ESG bonds are designed or structured to achieve or incentivise an ESG objective. The size of the global ESG debt market has increased significantly in recent years, with cumulative green bond issuances surpassing the $1tn mark at the end of 2020, according to data from the Climate Bonds Initiative (an international not-for-profit group aiming to promote sustainable investments). ESG bonds may be attractive to investors pursuing an ESG agenda. The bonds themselves come in different forms, including:
- Bonds which provide financing earmarked for projects that have positive environmental or social benefits. E.g. a bond issued by an energy provider to finance the construction of an offshore wind farm; and
- Bonds which structure contractual step-up or step-down features into the coupon rate of the instrument, based on whether the issuer meets specified ESG-focused KPIs. E.g. a bond with a coupon rate that increases by 25bps for the following 12 months (on a non-cumulative basis) if the issuer fails to reduce its CO2 emissions by 15% during the current year
This article addresses the classification and measurement considerations for IFRS 9 reporters that purchase ESG bonds with KPI-linked interest step-up/down features, focusing on the question of SPPI-compliance (a concept explained below).
Reminder – IFRS 9 Classification and Measurement
IFRS 9 contains three measurement categories for financial assets: amortised cost, fair value through OCI (‘FVOCI’), and fair value through profit or loss (‘FVTPL’). If associated financial liabilities are measured at amortised cost, reporters may also prefer to account for financial assets at amortised cost in order to avoid the P&L volatility and operational burden of re-measuring the instruments at fair value each reporting date. However, a financial asset may only be measured at amortised cost if:
- it is held within a business model in which the objective is to collect the contractual cash flows of the asset (rather than realising gains through sales); and
- the contractual terms of the financial asset give rise to cash flows that are solely payments of principal and interest on the principal amount outstanding (the asset is SPPI-compliant
Contractual cash flows that meet the SPPI criterion are those that are consistent with a basic lending arrangement. In such arrangements, the time value of money and the credit risk are typically the most significant elements of the interest rate. To achieve SPPI-compliance, compensation for credit risk need not be fixed at inception; it may vary in response to changes in the borrower’s credit risk.
Assessing whether contractual interest step-up/down features result in SPPI failure
Whether contractual interest step/down features in ESG bonds cause SPPI failure is a topic of ongoing debate. In many circumstances, it may be concluded that the step-up/down feature on the coupon rate introduces exposure to volatility in the contractual cash flows that is unrelated to a basic lending arrangement, requiring the asset to be measured at FVTPL.
However, financial assets may be considered SPPI-compliant if it can be demonstrated that there is a commensurate link between the interest rate change due to the (non-)attainment of the specified KPI and the credit risk of the borrower. For example, innovation to make a manufacturing process greener may save costs and improve the credit fundamentals of a steel producer that has issued a bond that contains interest step-up/down features linked to it achieving environmental targets. The onus is on management to evidence such a relationship if the instrument is to achieve SPPI-compliance.
In addition, a contractual cash flow characteristic does not affect the classification of a financial asset if it could have only a de minimis effect on the financial asset's contractual cash flows (IFRS 9.B4.1.18). It may be possible to argue that the ESG feature meets the definition of de minimis if the adjustment is small. However, this argument may be less widely accepted, and would certainly involve significant judgement.
Looking to the future
Standard setters are aware that KPI-linked interest step-up/down features in ESG bonds, whilst providing a societal benefit, may result in the instruments being recorded at FVTPL. In order not to disincentivise investment in these products, it is possible that the topic may be addressed by the upcoming IFRS 9 Post-Implementation Review.
Recommendations
In light of these considerations, it is recommended that companies should:
- Consider the accounting impact when determining whether to purchase products with contractual features that link the interest rate on the instrument with the (non-)achievement of ESG-related KPIs by the issuer.
- Discuss the proposed accounting treatment with their auditor.
- Keep abreast of further guidance issued by standard-setters addressing the classification and measurement impacts of ESG-features.
While this article specifically addresses the accounting considerations for reporters that purchase ESG bonds with interest step-up/down features, similar considerations may apply to other instruments with contractual features linking returns on the asset to the achievement of other specified goals.