Sovereign sustainability-linked bonds: The dawn of a revolution

Chile's first sovereign SLB relates to these two KPIs, with each having a target SPT1 and SPT2 (as set out in the table further below):

1. Reducing overall level of greenhouse gases (GHGs) produced in Chile.
2. Converting energy usage in Chile to renewable energy.

These KPIs are linked to Chile's National Determined Contribution (NDC) based on Chile's unconditional climate pledges at the United Nations and their obligations under the Paris Agreement.

If these SPTs are not met by the relevant dates, in 2034 the initial coupon rate of 4.34% p.a. will be upped by 12.5 basis points (bps) per KPI. This means that if neither KPI is complied with the interest on the bond will rise 25 bps in aggregate to 4.59% p.a. payable until maturity.  The key provisions of Chile's SLB are summarised in the table below:

Due to the success of Chile's more than 4 times oversubscribed issue, other sovereigns have begun to consider their own issues. Uruguay has set up its own sovereign SLB framework with its first USD$1.5 bn issue debuting on 28 October 2022. These SLBs will mature in 2034, carry an initial coupon rate of 5.750% p.a. and have SPTs linked to two KPIs. Like Chile, the performance relating to each KPI operates independently of the other in affecting the coupon rate and its SPTs are aligned with Uruguay’s NDC under the Paris Agreement.

Uruguay's SPTs are:

Uruguay's structure revolutionises the SLB model as it has ratchet-up but also ratchet-down provisions. Under this structure, if Uruguay were to fail to achieve its primary SPTs (the Primary SPTs), the coupon will ratchet up by 15 bps per missed SPT, meaning the coupon rate could rise to 6.050% p.a. (by an aggregate of 30 bps) if both are missed – This is consistent with the prevalent SLB model. However in addition, in respect of the same KPIs linked to its Primary SPTs, Uruguay also set overperformance SPTs (the Overperformance SPTs) which have a higher level of achievement than the Primary SPTs. If Uruguay achieves the Overperformance SPTs, this new model means that it will be rewarded and the coupon will ratchet down by 15 bps per Overperformance SPT that it meets, reducing the coupon to as low as 5.45% p.a. These rate changes will take place from and including 28 October 2027. If Uruguay's performance falls between the Primary SPT and the Overperformance SPT, there will be no change in the coupon rate in respect of that relevant KPI as illustrated below:

The great benefit of SLBs for both corporates and governments that separates them from other instruments such as green bonds is that there is no requirement for any 'use of proceeds' provisions. This makes a significant difference where the issuer may have a limited pipeline of green projects.  This means that the issuer is free to use the SLB proceeds raised as they see fit, so long as the SPTs are met by the relevant dates. This means the proceeds can also go towards social programmes like housing, education and infrastructure; alternatively they can be used for general government spending or to mitigate the different balance sheet risks a government or treasury could face (e.g. to reduce maturity and currency mismatches), thereby affording greater flexibility in using those proceeds.

Further, where the SLB has a tenor and a timeline to achieve the relevant SPTs which are over a longer period (possibly, cutting across several election or administration cycles), it has the potential and ability to commit several governments and administrations to the SLB structure and climate actions. SLBs could turn promises made on politicians' campaign stump into tangible targets that the country must honour in order to protect its public finances. It also provides a way to safeguard long-term climate action from political factions that might seek to reverse the country's gains.  

The pace of development in the sovereign SLB space has been an exciting development in sustainable finance and demonstrates a positive step in the right direction for governments' international pledges on climate action. In particular, the first two sovereign issuances have demonstrated that SLBs can be used to great effect for sovereigns and quasi-sovereigns to effect real change in our long-term transition to net zero by 2050, and for all parties (including issuers generally) to share collectively in the rewards of successes. We think this marks the dawn of a revolution to a future whereby the vast majority issuers (including corporates) will be issuing SLBs with SPTs – the financial payouts under the SLBs and (where applicable) the issuer's stock and business performance will reflect their success in mitigating the climate risk facing us all.