Opinion & Analysis

The potential of sovereign sustainability-linked bonds in the drive for net-zero

Executive summary

  • European Union governments have for some years issued green bonds that raise funds for climate-related spending. These bonds have been received well in capital markets but because they promise a certain use of proceeds, they complicate budget management and may not match investors’ claims of having an impact on national climate policies.
  • Public commitments made by major investors and asset owners suggest that limiting climate transition risks and the assessment of the alignment of sovereigns with net-zero targets will now become key determinants of portfolio allocation. Yield differentials in bond markets are already beginning to reflect transition risks that arise from the inadequate pursuit by issuers of climate targets.
  • Unlike standard green bonds, sustainability-linked bonds (SLBs) create a link between performance (outcome) indicators and the financial terms of the bonds. SLBs have grown rapidly in importance in private markets and are now being assessed by sovereign issuers.
  • We show that sovereign SLBs could help incentivise climate policies in EU countries, and accelerate emission reductions. They would be an effective tool for signalling commitment. A common EU framework for issuance by EU countries would enhance capital market integration and the transparency of national policies, and would limit climate transition risks in EU capital markets more broadly.

The authors thank Daniel Hardy, Jeromin Zettelmeyer and participants in a Bruegel workshop for valuable comments.


1 Introduction

The implications of the climate transition and the risk that companies will not reduce their emissions quickly enough have occupied investors for some time. Climate-related risks are now also beginning to influence sovereign debt markets (OECD, 2022). This is evident in the greater interest investors pay to issuer disclosure, in the form of environmental, social and governance (ESG) metrics, and also in the greater political accountability for climate outcomes required for public-sector issuers.

Two principal types of instruments have emerged in bond markets to reflect issuer policies and investor mandates. A first set, including green bonds, restricts the use of proceeds to certain expenditures and rewards issuers for documenting this green spending. A second and more recent type of bond links rewards for issuers to certain outcomes. These bonds give the issuer much greater freedom in spending, but impose financial penalties if commitments are not met. These bonds might also reward achievement of climate targets.  

The greening of sovereign debt is important because a large part of the expected €350 billion in additional annual capital expenditures to achieve net-zero emissions in the EU will need to be mobilised by the public sector, possibly amounting to 1.8 percent of annual GDP (Baccianti, 2022; Klaaßen and Steffen, 2023). In addition to meeting climate-related funding needs, sovereign debt managers must also contain the risks that will arise if their governments manage the transition to a low-carbon economy poorly – which could result in higher borrowing costs or liquidity constraints in debt markets (Bingler, 2022). Sovereign-debt issuance will need to adapt to these new investor demands that result from the climate transition. A debt-issuance strategy that reflects investors’ concerns about climate outcomes would be complicated by the fact that climate targets are largely set at the EU level, though implemented partially at the national level. Ambition and credibility in meeting EU and national climate commitments still vary widely between states.

In an effort to capture this shift in investor motivations, 13 European Union countries and the United Kingdom have issued green bonds since 2016. Yet, the volume of issuance to date is small relative to what will be required of public budgets. Volumes are set to rise: under the NextGenerationEU (NGEU) programme, the EU could mobilise up to €185 billion in green bond funding for spending in member states. This will come on top of green spending under other EU funds and programmes, which will increasingly absorb countries’ capacities to generate and account for public-sector green projects. But this notwithstanding, EU debt issuers lack a single instrument that delivers additional climate-related finance at scale, contains climate transition risks and delivers climate policy outcomes to investors.

The inherent features of sovereign green bonds, in particular relating to restrictions on the use of proceeds raised in capital markets, may make this instrument problematic in the management of fiscal revenues. Problems may become more pronounced if national, EU and other supranational green bond issuance is expanded (Hardy, 2022; Domínguez-Jiménez and Lehmann, 2021). A greater volume of green bonds outstanding would complicate sovereign-debt management and the functioning of government bond markets, which should be the bedrock of the EU’s capital markets union (CMU). In the face of this, sovereign issuers are now examining as an alternative sustainability-linked bonds (SLBs), which reward issuers for outcomes rather than the use of proceeds, and which have been expanding rapidly in corporate bond markets.

In this paper, we show that the ongoing shifts in investors’ motivations and their greater focus on climate outcomes can make sovereign SLBs viable within the EU. We find that sovereign SLBs would have many of the characteristics desired by debt managers and would constitute a much-needed ‘climate hedge’ for investors in the corporate bond market. However, national debt management offices would need to prepare various technical aspects, crucially by documenting and reporting climate outcomes reliably, by fostering coordination on the bond format and by designing a primary issuance process that reflects both the financial and climate-related terms of their bonds.

We start by assessing the extent to which sovereign green bonds issued by EU countries have established a meaningful new funding tool in line with the traditional objectives of sovereign debt management and capital market efficiency, and if this format could indeed mobilise the needed additional funds. We then examine shifting investor motivations. In regulation and in private law interpretations of their fiduciary duties, investors are now accountable for climate risks in their portfolios, and sovereign debt is no exception to this. We then examine whether sovereign SLBs can provide this accountability. Finally, we offer a framework for EU government SLBs, which would offer investors clarity on impact, and more credibly discipline national policy based on existing commitments under EU laws.

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Bruegel, 2023