (20 percent reduction in GHG emissions, 30 percent females in management positions and 40 percent on the board). However, market conditions have evolved, governments have raised their climate ambitions, and companies in the same industry have substantially raised their mitigation targets.

The bonds of Company A become less attractive and trade at a discount to competitors with higher targets.

To deal with this situation, Company A could raise its own internal targets—and communicate that officially to investors, including through their SDG Finance Framework—and, even though the targets are not upgraded in the bond itself, they would be taken into account by market participants and be reflected in the bond price.

The Use of Step-Up and Step-Down

Most sustainability-linked bonds and loans include a step-up mechanism in which interest rates increase if the issuing company fails to meet its SDG targets. While this feature has helped the rapid growth of outcome-based finance, the long-term growth and credibility of the market will require a meaningful variation in the financial characteristics of these instruments, likely beyond the current average of 34 basis points (see figure below).

*Types of structural adjustments incorporated into SLBs, % share*

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

Step-down and other structural adjustments have also been introduced. However, they are much less popular, especially in the bond market where the simplicity and standardization of instruments is critical.

Issuers should be cautious with this type of mechanism, especially concerning the nature of the targets they set for the financial instrument: if an issuer gets a step-up, it will affect the company negatively because the market will see it as a nonperforming company that is not meeting its commitments.

The market for sustainability-linked financial instruments is still new, and structures that are too complex might erode investor confidence.
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Meaningful Reward for Performance

Arbitrage in the Secondary Market

The Use of Step-Up and Step-Down