Welcome to our series on sustainability-linked financing. Our aim is to issue a series of publications discussing the IFRS-related accounting implications around this evolving and constantly debated topic. The series will provide insight into these implications and any developments from a practical perspective for both financing institutions as well as for borrowers.
The importance of sustainable business practice is becoming more and more prevalent. Sustainability reporting is also a massive focus area for investors and for regulators – in fact the International Sustainability Standards Board (‘ISSB’) has recently been established under the oversight of the IFRS foundation to develop specific sustainability reporting requirements under the IFRS framework.
With this rising focus on sustainability, ’green’ or ‘social’ loans/bonds and sustainability-linked financing is growing exponentially on a global scale and is expected to continue on this trajectory.
Financing institutions offering these options are able to meet their sustainability targets and position themselves as leaders in sustainability financing. This also provides alternative investment opportunities to investors and financing opportunities to borrowers that incentivise and encourage ‘green’ projects and improvement of sustainability targets.
We can commonly distinguish three types of sustainability/green financing:
- ‘Green’ or ‘social’ loans/Bonds are financing instruments dedicated to one or several “green” projects (for example installation of solar panels). These projects can be either identified in the financing contract or to be identified post-closing based on criteria listed in the financing contract. Where there is no sustainability-linked interest adjustment, these are very similar to any ‘vanilla’ type loans/bonds.
- ‘Green’ index or sustainability index (or indices) structured financing with cash flows linked to market index that is not specific to a borrower. These are similar to any other indexed instruments such as mutual funds or exchange-traded funds.
- Sustainability-linked loans/Bonds are financing instruments linked to the borrower meeting certain ESG (environmental, social and governance) KPIs. The interest rate is adjusted periodically by a specified number of basis points (‘bps’) depending on the borrower’s performance in relation to these KPIs. Common KPIs relate to reducing carbon emissions and water usage, however, there is a drive to incorporate more social KPIs such as gender and race equality as well as relevant governance KPIs. Those adjustments can be either step up (increase of the interest rate margin), step down (decrease of the interest rate margin) or both.
Accounting issues for the lender/investor
IFRS 9 Financial Instruments requires that financial assets whose contractual cash flows are SPPI are classified in accordance with the entity’s business model for managing the asset:
- Amortised Cost if they are subject to a Hold-To-Collect business model
- Fair value through other comprehensive income (‘FVOCI’) if they are held within a Hold-To-Collect-and Sell business model
- Fair value through profit or loss (‘FVPL’) in any other situations
Financial assets that do not pass the SPPI test must be classified in the FVPL category (except for some equity instruments may be irrevocably classified in FVOCI)
When assessing whether contractual cash flows are SPPI, the entity must consider whether they are consistent with the cash flows of a basic lending arrangement.
Consideration for the time value of money and credit risk are typically the most significant elements of interest, however, this can also include consideration for other basic lending risks and costs associated with holding the financial asset for a particular period of time. Interest can also include a profit margin that is consistent with a basic lending arrangement.
Contractual terms that introduce exposure to risks or volatility in the contractual cash flows that is unrelated to a basic lending arrangement do not give rise to contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.
The contractual cash flows on ‘green’ or ‘social’ loans/bonds that do not include sustainability-linked interest adjustments are essentially ‘vanilla’ (basic) lending arrangements. However, an SPPI test must be performed as for all other debt instruments with a particular attention on non-recourse features or CLI (contractually linked instrument) features.
Indexed instruments linked to ‘green’ or sustainability indices do not pass the SPPI test and are accounted for at FVPL, as one would for any other indexed-instrument investment.
The current concern and debate is therefore around sustainability-linked financing where the interest rate is adjusted periodically to reflect the ESG/sustainability or ‘green’ KPIs of the borrower/issuer, and whether these instruments pass the SPPI test.
What is at stake?
If these instruments fail the SPPI test, lenders and investors are not able to classify and measure these as financial assets at amortised cost (or at fair value through other comprehensive income (‘FVOCI’)).
In practice, it has become a challenge for lenders and investors to demonstrate that these instruments meet the SPPI criteria because the variability to contractual cash flows caused by the ESG adjustments raise the question of its compatibility with a basic lending arrangement as currently described in IFRS 9.
This is not ideal because these instruments are priced and set up very similarly to other loans and bonds and are managed and assessed by lenders and investors on the same basis. Stakeholders have therefore requested that the IASB clarifies the IFRS 9 requirements in this regard to secure a classification and measurement of these instruments that is consistent with the entity’s business model.
There has been significant engagement between the IASB and stakeholders over the last year and there is a consensus, especially within the financing sector, that this is urgent and should be prioritised as this is expected to become more and more prevalent globally. In September 2022 the IASB tentatively decided to amend IFRS 9 to address this issue (Per IASB update September 2022)
In the upcoming publications, we will unpack the SPPI challenge on sustainability-linked financing in more detail and will incorporate the various feedback received from the IASB, including the proposed amendment to IFRS 9. We will also discuss the implications and considerations from the borrower/issuer perspective.