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Sustainability-linked instruments: innovation in lending & issuances

The rise of sustainability-linked instruments (SLIs) in emerging markets marks a transformative shift in how financing is aligned with sustainability objectives. In recent years, these instruments have gained significant traction, reflecting a growing recognition of the need for sustainable practices across various sectors. SLIs have become popular given that they incentivise the pursuit of sustainability targets by linking pricing (typically interest rates) to their performance. SLIs can take the form of bonds, corporate loans, project finance loans, revolving credit facilitates, derivates etc., however, sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs) are the most commonly used instruments.

Climate Bonds Initiative marked a sustainability-linked bonds flows at US $2.4 billion in Q3 of 2024, with the cumulative total being US $55.4 billion since 2006. On the other hand, sustainability-linked loans dominated the global market and accounted for approximately US $134 billion, accounting for over 75% of total sustainable loan volumes as of Q3 2024. This surge is indicative of a broader trend where the global finance sector is increasingly leveraging SLIs to fund their operations whilst simultaneously committing to ambitious ESG/climate/sustainability targets.

Distinguishing features

SLIs have unique structuring and flexibility which distinguishes them from traditional financing mechanisms. These include:

  • Performance-based incentives: SLIs are designed to incentivise borrowers by linking interest rates or bond yields (i.e., the price of financing) to the achievement of specific predetermined sustainability performance targets (SPTs) measured using key performance indicators (KPIs). This implies that borrowers/issuers can benefit from lower financing costs if they meet or exceed their set targets. There are 2 key pricing-based mechanisms:
    • Step-up penalties: If a borrower fails to meet their sustainability targets by a specified date, the interest rate on their loan/bond increases by a predetermined amount, often expressed in basis points. This step-up serves as a financial consequence for not achieving the set goals, encouraging companies to prioritise their sustainability commitments
    • Step-down rewards: If borrowers successfully meet or exceed their targets, they benefit from a reduction in interest rates. This step-down mechanism rewards companies for their efforts in enhancing their ESG performance
  • Flexibility in use of proceeds: Unlike instruments such as thematic bonds where use of proceeds are tied directly to green or climate projects, SLIs can be used for general sustainability goals, making them more adaptable for projects/borrowers/issuers without a clear pipeline of green projects
  • Applicability across sectors: The flexibility in use of proceeds allows SLIs to make for a suitable option in hard to abate sectors, where use of proceeds instruments might not be appropriate/applicable. By providing a sustainable finance mechanism for these sectors, SLIs allow the broadening of the scope of sustainable finance and mobilising greater capital in key sectors

 

Innovation

Performance-based instruments such as these represent a significant innovation in the sustainable finance space by shifting the focus from activity-based funding to performance-based outcomes. The flexibility of these instruments addresses a critical challenge for climate and sustainability projects: the need for accessible financing that is not restricted to narrowly defined initiatives. These structuring approaches have also allowed for further innovation in lending and issuances.

 

Types of structures

A recent innovation is the sustainability-linked loan financing bond (SLLB) which combine the features of SLLs and bond financing, where such bonds are used to finance or refinance a portfolio of SLLs. Aligned with ICMA’s Green Bond, Social Bond, Sustainability Bond and SLL Principles, SLLBs must have 4 core components. These include (1) use of proceeds, which outline an eligibility criteria for SLLs with the selection of KPIs and SPTs, (2) process for SLL evaluation and selection, which outlines the governance structure for the evaluation and monitoring of SLL eligibility, (3) management of proceeds, which tracks the net proceeds to SLLs and (4) reporting, which provides updates on progress such as KPI/SPT achievement. Crédit Agricole CIB launched its SLLB Framework in 2024 aimed at refinancing a portfolio of SLLs. It also launched a JPY 3 billion SLLB with Sumitomo Life Insurance Company.

Sustainability-linked perpetuals combine tradition perpetual bonds (i.e., bonds with no fixed maturity) with sustainability-linked instrument features. These instruments provide investors with ongoing interest payments indefinitely, while also tying the financial terms to the issuer’s performance against predefined sustainability targets. SLPs typically feature very long or even indefinite maturities, where the issuer is obligated to pay fixed coupons to bondholders indefinitely or until the bond is called or redeemed.

These perpetual or hybrid bonds are generally subordinated within the issuer’s capital structure, which gives them equity-like loss characteristics. Due to their long duration and subordinated status, rating agencies often classify perpetual/hybrid bonds as comprising both debt and equity. These have not historically been popular, since step-up coupons structures often prevent them from qualifying for equity treatment from major rating agencies. This limitation reduces their attractiveness to issuers. However, there have been issuances, specifically in Asia in 2024. Malaysian Real Estate Investment Trust (REIT), Sunway REIT priced 2 SLPs that garnered 75% equity treatment from RAM Rating Services Berhad (leading Southeast Asian credit ratings agency). Additionally, Fuyo General Lease, a Japanese REIT also issued a bond that received 50% equity treatment from JCR and R&I (Japanese credit ratings agencies).

 

Types of sectors/focus

Novel instruments have also emerged. The World Bank’s five-year US $50 million Emission Reduction-Linked Bond helps provide clean drinking water to children in Vietnam, with investor returns linked to the issuance of Verified Carbon Units (VCUs) generated by a water purification project in Vietnam. This project aims to manufacture and distribute 300,000 water purifiers to approximately 8,000 schools, providing clean water to approximately 2 million children while reducing GHG emissions by nearly 3 million tons of CO2 over 5 years.

Instead of receiving traditional coupon payments, investors forgo these payments, which are then used to fund the upfront costs of the water purifiers. They receive semi-annual payments linked to the VCUs generated by the project, creating a direct financial incentive for both the project’s success and environmental outcomes. The bond is fully principal-protected, ensuring that investors’ initial capital is safeguarded while supporting global sustainable development initiatives.

These innovations point to the growing appetite for novelty and creativity in structuring approaches in the sustainable finance space. To gain in popularity and market share, SLIs need to leverage emerging advances in technology, policies and regulations, and new structuring approaches to scale financing for sustainability projects, while addressing the gaps in traditional sustainable finance instruments and mechanisms.

 

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