Could a sovereign sustainability-linked bond help protect the Amazon?

This blog is part one of a two-part blog series. This blog describes the Brazilian context and the difficulties with purely outcome-based key performance indicators (KPIs). The next blog suggests an alternative approach, a model-based KPI, and illustrates what it could mean for the Legal Amazon.

Deforestation in Brazil's "Legal Amazon"

International investors are increasingly interested in promoting sustainable development. Deforestation in the Brazilian Amazon is among the world's greatest environmental challenges, despite declines from a 2004 peak in Brazil's Legal Amazon, which includes nine states covering the Brazilian share of the Amazon and parts of two other biomes. Recently, deforestation appears to be accelerating again. Could more decisive government action have averted this recent increase? If so, can financial instruments help incentivize governments to protect critical natural assets like the Amazon going forward? It's possible.

Figure 1: Deforestation in Brazil's "Legal Amazon" region

What are sustainability-linked bonds?

Issuances of green bonds, social bonds and other use of proceeds bonds continue to break new records and are projected to make up more than 40% of new issuances in Europe. Voices criticizing greenwashing, reporting standards and questioning whether green financing instruments are really adding to sustainable finance have become louder as well. As described in a previous blog, sustainability-linked bonds (SLBs) are performance-based financing instruments that follow a different approach. Rather than earmarking the bond proceeds for green, environmental, or social projects, SLBs tie financial incentives and disincentives to so-called key performance indicators (KPIs). In other words, the issuer has more "skin in the game" in that they are accountable not just for investing the funds, but also for the investment's sustainability performance.

The idea behind SLBs is simple, yet effective. An issuer borrows money and commits to specific sustainable performance targets (SPTs). For sovereigns, this could be about cutting down emissions, reducing deforestation or providing access to clean water. If the target is reached, the issuer is rewarded with lower financing costs (a step-down). If they fail to reach the target, the repayment of the SLBs becomes more expensive (a step-up).

What is an ambitious target?

By choosing an ambitious SPT, issuers send a strong signal to the market about their commitment to sustainability. But what makes an SPT ambitious? When is it too ambitious and not credible anymore? It depends on the KPI and what is meant by performance. In 2020, the ICMA released a report on Sustainability-Linked Bond Principles which describes that KPIs should be relevant, measurable, externally verifiable, and able to be benchmarked "[…] to facilitate the assessment of the SPT's level of ambition." In other words, performance needs a benchmark to become meaningful.

To illustrate, suppose a country issues a 5-year SLB and commits to lowering greenhouse gas (GHG) emissions by 1,000 MtCO2e. This is an absolute KPI, which is simple and straightforward. However, what if the bond was issued right before the global pandemic hit, which led to record low emissions around the world? Reaching the SPT would be guaranteed. But should the issuer be rewarded? Those in favor would argue that in the big picture, what matters is that we have fewer GHG emissions in the atmosphere. Some investors may counter and say that rewarding the issuer for an outcome that is not due to its efforts is hardly in the point of performance-based financing, especially if failing to meet the targets would have otherwise triggered a step-up.