How do ESG-linked features impact the borrower/issuer under IFRS 9?

The borrower/issuer does not face the same classification complications as the lender/investor

The SPPI criterion that is applied in classifying financial assets does not apply to financial liabilities. The default measurement classification under IFRS 9 for financial liabilities is amortised cost.

Financial liabilities can, however, be classified at fair value through profit or loss (FVPL) when:

-       a financial liability is managed in a trading business model;

-       a financial liability is designated at FVPL for the purpose of eliminating or reducing an accounting mismatch;

-       a financial liability is designated at FVPL because it is managed and its performance evaluated on a fair value basis or

-       the financial liability is designated at FVPL because it includes one or more embedded derivatives.

The latest leads us nicely into the next important consideration for borrower/issuers.

The rhino, the bond, the embedded derivative

ESG-linked instruments come in many shapes and forms, one example that we will explore below is a ‘Rhino Bond’. Loan/bond contracts with cash flows that change based on an underlying ESG variable, raises the question:

Is there an embedded derivative?

In a nutshell

An embedded derivative is a component of a hybrid contract (a contract containing a non-derivative host and an embedded derivative) with cash flows that vary in a way similar to a stand-alone derivative contract.

A derivative is defined in IFRS 9 as a contract where the value changes in response to a financial variable such as a commodity price, foreign exchange rates, indices, interest rates etc. or a non-financial variable that is not specific to a party to the contract. In addition, these contracts require no, or an insignificant, initial net investment and are settled at a future date.

If all the elements of this definition are met and if the economic characteristics and risks of the embedded derivative are not closely related to the host contract, the embedded derivative shall be accounted for separately from the host contract unless the hybrid financial liability has been designated at FVPL.

Adding ESG variables to the mix

ESG features are specifically focused on environmental, social and/or governance aspects such as reducing carbon emissions and water usage and/or increasing gender and race equality; they would not generally include financial measures making them non-financial variables.

By way of example, where loans/bonds include adjustments linked to contractually specified ESG KPIs, that are specific to the borrower/issuer, the cash flows on the loan/bond change in response to non-financial variables that are also specific to a party to the contract. It is therefore unlikely that these contracts would include an embedded derivative as they would not meet all the elements of a derivative as per the definition. 

Here are two examples of how these contracts may be set up in practice:

•  The borrower pays interest on a loan at 10% per annum, with a reduction of 20 basis points (‘bps’) in year 2, and a further reduction of 20 bps in year 3 if they reduce their water consumption by 5% in year 2 and 10% by year 3. If not, the borrower pays 10% per annum throughout the entire 3-year period.
• The borrower pays interest based on a specified benchmark (such as EURIBOR, SONIA or JIBAR) plus a fixed credit spread of 2%. If the borrower does not meet their ESG KPIs, for example by reducing their carbon footprint by a specified percentage, in years 1, 2 and 3, the spread is increased by 20 bps for each year that these KPIs are not met.

ESG-linked loans/bonds, which include KPIs specific to the borrower/issuer, appear to be a more common occurrence and are growing exponentially in the financial markets. However, it is possible that the ESG adjustments are not linked specifically to the borrower/issuer.

Introducing the ‘Rhino Bond’

In 2022, The World Bank issued the Wildlife Conservation Bond – commonly referred to as the ‘Rhino Bond’ aimed at protecting and growing the black rhino population.

Instead of investors receiving the usual coupon payments (as with ‘vanilla’ bonds), the issuer will invest funds into the conservation of the black rhino population in two specified parks in South Africa. At maturity, bondholders will receive a ‘Conservation Success Payment’ in addition to the principal redemption amount. The success payment which is capped at a maximum value, is calculated based on the growth rate of the black rhino population over the 5-year contractual period. In this way, the bondholders’ ultimately receive a return that reflects the success of the investment into rhino conservation.

With the world’s focus on sustainability, this is a ground-breaking mechanism to incentivise investors to fund conservation projects – the investor shares in the risk, but also shares in the reward where the project is successful*.

The growth rate of the rhino population is a non-financial variable, in this case it is probably not specific to a party to the contract. The bond issuer would need to determine whether or not there is an embedded derivative that must be separated (bifurcated) from the host bond contract, and accounted for as a stand-alone derivative at FVPL before charging ahead with the accounting.

Another practical example is a bond where the issuer pays interest based on movements in an Equity ESG index that tracks the performance of securities based on sustainability measures like the S&P 500® ESG Index. The underlying variable in this example is a market index that is not a non-financial variable specific to a party to the contract.

Closely-related

Where the issuer has not designated the bond at FVTPL (refer also to classification discussion above), the economic characteristics and risks of the embedded derivative component (i.e. the return to the investor that varies based on the growth rate of the rhino population, and the movements in the ESG index) will need to be assessed as to whether they are closely related to the host bond contract, or not.

The concept of ‘closely-related’ is difficult to interpret in IFRS 9, this assessment therefore requires judgement. The standard does, however, clarify that equity-indexed interest that is embedded in a host debt instrument is not considered to be closely-related because the risks inherent in these components are dissimilar (Refer to IFRS 9.B4.3.5(c)). A bond with interest linked to an ESG market index as described above, would therefore not meet the ‘closely-related’ test.

Similarly, for the rhino bonds, it is also unlikely that one would be able to conclude that the risks inherent in a host bond contract are similar to the risks inherent in an embedded derivative linked to the growth rate of the rhino population in a given geographic area. Risks inherent in a debt instrument would include, for example, credit risk and interest rate risk, whereas the growth rate of the rhino population is exposed to risks such as poaching, habitat, environment, ineffective conservation management etc. 

Where the embedded derivative is not closely-related to the host contract, it must be separated and accounted for as a derivative instrument at FVPL.

That being said, separating non closely-related embedded derivatives would require them to be measured at their fair value which could be complex when the ESG indexation is a weighty non-financial variable such as the conservation of the rhino population. The IASB’s views are not black and white on this, IFRS 9 allows for the entire hybrid contract to be designated at FVPL, where the fair value of an embedded derivative cannot be measured reliably. Is this a benefit? The fair value measurement of a rhino feature is still expected to be challenging, and putting the entire instrument at FVPL will trigger other challenges such as measuring and accounting for the own credit risk component of the Bond.

The next article in our sustainability-linked financing series will discuss the impact of ESG features on the effective interest rate (‘EIR’).

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*Sources:

1. Wildlife Conservation Bond Boosts South Africa’s Efforts to Protect Black Rhinos and Support Local Communities - The World Bank

2. ‘Rhino bond’ charges onto markets to save South African animals - Mail & Guardian, South Africa