# **1 Introduction**

With sustainability becoming mainstream in financial markets, some investors are increasingly keen to align traditional investment goals with those of responsible or impact investing. Since the European Investment Bank issued the first green bond in 2007, the World Bank in 2008, and the International Finance Corporation in 2013, the green, social, sustainable bonds (GSSB) market has grown exponentially. With GSSBs, also called use-of-proceeds bonds, the proceeds are earmarked to fund predefined projects. However, these instruments face criticism from both issuers and investors, including concerns about “greenwashing” when targets are set too low, the rigidity of the use-of-proceeds model (especially for sovereign issuers), and the lack of measurable additionality. In this environment, issuers and investors are considering alternative mechanisms that tie financing to impact on the ground. A key question is how the investment’s impact should be measured, which is particularly challenging at the sovereign level.

Sustainability-linked bonds (SLBs)1 have emerged as promising instruments to meet this demand (Flugge et al., 2021; Lindner et al., 2023). The instrument is already well established in the corporate market, with US$225 billion SLBs outstanding as of March 2023. The experience of SLBs in the corporate debt asset class provides a motivation to start with high standards for the public sector, given the potential of these instruments to induce changes in public policy (Silva et al., 2023; SSDH, 2023). While market standards for sovereign SLBs (in terms of structure) have not been established, two successful issuances of sovereign SLBs exist as of the time of writing. Chile issued an SLB in March 2022 with a step-up coupon structure linked to greenhouse gas emissions targets and non-conventional renewable energy generation (Ministry of Finance of Chile, 2022). Chile’s structure, with a coupon step-up of 25 basis points, has been the standard in corporate markets (Lindner et al., 2023). However, in October 2022 Uruguay issued an SLB with both a step-up and step-down coupon structure (Ministry of Economy and Finance of Uruguay, 2022). Which payoff structures will become standard in sovereign SLB issuances remains to be seen.

**The case for sustainability-linked bonds** A key difference between SLBs and labeled bonds is that the proceeds of SLBs are not earmarked. Instead, their proceeds can be accounted for like conventional bonds and added to the general government budget. The main stipulation is that the SLB’s coupons are linked to a key performance indicator (KPI), which tracks the issuer’s progress towards a sustainability performance target (SPT). The issuer is incentivized to perform2 through financial carrots and sticks: missing the target leads to an interest rate penalty (step-up), while achieving the target leads to an interest rate reward (step-down).3

The less restrictive use of proceeds gives SLBs distinct advantages over labeled bonds. First, the issuer can use the proceeds to fund policies and programs that are not directly linked to an SPT but may benefit it indirectly (Lindner et al., 2023). For instance, a labeled bond intended to curb deforestation in the Amazon may have its proceeds earmarked to support local law enforcement. In contrast, the proceeds of an SLB could be used partly to enhance forest governance and partly to boost productivity, which will foster economic development and shift the economy away from resource extraction, including deforestation, in the longer run (Hanusch, 2023; World Bank

> 1In this paper we focus on sustainability-linked bonds but the same insights hold for sustainability-linked loans.

> 2We use the term perform to describe efforts the issuer undertakes to reach the SPT. These can include passing necessary legislation, enforcing existing regulations, investing in structural reforms or diversifying the economy.

> 3Step-ups and step-downs refer to the practice of increasing or lowering coupon payments of bonds. A step-down means that the debtor pays a lower interest rate, which serves as an incentive to achieve the SPT. Conversely, a step-up would entail higher interest payments. SLBs could be issued with either or both incentive structures, depending on the case.

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