Group, 2023). Such performance-based financing can both be effective in setting incentives and an attractive addition to governments’ fiscal instruments. Second, the possibility to scale the labeled bond market depends on the number of eligible projects. This is not the case for SLBs, which gives them more scalability and also the ability to mobilize more private capital.

The financial incentives in the SLB structure assure that issuers have “skin-in-the-game” as achieving the SPT is in their financial interest. This gives SLBs a third powerful advantage: they allow issuers to adapt and explore policy measures during the SLB’s lifetime. From the point of view of economic theory, the SLB structure is an elegant solution to the problem of incomplete contracts. Since it is impossible to completely specify how the issuer should act in all future scenarios to reach the targets, theory suggests that targets can also be achieved if the decision power is delegated to the issuer, as long as the issuer’s incentives are aligned with the target. This decision delegation ensures that issuers will react to a changing environment and adapt policies to achieve the SPT, without having to stipulate how the funds should be used ex-ante.

**Choosing the appropriate KPI** The effectiveness of an SLB in incentivizing issuer performance rests upon the choice of KPIs. We differentiate between _outcome_ KPIs, where performance is measured only using the outcome indicator of interest, and _benchmarked_ KPIs, where performance is assessed relative to a benchmark model. The idea behind a benchmark is to decompose an observed outcome into a performance part, which can be attributed to the issuer’s actions, and an exogenous part that is not in the issuer’s control. In Section 4, for example, lower deforestation may be due to effective government policies, e.g. designating protected areas, or the consequence of exogenous factors that render deforestation unprofitable, e.g. lower global commodity prices or unfavorable effective exchange rates (Arcand et al., 2008; Carvalho et al., 2019; Hanusch, 2023), or both. The benchmark level of deforestation reflects the expected amount of forest loss if the issuer would not undertake any additional efforts to avoid deforestation (see Figure 5).

In Section 2, we introduce the Relative Evaluation And benCHmarking (REACH) framework. We discuss the three requirements (R1)-(R3) that benchmarks ideally satisfy in order to facilitate both goals: setting strong performance incentives for the issuer and obtaining evidence-based additionality metrics for the investor. We further explain why all three requirements are necessary in the context of the _informativeness principle_ (Holmström, 2016).

An SLB whose KPIs are assessed relative to a benchmark will also have sustainable performance targets that are defined in relative terms. We acknowledge that giving up absolute targets in favor of relative targets may lead to some level of unease as absolute SPTs are simple and easy to understand. However, they dilute performance incentives and hamper impact evaluation, which in turn weakens the SLB’s effectiveness and signaling effect. Moreover, absolute targets pose practical challenges. Suppose we target zero deforestation by 2030. How ambitious or feasible is this target? To answer this question, one would need deforestation predictions until 2030 under the business-as-usual scenario. Since deforestation is path-dependent and influenced by natural and economic factors with feedback effects, this exercise is far from trivial. This does not mean that absolute targets are irrelevant and as we will demonstrate in Section 5 they can for example be used to evaluate near-term targets.

Using a benchmark model to deduce performance may not be common in sustainability finance, but the concept is widely used in other areas of finance. Our proposed way of benchmarking performance finds conceptual similarities in factor attribution and empirical asset pricing. For example, the financial performance of investment funds is not assessed in absolute terms. Instead, actively managed funds or passive index funds are evaluated with respect to a benchmark index 3