What are sustainability-linked bonds and how can they help developing countries?

Sustainability-linked bonds (SLBs) are a new and increasingly popular kind of conservation finance. They emerged in 2019 through private sector issuances but are used in both the public and private sectors. Their aim is to improve climate and environmental outcomes.

Unlike other forms of sustainability-linked debt financing, such as green bonds or debt-for-nature swaps, which are ‘use-of-proceeds’ bonds that finance specific projects, SLBs do not come with a loss of control over budget priorities or expenditure. SLB issuers decide how the borrowed funds are used: instead of earmarking funding for a particular project, SLBs make the financial or structural characteristics of a bond (e.g. interest rates) conditional on whether or not the issuer meets predetermined Key Performance Indicators (KPIs). However, like all forms of conservation finance, SLBs mobilise capital to meet sustainability goals by creating opportunities for the private sector to turn a profit (see our explainer ‘What is conservation finance?’ for more on this).

The private SLB market has taken off quickly, growing from US$9 billion to $100 billion between 2020 and 2021.

What are sovereign SLBs and how do they benefit developing countries and the environment?

Sovereign SLBs link sovereign debt with national climate and environmental commitments.

In 2022, Chile and Uruguay issued the world’s first sovereign SLBs with issuances of $3 billion (at a yield of 5.3%) and $1.5 billion (yield: 5.75%), respectively. Historically, sovereign bonds issued by Chile and Uruguay in US dollars have come with yields of around 2.5–6.5% and 4–7%, respectively, which suggests that the yields from these new sovereign SLBs are not concessional (i.e. cheaper than market rate). Since the issuance of the world’s first sovereign SLBs, Brazil’s government (led by President Luiz Inácio Lula da Silva since January 2023) has indicated that it intends to issue approximately $2 billion in sovereign SLBs by early 2024.

Although to date it appears that SLBs have not been issued at concessional interest rates, they can broaden access to international finance for low- and middle-income countries. Many countries in these categories have been beset by a ‘polycrisis’ in recent years: a barrage of obstacles to development that include climate change, the COVID-19 pandemic and crushing debt. Conservation finance can unlock new funds to help meet development objectives in these difficult circumstances.

To take the case of Uruguay, the country’s 2022 sovereign SLB issuance included two sustainability KPIs – a quantified drop in greenhouse gas emissions and retention of native forest area – and was met with substantial foreign investment. 188 investors from Europe, Asia, the United States and Latin America bought into Uruguay’s sovereign SLBs, of whom one-fifth were new holders of the country’s national debt. While it is difficult to make a direct comparison between the sovereign SLBs’ investor profiles and those of prior sovereign debt issuances, sovereign SLB buy-in appears to match the country’s existing trend towards a high percentage of foreign investment in national debt.

Sovereign SLBs are associated with high ‘environmental integrity’, though they may not be ‘additional’: that is, some or all of their pro-environmental activities might have happened anyway, in the absence of special financial instruments. ‘Additionality’ is a key priority in international climate finance.

Uruguay has made impressive progress towards the KPIs, which is detailed in the country’s 2023 sovereign SLB report (the results of which have been verified by the UN Development Programme). Uruguay has reduced its greenhouse gas emissions per GDP unit by 41% (compared with a 1990 baseline). In addition, it has retained 100% of its native forest area (compared with a 2012 baseline).

However, the KPIs used in Uruguay’s sovereign SLB are taken from the country’s ‘nationally determined contribution’ (NDC) commitment to the UN Framework Convention on Climate Change. Thus, it could be argued that the sovereign SLB does not ratchet up ambition beyond existing commitments and therefore is not ‘additional’. On the other hand, it could be argued that the global financial system should reward effective decarbonisation policies, encouraging efforts to combat global warming, even if the policies are not additional. Also, issuing the sovereign SLB might improve Uruguay’s ability to meet its original NDC by increasing the country’s access to global capital.

How might sovereign SLBs help countries retain control over national budgets?

Viewed through the lens of self-determination and climate justice, sovereign SLBs hold special benefits as they come with fewer conditions than many kinds of sovereign loans, debt issuances, or traditional conservation finance.

Such conditions or restrictions are a feature of increasingly popular ‘debt-for-nature swaps’, which usually occur in highly indebted countries facing default. Some of these countries accept deals with high transaction costs that mandate that they spend much of the savings from debt relief on green initiatives. Transaction costs and conditionalities reduce the total quantity of savings available to finance other development priorities, like health or education.

Sovereign SLBs might present an alternative way forward, but they are only feasible when there is sufficient investor confidence: that is, when investors have faith in a country’s willingness and ability to repay its debts. This means that sovereign SLBs might not easily replace more restrictive arrangements in ‘high risk’ countries.

What might the future hold for sovereign SLBs?

If sovereign SLBs follow the trajectory of their private sector counterparts, we may be witnessing only the beginning of their ascent.

However, rapid growth in the broader conservation finance market – especially in the private sector – has been accompanied by greenwashing, leading to remedial measures by the EU and others. Although sovereign SLBs appear to uphold environmental integrity, it remains to be seen whether they will be sufficiently ambitious and additional to make a meaningful difference to domestic and international climate and nature goals.

Furthermore, the evidence suggests that sovereign SLBs have not been concessional thus far. This raises questions about when and why developing countries might issue them over other, less sustainably oriented forms of sovereign debt. Also, since sovereign SLBs are debt instruments, they are inaccessible to countries mired in such dire financial straits that they cannot credibly issue national debt (a category that includes many countries with high biodiversity).

Sovereign SLBs are not a silver bullet, and they will not match the needs or circumstances of all countries. However, they can accomplish broadened access to international finance for countries that enjoy relative financial security and high climate ambition.

This Explainer has been written by Alejandra Padin-Dujon and Ben Filewod. The authors thank Elena Almeida for her review.