24 March 2023

Bruegel's Lehmann, Martins: 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...

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