Sustainability-Linked Financial Instruments: Creating Targets and Measuring Your Company's Performance (2024)

The financial markets are constantly evolving to provide varied and sophisticated instruments as a way to make sustainability a key part of doing business. The mechanisms that have recently gained the most attention are sustainability-linked bonds and loans, which can be used to raise general corporate funds with an aim to achieving certain sustainability goals. The financial characteristics of these instruments (i.e., bond coupon rate or loan terms) are tied to meeting predetermined targets. These instruments facilitate funding without ties to specific green or social projects in exchange for a commitment to reach sustainability objectives.

The overall sustainability outcomes of an issuance are measured by key performance indicators (KPIs) and sustainable performance targets (SPTs). To meet the general requirements − as stated in the International Capital Market Association’s (ICMA) Sustainability-Linked Bond Principles (SLBP)¹and the Loan Syndications and Trading Association’s (LSTA) Sustainability-Linked Loan Principles (SLLP)²− KPIs are expected to be relevant and material to your core business and SPTs must be considered ambitious.

While it is up to you as the issuer to choose the most preferred and feasible KPIs and SPTs, it is up to an external reviewer to ultimately assess credibility. To select the best-suited KPIs and establish ambitious SPTs, here are several factors to consider.

Identifying the Strongest KPIs for Your Industry

The KPIs selected and their relevance to your industry will significantly impact the credibility of the sustainability-linked frameworks. A KPI must reflect material aspects of your company’s operations within the boundaries of environmental, social, and governance (ESG) factors. For example, a transportation company with heavy use of fossil fuels in their operations might want to include carbon emissions as a KPI, while in the case of a company focused on healthcare, social topics such as affordability might be seen as more relevant.

To understand the full measure of a KPI’s performance, issuers are expected to identify a benchmark, preferably from an external source. This allows the issuer to compare the KPI against a specific reference, trajectory, or standard. Benchmarking can play an important role in improving the strength and credibility of your KPI.

What Makes an SPT Ambitious and Credible?

For an SPT to be considered ambitious, according to ICMA, the target should represent a material improvement in the respective KPIs and go beyond a “business as usual” trajectory. Where possible, SPTs should be compared to targets set by industry peers and should also allow for comparison with science-based trajectories or references. A peer review is recommended to evaluate what similar companies are targeting and how those targets compare to those of your company as the issuer. In cases where there is no comparable target, the SPT assessment could rely on your company’s previous performance.

Choosing the Right Methodology: It Matters How Your Data Is Measured

Methodology is the process through which research is conducted; that is, how the data is gathered and how it is interpreted. KPIs should be “measurable or quantifiable on a consistent methodological basis,” according to ICMA’s SLBP.³Issuers are encouraged to provide a clear definition of full scope and parameters of their KPIs. It is a second-party opinion provider’s role to assess how an issuer’s methodology follows a credible and consistent approach. On some topics, a standard methodological consensus has already been reached. For example, the Greenhouse Gas Protocol outlines the standard for how to calculate carbon emissions and how best to report your findings.

Carbon Emissions: Commonly Used KPIs

Carbon emissions have emerged as the most widely used KPI in sustainability-linked debt transactions, owing to the urgent need to tackle climate change on a global scale. However, your company should also consider if carbon emissions are in fact the most material for your organization. While curbing GHG emissions is central to living up to the Paris Agreement, not all industries are equally positioned to play a leading role in the net-zero transition.

Another factor to consider when including a carbon emissions KPI is the company’s greenhouse gas (GHG) inventory − a comprehensive calculation of Scope 1, 2 and 3 emissions. Scope 1 includes direct emissions from company operations; Scope 2 includes emissions from energy produced on behalf of the company; Scope 3 includes emissions from the company’s value chain.

When designing a carbon emissions KPI, the portion of GHG inventory coverage is not expected to be 100% for a KPI to be credible. But it should be meaningful. For instance, a meat processing company may have low direct GHG emissions but will inherit significant emissions through its value chain because meat sourcing produces emissions related to livestock, land usage and transportation. This means that if the company only intends to tackle direct (i.e., Scope 1) emissions, the KPI might not be considered material enough.

Absolute Versus Intensity Emissions

Finally, a carbon emissions KPI can be measured in one of two ways: absolute emissions and intensity emissions. An absolute emissions KPI aims to measure a certain amount of emissions within a given period. For instance, a company intending to reduce emissions by 25% during a calendar year is using an absolute metric and targeting an absolute reduction. An absolute emissions KPI will allow comparability against the targets needed to reduce general emissions in the future to combat global warming.

By contrast, an intensity emissions KPI measures an amount of emissions against an economic or production output. For example, a cement company could measure its annual emissions by annual tons of cement produced. And it can target a reduction of its carbon intensity while increasing production. An intensity-based KPI might allow comparability against a benchmark as long as a specific decarbonization pathway has been identified for that industry and metric.

To learn more about sustainability-linked bonds and loans, visit www.sustainalytics.com.

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