Do Sustainability-Linked Notes have Embedded Derivatives?

Abstract

Following the 2010 initiative of the World Bank, business enterprises began in 2019 to issue sustainability-linked bonds. These debt instruments allow issuers to provide lower coupon interest rate contingent on their achieving predefined environmental, social, and governance targets. Failure to achieve the agreed-upon targets leads to increasing the coupon rate according to a step-up plan. The accounting for these sustainability-linked debt instruments hinges on whether these step-up features are embedded derivatives and, if so, are they subject to bifurcation? I develop some of these issues and include three actual cases—Holcim Group, Enbridge, and Ford Motors—and then provide a possible approach to accounting for the special step-up features as bifurcated embedded derivatives.

Keywords: Sustainability, Step-up, Step-down, Environment, Social, Carbon Emission

JEL Classification: M41, G1, G3