Why ESG-linked features impact financial assets classification under IFRS?
Why ESG-linked features impact financial assets classification under IFRS?
Thu 12 Jan 2023
In our last article on sustainability-linked financing, we highlighted the accounting issues related to these contracts that are currently being debated between stakeholders. The most critical issue is the classification of loans or bonds that reference the borrower or issuer’s environmental, social and governance (ESG) key performance indicators (KPIs) on the balance sheet of lenders – generally banks – and investors. In particular, the interest rate on these loans or bonds is adjusted periodically up or down depending on whether the ESG KPI targets are achieved or not. Examples of these KPIs include parity, water usage, greenhouse gas (GHG) emissions, food waste, obtaining ESG labels/trophies…
To be SPPI… or not?
For the classification of financial assets, IFRS 9 Financial Instruments requires the holder to assess whether the instrument’s contractual cash flows comprise solely payments of principal and interest (SPPI). When this criterion is not met, financial assets must be classified at fair value through profit or loss (FVPL).
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 in which interests are a compensation for the time value of money, credit risk, some other risks such as liquidity risk, some costs such as administrative costs and a profit margin.
Therefore, contractual terms that introduce exposure to risks or volatility in the contractual cash flows unrelated to a basic lending arrangement, such as stocks or commodities prices, do not meet SPPI criterion.
When the IASB issued IFRS 9 in 2014, ESG-linked financing was not yet on track. Thus, ESG indexation features were not considered when drafting IFRS 9 and were not explicitly mentioned as a component of a basic loan arrangement. An interpretation issue, therefore, arises to determine how to articulate general SPPI principles with these new features.
From the perspective of lenders, such as banks, these ESG-linked loans are now granted as business as usual. Most of them are classified as standard loans at amortised cost consistently with the bank’s business model. However, where such an instrument is non-SPPI, it would result in a FVPL classification triggering the requirement to determine the fair value. Such evaluation is a first difficulty as it is not a usual practice for loans (credit risk and ESG KPIs are not easy to fair value). It may also create volatility in the net income statement and, thus, in the regulatory capital.
This accounting question arises in the context of a fast-developing ESG-linked loan market. Indeed, according to Refinitiv LPC, the volume of ESG-linked loans granted in 2021 reached a new record at more than $700bn worldwide, more than three times the level reached in 2020.
Short term solutions
Pending more guidance from the International Accounting Standards Board (IASB), there are two main and simple approaches developed by banks to classify ESG-linked loans at amortised cost:
- The de minimis approach which is based on paragraph B4.1.18 of IFRS 9. This paragraph states that a feature is not contemplated for the SPPI assessment if this feature only has a de minimis effect on the amount of cash flows, in all scenarios. This assessment is made in each reporting period and cumulatively over the life of the instrument. As the standard doesn’t define any threshold to apply the de minimis approach, ESG KPIs indexation can be viewed as de minimis each time that its effect is limited to a “small” number of basis points. However, judgement is required to determine what shall be considered as “small” or “de minimis”.
- The materiality approach which is based either on the demonstration that the outstanding amounts of ESG linked instruments are non-significant, or on the demonstration that the difference between amortized cost, including expected credit loss (ECL) impairment, and FVPL for those instruments is non-significant on the net income statement of the bank.
However, these approaches may not be appropriate from a long-term perspective as :
- These approaches require a systematic SPPI assessment on an individual basis, which can increase operational costs (most of the time, banks perform SPPI assessments by type of products for standard loans);
- the first approach may limit further development of the ESG KPI indexation range needed to stimulate the environmental and social transition; and
- considering the current and projected growth of these products it is unlikely that the materiality argument applied in the second approach will continue to be appropriate in the future for most investors or lenders.
Other approaches being considered
In a paper produced by the IASB staff in July 2021 to support the IASB work after an outreach process, other approaches to classify ESG-linked loans at amortised cost were considered. The main concepts developed were the following:
- The inclusion of the ESG indexation in the credit risk component of interest cash flows. According to IFRS 9 principles, credit risk adjustments during the life of a financial asset are considered SPPI. This approach considers whether one can include ESG indexation in the credit risk component of a loan. In addition, it is consistent with the recent developments in the financial industry for including more and more environmental, social and governance factors in their credit risk assessment and ratings. However, it raises several challenges as entities may lack historical data to support the link between ESG KPIs indexation and credit risk. Moreover, the staff mentioned that in their opinion, ESG factors might affect the borrower’s credit risk over the long term but not necessarily the credit risk profile of a specific loan over its remaining life.
- The inclusion of ESG indexation in the profit margin component of interest cash flows. As profit margin is, most of the time, a small, fixed component of the interest cash flows, the staff considered that simply stating that this adjustment to cash flows forms part of the profit margin is insufficient to avoid an SPPI assessment of ESG features.
A critical question in a SPPI assessment is to determine what the lender is being compensated for. Any compensation for a risk that is not integral to a basic loan arrangement, such as commodity or equity exposure, would trigger a non-SPPI classification. The contingency of the cash flow is an ESG event, but it does not necessarily mean that the lender is being compensated for an exposure to the ESG risk of the borrower. Given that the indexation is generally small and standardised (i.e. not tailored to the ESG risk profile of the borrower), one could consider that this spread does not compensate the lender for a particular type of risk exposure.
Latest news from the IASB
The IASB tentatively decided at the September 2022 Board to amend IFRS 9 to clarify how SPPI principles shall be applied. This clarification aims at capturing the issues raised by ESG-linked instruments. The draft amendment is expected to be issued by the end of March 2023.
In our next article, we will present the clarifications considered by the Board as well as the transitional requirements.
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