Recently, concern about environmental, social, and governance (ESG) matters has grown among investors and society at large. Consequently, this concern has led to demand for greater transparency and regulation in these fields. As a result, companies are now prioritizing ESG disclosures and reporting. This demand stems not only from societal pressures and investors, but also extends to debt-markets, which encourage and fund companies to participate in ESG objectives through sustainability linked bonds. This article focuses on reporting and disclosures related to sustainability linked bonds.
What Are Sustainability Linked Bonds?
Sustainability linked (or ESG linked) bonds are defined by KPMG as “loans where the pricing varies depending on whether the issuer achieves its ESG objectives within a predefined timeline.” No restrictions exist on the projects that sustainability linked bonds can fund. There are also no specific requirements for what constitutes an ESG objective as it relates to a sustainability linked bond, and can relate to environmental, social, or governance metrics. ESG objectives can vary widely, from water usage reductions to racial diversity of board members.
Because the ESG feature in a sustainability linked bond has risks and characteristics separate from the bond, it often requires bifurcation. To learn more about accounting for the ESG features in sustainability linked bonds, see our Embedded Features Overview article.
How to Disclose Sustainability Linked Bonds
Reporting Information and Disclosures for Sustainability Linked Bonds
Reporting requirements encompass not only the standard bond issuance disclosures found in ASC 210-10-S99-1, but also the details of the ESG embedded feature, its impact on the bond, and the bond's term. Companies must include these disclosures in both annual (10-K) and quarterly (10-Q) filings submitted to the Securities and Exchange Commission.
Recommended Disclosures for Sustainability Linked Bonds
The International Capital Market Association (ICMA) is a trade association and self-regulatory group for capital market participants. The ICMA created the “Sustainability-Linked Bond Principles” (SLBP) to assist companies in disclosing information related to sustainability linked bonds. The ICMA recommends five specific disclosures:
- Selection of KPIs
- Calibration of Sustainability Performance Targets
- Bond Characteristics
Altogether, these disclosures allow investors to hold issuers accountable and enable underwriters to create best practices resulting valid transactions.
Selection of KPIs
The ICMA states, “The credibility of the Sustainability Linked Bond market will rest on the selection of one or more KPI(s).” Four metrics can help establish KPIs as a credible component of the sustainability linked feature.
First, the KPIs must be “relevant, core, and material to the issuer’s overall business.” Companies ought to convey to investors the reasoning behind selecting each KPI and its significance to their business. Including a clear and direct definition of the KPI is also essential. Issuers of sustainability linked bonds should not receive rewards for accomplishing goals unrelated to their business.
Second, the KPIs must be “measurable or quantifiable on a consistent methodological basis.” Consequently, this allows investors to track a company’s progress and keeps businesses accountable. Issuers should also consider choosing KPIs previously featured in financial statements or sustainability reports, enabling investors to evaluate the historical performance of the selected KPIs.
Third, the KPIs must be “externally verifiable.” This metric is tied to the fifth and final disclosure recommended by the ICMA - “Verification.” Companies must select KPIs that can be verified by a third party to ensure accountability for achieving or missing goals.
Finally, the KPIs must be “able to be benchmarked.” As sustainability bonds become more common, it will become increasingly important that KPIs selected by a company are both comparable to those chosen by other companies in their industry and ambitious in their level of sustainability. For instance, a business aiming to reduce water consumption by 1% should not receive rewards if the industry average reduction is 5%.
Calibration of Sustainability Performance Targets
Sustainability Performance Targets (SPTs) are “measurable improvements in key performance indicators on to which issuers commit to a predefined timeline.” For example, a company could set a KPI of water usage per employee. The associated SPT would be to reduce water usage to one gallon per employee per day.
SPTs set by a company should require effort to achieve. They should constitute a material improvement in the chosen area of performance and should synergize with the company’s ESG strategy. Accordingly, SPTs should be associated with a predetermined timeline that can be concurrent with, or predate, the life of the bond.
Issuers should use the following three benchmarking approaches when setting SPTs:
- Tracking the issuers performance for the KPI over the past three years or using forward looking guidance
- Comparing set targets to SPTs established by other companies in the same industry
- Reference to other targets set by countries or international organizations to “determine relevant targets across environmental and social themes”
After establishing benchmarks for SPTs, companies should disclose:
- Their timelines for the achievement of their SPTs
- The chosen baseline identified for improvement and the reasons for selecting it
- How the issuers plan on achieving the SPT—including what actions the company plans to take to achieve the SPT
- The issuers’ ESG strategy and governance of its ESG efforts
By setting benchmarks that encourage the issuer to set material SPTs and disclosing how the issuer plans to achieve said SPTs, the company will ensure that chosen SPTs will be appropriate to use in a sustainability linked bond.
The unique aspect of sustainability linked bonds is that the bond’s financial and structural characteristics change based on reaching SPTs. A sustainability linked bond's most common characteristic is an embedded feature that adjusts the coupon rate based on achieving certain ESG targets, although other variations could be incorporated. Consequently, issuers must diligently document and report any specific variations in the bond's characteristics that may arise if they meet the targets. The ICMA also recommends that “any fallback mechanisms in case the SPTs cannot be calculated or observed in a satisfactory manner, should be explained.”
Companies that issue sustainability linked bonds should also report the following:
- Current information on the performance of the chosen KPIs
- A verification report that highlights the performance of the SPTs and the related impact on the bond’s financial characteristics
- Any relevant information for the analysis of the selected SPTs and KPIs by investors
Report this information at least annually and whenever the SPT performance results in a structural change in the bond's financial characteristics. Doing so provides investors with the necessary information to make informed decisions.
Issuers should also consider disclosing any extraordinary events that could potentially impact the measurement and observation of KPIs and SPTs, such as M&A activity or potential changes in the regulatory environment.
Companies should acquire external verification of their sustainability performance targets and KPIs through a third party at least once a year. The third party can be either an auditor, an environmental consultant, or any other qualified external party with relevant expertise. Make the results of the verification publicly available.
Overall, sustainability linked bonds are becoming increasingly prevalent as more companies increase their ESG efforts. By prioritizing ESG matters, companies can potentially reduce their cost of capital. However, companies that issue sustainability linked bonds will have to ensure appropriate disclosure and reporting. Understanding how to utilize and disclose these sources of financing can specifically help companies benefit from ESG goals.