An option pricing approach for Sustainability-Linked Bonds

50 minute read

Sustainability–Linked Bonds (SLBs) have immense potential as a tool for transition finance. There is, however, rising scepticism among investors over the credibility of SLBs due to their frequent lack of ambition. There is concern that the sustainability targets set by issuers are often insufficient to support a substantial transition.

Until the market’s concerns start to be reflected in pricing in the primary as well as secondary markets, there will be no effective mechanism to hold companies accountable for setting up weak structures. As long as this remains the case, issuers will continue to set KPIs that lack ambition.

This paper aims to encourage issuers to set robust sustainability targets when structuring SLBs because ambitious and transparent SLBs can and should deliver an attractive cost-of-capital compared to traditional bonds.

We propose using an “option pricing” approach, in which we apply a technique commonly used in derivatives trading to SLBs, to help investors objectively measure the fair value of coupon step-ups. This approach has been developed by us with market input over recent months. The paper describes the methodology for putting this approach into practice.