Sustainability-linked bonds are a promising pillar of sustainable finance that can help raise the funding needed to underpin successful energy transitions in developing economies. The bonds’ structure as well as how they are regulated will need to evolve to meet the demands of a fast-growing and maturing market.

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February 2023

Key Findings

  • New research underscores the need for robust design of sustainability-linked bonds to ensure greater impact and encourage further market growth.
  • Two structural features in particular—target dates and callability provisions—can influence the efficacy of incentivized sustainability targets embedded in these instruments.
  • Addressing these issues, particularly for borrowers with poor environmental performance, can help to maximize the bonds’ sustainability impact.
  • More rigorous industry standards, robust third-party verification, and greater awareness are essential to address investor concerns.

The market for sustainability-linked bonds, which set financial incentives for borrowers according to their performance against environmental, social or governance standards, is one of the fastest-growing corners of finance with over $100 billion issued globally in 2021.

But it is less than five years since the first use of the instrument, an issue by Italian utility Enel in 2019, and the bonds’ structure as well as how they are regulated will need to evolve in response to the demands of a fast-growing and maturing market. Recent research by IFC economists identifies two bond features that can dilute their effectiveness in promoting more sustainable business practices. Addressing these issues would help to reduce the potential for bond issuers to circumvent financial penalties imposed for failing to meet sustainability targets.

Sustainability-linked bonds typically set the interest rate charged on the debt according to whether the issuer meets goals in areas like renewable energy use, by a predetermined deadline that falls before the debt matures. Failure to meet that target may result in a more costly interest charge, referred to in bond prospectuses as a coupon step-up penalty. Some bonds include a ‘step-down,’ where exceeding the target results in lower charges.

Linking borrowing costs to sustainability targets distinguishes these instruments from other securities focused on sustainability such as green and social bonds, which do not vary the interest rate but commit the borrower to spending the proceeds on projects that meet environmental, social or governance standards. Sustainability-linked bonds purport to avoid the question of how to enforce standards since the interest rate penalty acts as the enforcer.

However, an analysis of all sustainability-linked bonds issued before the end of 2021 identifies two ways in which the bonds’ design could weaken the effectiveness of those penalties. First, deadlines set too close to the end of the bond’s term reduce the number of coupon penalties an issuer would have to pay in the event of failure to meet sustainability targets. Second, a right to buy back and cancel the debt before it matures, known as a call option and a common feature of these bonds, enables issuers that fail the sustainability test to ‘call’ the debt and avoid penalties added to the remaining interest payments.

The IFC study presents evidence suggesting that most bonds with step-up penalties have target dates in the latter half of the bond’s term. Some even set it in the last 10 percent of the period. Exhibit 1 illustrates this, showing a higher proportion with a deadline in the second half of the bond’s term, in stark contrast to securities with step-down charges. Moreover, bonds with larger coupon step-up penalties are more likely to have later target dates.


Issuers minimize step-up penalties by setting target dates in the latter half of the bond's term

Distribution of target dates within a bond's term

Source: World Bank working paper

Meanwhile, the study also finds that sustainability-linked bonds are three times more likely to be callable than corporate green bonds and five times more likely than conventional corporate bonds (See Exhibit 2). Furthermore, bonds with coupon step-up penalties are more likely to be callable than those with other types of financial incentives where callability does not affect penalty payout.


Sustainability-linked bonds are more likely to be callable

Portion of callable bonds among different types of corporate bonds

Source: Figures on corporate non-green callable bonds from Dias (2021)

The study further uncovers evidence that call options may be structured in a manner to minimize potential penalties by setting the first call date close to the target date for meeting sustainability goals. Step-up coupon penalties are only imposed after the target date, so there is little incentive to call a bond before then. However, the total penalty amount increases with the duration of time after the target date. Therefore, a borrower interested in exploiting the call provision to minimize penalties is better off calling the bond soon after the target date, and hence should set the first call date to reflect this. Exhibit 3 shows that an overwhelming proportion of callable sustainability-linked bonds set the first call date within six months of the target date.


Most callable sustainability-linked bonds set the first call date within six months of the target date

Distribution of call dates relative to target dates

Source: World Bank working paper
Note: For visualization purposes, the plot excludes one outlier value of call date at 122 months after the target date.


Why does this matter?

Sustainability-linked bonds are a promising pillar of sustainable finance that can help deepen the capital markets of developing economies, which urgently need funding to underpin successful green transitions. To realize their potential, it is critical to strengthen the structure of these bonds so that they shift borrower behavior toward more sustainable actions.

It is crucial to address the structural issues outlined above. This can be achieved by setting target dates and first call dates at an appropriate point in the bond’s life as well as introducing adequate penalties on calling a bond while sustainability targets remain unmet. Doing so can signal to the market that the embedded financial incentives are strong enough to motivate a shift in borrower behavior. This is especially important for high-emitting borrowers, as the study finds that their issuances are more likely to raise the concerns highlighted here.

Improved design of sustainability-linked bonds will increase their appeal to investors and ultimately underpin their effectiveness as key instruments of sustainable finance. Policymakers and financial institutions can facilitate this evolution by increasing awareness and encouraging investors to scrutinize bond offerings more closely. Industry-driven standards, such as those of the International Capital Market Association, can also play a role by expanding their scope to incorporate structural issues.

Raising standards, improving transparency and increasing oversight would help to maintain the impressive momentum seen in recent years by the sustainability-linked bond market.

About the Authors

Imtiaz Ul Haq is an Economist at the Economic Policy Research department at IFC. He holds a PhD in finance and has published on topics in financial markets, investments, and financial technology.

Djeneba Doumbia is an Economist at the Macroeconomics, Trade, and Investment Global Practice at the World Bank.