Sovereign Sustainability-Linked Bonds (SLBs)

(i) Can sovereign SLBs become a valuable tool in financing sustainable development?

Rising debt distress risks emerging markets’ ability to finance decarbonisation commitments under the Paris Agreement and their own National Determined Contributions (NDC), even as they are disproportionately exposed to the effects of climate change and natural disasters[1].

Can sovereign Sustainability Linked Bonds (SLBs) help? SLBs can be designed to link sovereign financing with national climate and environmental commitments, rewarding countries that meet their climate targets with a discount on the bond’s coupon.

Chile has paved the way with the world’s first sovereign SLB issuance in March 2022. The USD 2 billion bond was four times oversubscribed. It ties Chile to its NDC, committing the country to emitting no more than 95 metric tons of carbon dioxide and equivalent by 2030 and that 60% of electricity production be derived from renewable energy by 2032.

Unlike the constraints of “use of proceeds” green bonds, SLBs allow issuers to finance a wide range of investments, spanning from climate change mitigation and adaptation to social projects, as proceeds are not earmarked for any specific projects selected upfront.

With sufficient investor demand, SLBs could increase the sovereign debt sustainability by reducing the cost of debt servicing, thanks to a coupon step-down mechanism. Debt sustainability would be further enhanced by the fact that SLBs - just like the other “thematic” bonds - are normally issued with a discount for issuers (referred to as “greenium”), as revealed by a recent analysis from the Climate Bonds Initiative

(ii) The Green, Social & Sustainability (GSS) bond market has grown exponentially and hosts a variety of issuers, including sovereigns

The Green, Social & Sustainability (GSS) bond market has grown exponentially and hosts a variety of issuers, including sovereigns

Financial markets have been increasingly mobilised to address the challenges of climate change. The European Investment Bank launched its Climate Awareness Bond in 2007 and the World Bank introduced the world’s first green bond in 2008, giving birth to the so-called Green, Social & Sustainability (GSS) bond market. GSS bonds work just like any other ‘vanilla’ bond, with the difference that the issuers commit to use the bond’s proceeds exclusively to finance Green, Social & Sustainability projects. Additional documentation prior to the issuance and reporting after the issuance are required to ensure that proceeds are transparently allocated for the intended purposes. GSS bonds follow self-regulation principles—such as the ICMA Principles—developed by market stakeholders.

The Green, Social & Sustainability (GSS) bond market has grown exponentially and hosts a variety of issuers, including sovereigns

Since the inaugural World Bank issuance in 2008, the GSS bond market has experienced an extraordinary growth and diversification, that can be disentangled in three main trends:

  • Astonishing growth in overall issuance volume, which hit the USD 1 trillion milestone in cumulative issuance in 2020 (see Figure below).
  • Diversification of issuers, moving from a market dominated by Development Banks to corporates and, more recently, sovereigns.
  • Diversification of instruments, moving from the ‘use of proceeds’ model to the Sustainability-linked mechanism (SLB).

(iii) SLBs have emerged as a key mechanism for channeling capital towards sustainability objectives 

The GSS bonds market experienced an important innovation in 2019, when the Italian utility Enel launched the world’s first Sustainability-linked Bond (SLB). SLBs are debt securities whose financial characteristics (coupon or principal) can vary based on the (non) achievement of pre-defined Sustainability / ESG objectives. In other words, the issuer faces a step-up in the coupon/principal should it fail to meet the predefined targets (or a step-down should it meet them). They are self-regulated by ICMA’s Sustainability-Linked Bond Principles. Differently from ‘use of proceeds’ bonds, SLBs’ proceeds are not earmarked for any specific purposes but they can be used for general corporate purposes.

Interestingly, a mix of use of proceeds and sustainability-linked targets can be found in the same transaction. For instance, the European Investment Bank agreed on a EUR 600 million facility with Italian utility Enel to finance renewable energy investments in South America, with part of the proceeds allocated to specific investments and part linked to a target in terms of Scope 1 GHG emissions.

SLBs are an emerging instrument, whose popularity is rapidly growing. In H1 2022, USD 176.6 billion of SLBs were issued (source: Climate Bonds Initiative) compared to USD 91.7 billion in 2021 (source: Environmental Finance) and to USD 10.6 billion in 2020 (Source: PwC).

Designing a SLB requires establishing appropriate, ambitious, time-bound, and possibly science-based KPIs. Examples range from the increase in percentage of energy generated from renewable sources to targets in CO2 emissions reduction. Further, the issuer is required to regularly report on its progress against the KPIs.

Pros and cons of SLBs vs. traditional GSS approach

Pros of SLBs

  1. Flexibility in the allocation of proceeds, leaving the issuer to decide how to best achieve its sustainability targets;

  2. Creates an alignment between the corporate sustainability strategy and the financial structure, through a financial incentive;

  3. Issuers can benefit from a discount on coupon payments (normally around 25 bps based on existing market transactions) if the KPIs are met.

  4. SLBs can be used by issuers that operate in hard-to-abate and carbon-intensive industries. These issuers would struggle in finding the green investments necessary to justify the issuance of a use-of-proceeds bond.

Cons of SLBs

  1. SLBs require quite complex structuring in order to design the KPIs and financial structure. Reporting and verification can be burdensome.

  2. Unambitious KPIs risk to seriously jeopardise the integrity of the security and defeat the sustainability purposes. Similarly, the more rigorous environmental investors do not appreciate the flexibility in the use of proceeds that could be used potentially even for environmentally harmful investments. In sum, SLBs are more prone to the risk of being accused of ‘greenwashing’ compared to ‘use of proceeds’. 

  3. Enforceability of the KPIs written into the contracts can also be an issue. To date, no SLB has reached its maturity, therefore this aspect should be carefully monitored in the future.

  4. Alignment with taxonomies—such as the EU Taxonomy—can be problematic for SLBs, which lack a clear “use of proceeds” reporting.

(iv) Sovereign SLBs could fit with the needs of emerging markets

Sovereign SLBs could fit with the needs of emerging markets

The characteristics and benefits of SLBs outlined so far could make them an interesting financing tool for sovereigns in EMDEs.

As mentioned in the introduction, EMDEs are i) disproportionately exposed to the effects of climate change and ii) affected by high and growing levels of sovereign bond yields and cost of debt servicing (as shown in the figures below). Sovereign SLBs represent an attractive solution for EMDEs to tackle both issues at the same time. On the one hand, they can structure an SLB to finance investments that contribute to the achievement of SDGs and help build their resilience and prosperity. On the other hand, they can benefit from significant savings in debt servicing in the event that KPIs are met.

Sovereign SLBs could fit with the needs of emerging markets

EMDEs Sovereign SLBs with SDG-related or Paris-aligned KPIs would represent an attractive security for international investors that are i) committed to consistently embed ESG considerations in their investment decisions ii) are looking for a security that might become more mainstream and liquid over time, as the SLB market develops and it expands to sovereigns.

(v) Sovereign SLB design presents particular challenges but with the right support they can be resolved

Challenge: setting (ambitious) KPI is the most critical element of SLBs. Choosing the right KPIs ensures that i) the sustainability/environmental dimension of the security is ambitious and ii) the penalty/incentive system is appropriate. Additionally, a sovereign SLB should embed KPIs that are far-reaching and encompass multiple dimensions. Governments are responsible for the green transition, but they must always carefully balance it with its social consequences. 

Solution: a careful design of the KPIs, based on market best practices and involving third-party consultation and verification would ensure the integrity of the transaction. The World Bank has published a report on this topic, paving the way for the KPI-setting of sovereign SLBs. In addition, ICMA provides an exhaustive list of potential KPIs for SLBs, as part of the Sustainability-linked Bonds Standards. Importantly, all these KPIs align with several existing international ESG standards, including the EU Taxonomy. In addition, the sustainability-linked structure offers the required flexibility to ensure that governments deliver on their international climate commitments, in line with their NDC,  without overlooking the social implications, ensuring the so-called ‘Just Transition’. 

Challenge: Assurance, Monitoring & Enforceability are another critical element of SLBs. Ensuring that the reporting on the KPIs is reliable directly affects the reputation of the issuer and the security and its demand from investors. A potential sovereign transaction in EMDEs would add an additional layer of complexity in the assurance process. Public administration in EMDEs might be unstable and subject to political influence and corruption. This might also create enforceability problems should the issuer and the investors come into a legal dispute over the achievement of the KPIs.

Solution: the World Bank has led the pioneering issuance of Green Bonds in EMDEs, namely in Nigeria, Egypt and Fiji. The reporting process of Green Bonds differs from the one of SLBs but it entails the same challenges and goals. These experiences can be a source of best-practices and lessons learnt for the reporting of GSS bonds in EMDEs. Another interesting example is the Rhino Impact Investment Project, which developed the world’s first pay-for-results financial instrument for species conservation. The project introduced innovative KPI measurement systems to assure the results in the developments of the Rhino population.

Challenge: Sovereign debt sustainability in a sovereign SLB would be the main concern of international investors, particularly in a transaction in EMDEs. Existing corporate SLBs include a step-up coupon, should the issuer fail to meet the KPIs. It is unlikely that sovereign issuers would want to expose themselves to the risk of a step-up and similarly investors might be concerned about debt sustainability.

Solution: a sovereign SLB could be structured in a novel way, including a coupon step-down instead of a step-up. This would be favoured by issuers who would face a positive incentive to meet the KPIs instead of a penalty for not meeting them. It would also reassure investors on the debt sustainability. On the other hand, investors might find such a structure less attractive from a return perspective. Involving trust funds, such as the Green Climate Fund and responsible/impact investors could be a solution. Many investors increasingly look beyond the traditional risk-return paradigm and are eager to include ESG/climate assets in their portfolio, to achieve impact and diversification.

Challenge: Identifying the appropriate issuers & investors for a pioneer transaction requires a careful market screening and an engagement with several stakeholders. Structuring a credible and attractive sovereign SLB requires an issuer that has i) a positive track-record on capital markets and ii) a strong sustainability commitment and decarbonisation strategy. It would also require finding investors that are interested in combining impact with financial return, as mentioned in the paragraph above. The experience of Chile’s SLBs shows that the demand for such instruments can be strong. 


i) engaging with stakeholders (sovereign issuers, financial institutions, MDBs) to capture expectations and doubts on a sovereign SLB. In terms of engaging with market stakeholders, the Luxembourg Stock Exchange could represent a useful platform. Through its Green Exchange, it is one of the main listing venues at global level for SLBs, providing a platform with international visibility and assisting issuers throughout the whole issuance and post-issuance process. 

ii) ranking potential issuers based on two criteria: cost of debt servicing and impact of climate change / decarbonisation strategy. Ideally, countries with a high debt servicing burden and that are deeply impacted by climate change would be the most suitable candidates for a sovereign SLB. 

A final remark on investors about impact: Should the KPIs not be met, investors would earn a larger coupon. It can be assumed that this would not be a satisfying outcome for impact oriented investors, as they would achieve a higher financial return but no sustainability impact. A mechanism for which the proceeds of the step-up coupon would be allocated—in part or in total—to help the issuer get back on track to achieve the intended KPIs could be envisaged.

[1] Countries in Africa spent an estimated 5% of their GDP on climate adaptation and mitigation measures as of 2021. This percentage is expected to shoot up to 15%, according to Vera Songwe, Executive Secretary for the UN’s Commission for Africa. See:

Contact us

Andrew McDowell

Partner, Strategy& Luxembourg

Tel: +352 49 48 48 2034

Stay Connected: