Virtue and a reward: Linking sustainable policies with sovereign debt

Earlier this year, we described how the global pandemic is drawing renewed attention to the interlocking challenges of rising sovereign debt levels, climate change and environmental degradation. Addressing these problems will require unprecedented levels of investment, and policy makers are looking for ways to link the solutions.

The corporate sector has already started making these connections through sustainability-linked loans and bonds (SLBs), which tie the interest paid to investors to the issuer’s ability to meet key performance indicators (KPIs) on environmental or social policies. Unlike sustainable debt, such as green or blue bonds, an SLB has no restrictions on the use of proceeds. Instead, it is designed to promote sustainability while providing general-use liquidity to the issuer. 

About $10 billion of these bonds were issued in 2020, and Moody’s estimates that number could rise to $100 billion in 2021. This asset class has yielded some early lessons. Corporate issues have been mainly structured with “step-up” coupons, where the issuer agrees to pay a higher rate (25 basis points on average) if it fails to meet its KPIs. Investors have shown willingness to pay some discount to incentivize results (and for potential upside).

Now, several countries are considering issuing sovereign debt that follows this model. These bonds would allow nations to raise debt to deal with immediate COVID-related costs and general-purpose budget finance needs  while signaling commitments to medium-term sustainable development goals that contribute to sustainable development and reduce potential financial risks. 

The debt could be linked to policy, program or project objectives. In addition, it would avoid costly budget tagging and project identification because the proceeds would be used for general-purpose financing and would provide capital incentives for governments prepared to commit to ambitious targets. The SLBs might also contribute to debt sustainability by reducing the cost of capital, though they wouldn’t be debt swaps or debt restructuring instruments. Countries’ overall debt levels could be maintained by rolling over existing obligations to lower cost issuance.

Sovereign SLBs  would likely be structured differently from their corporate counterparts. They would be more likely to use “step-down” structures that reward issuing countries for implementing ambitious targets on climate, the environment and sustainable development. So, who would pay when these targets are met? Most likely, the performance cost would be borne by a combination of investors supported by some concessional, philanthropic funding.

We have also been working in conjunction with partners, including the Potomac Group, to explore how to make these payments work, while keeping the design of the instrument as close to regular sovereign bonds as possible to make pricing easier, avoid the fragmentation of small markets and allow for replication and scale.

One option is for the payment mechanism to be set up as a special purpose vehicle (SPV) called a Performance Trust fund. Governments could negotiate a below-market yield with investors, on the assumption of a high probability of compliance with KPI targets. As the government makes coupon payments the differential between this below-market rate and the market rate (“contingent payment”) would be placed in the SPV, perhaps in the form of zero-coupon bonds. If the KPIs are met over the life of the bond, the contingent payment would be made to the government and investors would be able to demonstrate measurable impact toward national climate, nature and development goals, including alignment with the Paris Agreement. If the KPIs are not met, investors would receive the contingent payment back and effectively the market interest rate. The donor capital portion of the trust would also pay out in pre-determined portions to the issuing government upon achievement of their goals, which would provide for relatively large payments with no defined use-of-proceeds, a strong incentive to comply for many policymakers. This would help further lower the cost of capital and help bridge any difference between the desired discount of the government for its commitment to KPIs and the lower coupon that investors may be willing to receive as the market for these instruments develops.

Learning from the corporate market, setting significant KPIs for these sovereign bonds will also be vital to establish a robust asset class. A limited number of understandable, internationally accepted indicators would have to be selected. The World Bank has been analyzing existing data sets and is working on a framework for assessing both the robustness of the KPI and the ambition of the targets set. An annual performance report measuring progress would need to be prepared by an internationally accredited auditing firm and would be provided to both investors and donors. International rating agencies and the main sovereign index providers should also be consulted during the structuring stage to further add confidence in these bonds.

Table 1: Possible Framework for Assessing Robustness of Sovereign SLB indicators + targets

The World Bank and other development financing institutions have a role to play in creating this market: by drawing on our experience of innovative structuring and of linking financing to policy actions; by helping to validate strong indicators, targets and monitoring, reporting and verification (MRV) structures; and potentially through our financial instruments, which we can deploy to help attract capital to the emerging markets that need it most to meet the Paris Agreement and Sustainable Development Goals.

Our analysis of today’s sovereign bond markets shows that, sadly, virtue is not its own reward, and the stewardship of natural assets by countries is not being well recognized by markets, even though it is not only of national importance but also a vital global public good.  We believe that instruments such as sovereign SLBs can help reward sustainable policy making and make climate and environmental factors a natural part of investment decisions.