Developing countries are highly vulnerable to climate change. To add, emerging markets are on average further away from meeting the United Nations’ sustainable development goals than developed nations. Significant capital is therefore needed to close the sustainable funding gap in these countries.
According to the UN Conference on Trade and Development, in developing countries alone, SDG investment needs amount to $4.5tn for basic infrastructure, food security, climate change mitigation and adaptation, health and education.
To mobilise private capital for sustainable development, capital markets are a critical source of long-term funding. In the past, emerging markets have lagged developed markets in terms of sustainable finance. But luckily their relative share of financial flows has increased in recent years. To ensure this positive trend continues, we need innovative financing instruments for sustainable development.
The global fixed income market, with a volume of more than $100tn, is one important source of innovation to support the transition to a more sustainable future. Hence, we must investigate the sovereign sustainable bond segment, in which sustainability-linked bonds have successfully found their place since last year, alongside the traditional use-of-proceeds variants (green, social and sustainability bonds).
But first, it’s important to clarify what target-linked financing, which is still relatively new, entails. SLBs, which first emerged in 2019, are forward-looking and performance-orientated financial instruments in which issuers explicitly commit to future improvements in sustainability criteria within a predefined timeframe.
Sustainability development is measured using predefined key performance indicators and evaluated against sustainability performance targets. The financing costs of SLBs are linked to the achievement of these targets. If the issuer fails to meet the targets, financing becomes more expensive.
As the use of proceeds of SLBs are not earmarked and can therefore also be used for general financing, they are also suitable for issuers who do not have the necessary volume for a use-of-proceeds bond.
Governments, for example, can use the instrument as a source of funds for general budget spending like any other government debt. It can also use the instrument to mitigate balance sheet risks by reducing maturity or currency mismatches, but with a link to a refinancing mechanism if nationally determined contributions or other targets are met.
For credible sustainable financing using SLBs, it is important to choose KPIs that are relevant, measurable and comparable. These factors are central to the issuer’s sustainability goals. They should also have a high strategic importance for the issuer’s future. In addition, the SPTs should be in line with the issuer’s sustainability strategy and be ambitious, i.e., go beyond a ‘business-as-usual scenario’.
Are SLBs here to stay?
By the end of the third quarter in 2023, 49 sovereigns have issued sustainable bonds with a cumulative volume of more than $400bn, with the use of proceeds structure clearly dominating. So far, 32 countries have issued green bonds, three countries have issued social bonds and 16 countries, sustainability bonds.
While SLBs have become popular among corporate issuers, they are far less established among sovereign borrowers. Although SLBs are a suitable instrument for linking sustainable sovereign financing to, for example, NDCs, only Chile and Uruguay have so far opted for the target-linked funding variant. Scaling up SLB issuance in developing countries would offer more and more issuers access to new sources of finance.
By issuing the world’s first sovereign SLB in March 2022, Chile successfully demonstrated that sustainable bonds could monetise not just sustainable public expenditure and infrastructure but can also be instrumental in monetising sustainable policies and national commitments. These include the NDCs set by the country under the Paris Agreement on climate change. In October 2022, Uruguay also linked the coupon of its SLB to compliance with the climate and environmental goals that the country set in its first NDCs to the Paris Agreement. In addition, it also featured a nature-based KPI.
Major potential in sovereign sustainable bond market
Following the success of Chile and Uruguay, it is likely that SLBs will attract issuers from beyond Latin America and that we will see issuance from southeast Asia or Africa, for example. SLBs are expected to become increasingly popular among sovereign issuers from emerging markets as the flexibility in how the borrower uses the money raised makes this type of debt attractive to smaller issuers that may not have an extensive pipeline of green or social projects that would qualify for green or social bond proceeds.
Looking at the numbers, the sovereign sustainable bond market offers enormous potential here. About 170 countries are issuing sovereign debt. Hence, there are plenty which have not come to the market yet. This includes three sovereign issuers with the largest outstanding volume (the US, Japan and China) as well as many issuers from developing countries.
Marcus Pratsch is head of sustainable bonds and finance at DZ BANK AG.
This article is part of the Sustainable Policy Institute’s Autumn 2023 journal launching 27 November.