Should an investment in a loan with ESG-linked adjustments or other similar investments meet the SPPI requirement under IFRS 9?
The recent decision by the IASB.
Recent market developments have given rise to a variety of financial instruments that are linked to sustainability initiatives, indices, or targets. The most common two of financial instruments with such features raised by stakeholders can be categorized into the following types:
- Structured instruments linked to green indices: financial instruments with contractual cash flows that are linked to a green index that is not specific to a party to the contract. The contractual cash flows of such instruments vary with changes in the relevant index similar to those of any indexed instruments.
- Loans with environmental, social or governance (ESG) features: the interest rate of these loans is linked to pre-determined ESG targets that are specific to the borrower. The interest rate of such loans is adjusted periodically to reflect changes in the borrower’s performance relative to the specified ESG targets (ESG-linked adjustments). For example, a loan bears a coupon of a benchmark interest rate plus a margin of 200 bps. The loan includes two ESG targets relating to water usage and CO2 emissions. If both of the targets are met, the margin reduces for the next year to 190 bps. If one of the targets is met, then the margin stays at 200 bps. If none of the targets are met, then the margin increases to 210 bps.
This article explains the Exposure Draft recently issued by the International Accounting Standards Board (IASB) on how to assess whether a loan with ESG-linked adjustments has cash flows that are solely payments of principal and interest (SPPI). This assessment is important because if the instrument does not meet this SPPI test, then the instrument must be subsequently measured at fair value through profit or loss by the holder, rather at amortised cost or at fair value through other comprehensive income.
When developing IFRS 9, the IASB concluded that amortised cost provides useful information about the amount, timing and uncertainty of a financial asset’s future cash flows only if those cash flows are solely payments of principal and interest on the principal amount outstanding (SPPI). The IASB recently considered and decided that the assessment of contractual cash flow characteristics in IFRS 9 is relevant to financial assets with ESG-linked features just as it is to other financial assets. In this regard, the IASB proposes to amend IFRS 9 to clarify the requirements on:
- Elements of interest in a basic lending arrangement; the IASB proposes to clarify that:
a.) the assessment of interest focuses on what an entity is being compensated for, rather than how much compensation an entity receives; and
[The Basis for Conclusion to IFRS 9 currently notes that the assessment of interest focuses on what the entity is being compensated for (i.e. whether the entity is receiving consideration for basic lending risks, costs and a profit margin or is being compensated for something else), instead of how much the entity receives for a particular element. For example, different entities may price the credit risk element differently. The IASB decided to incorporate this principle into the application guidance.]
b.) contractual cash flows are inconsistent with a basic lending arrangement if:
i. the cash flows include compensation for risks or market factors not typically considered basic lending risks or costs, even if such terms are common in the market; and
[The IASB notes in the Basis for Conclusion to the Exposure Draft that just because something is common practice in a particular jurisdiction, it does not necessarily result in contractual cash flows that are solely payments of principal and interest on the principal amount outstanding.]
ii. the cash flows change in a way that is not aligned with the direction and magnitude of changes in lending risks or costs.
[In a basic lending relationship, there is a relationship between the perceived risk the lender is taking on and the compensation it receives for that risk. For contractual cash flows to be consistent with a basic lending arrangement, a change in contractual cash flows has to be directionally consistent with and proportionate to, a change in lending risks or costs. For example, if the rate of interest decreases when the credit risk of the borrower has increased, the change in contractual cash flows is inconsistent with a basic lending arrangement.]
- Contractual terms that change the timing or amount of contractual cash flows; the IASB proposes to clarify that:
a.) an entity shall assess whether the contractually specified change would meet the SPPI requirement irrespective of the probability of the contingent event occurring;
[The contractual cash flow assessment is based on all contractual cash flows that could arise over the life of the financial instrument. It is not a probability-based assessment.]
b.) a change in contractual cash flows is consistent with a basic lending arrangement if the occurrence (or non-occurrence) of the contingent event is specific to the debtor; and
[Changes in contractual cash flows arising from contingent events that are not specific to a debtor or depend on factors that are unrelated to the debtor would not be consistent with a basic lending arrangement. For example, a reduction in interest rates based on reduction in industry-wide greenhouse gas emissions would not be consistent with a basic lending arrangement. It should be noted that not all contingent events that are specific to a debtor would be consistent with a basic lending arrangement. For example, a reduction in interest rate on a specified increase in debtor’s revenue would not generally be considered to be consistent with a basic lending arrangement.]
c.) the resulting contractual cash flows should represent neither an investment in the debtor nor an exposure to the performance of specified assets.
[The nature of a contingent event could be an indicator that a financial asset’s contractual cash flows represent an investment in the debtor or exposure to the performance of specified assets.]
Based on the clarification above, the IASB provides illustrative examples of an analysis in the table below whether the SPPI requirement is met or not.
| Instrument | Analysis |
|
Debt with interest linked to a debtor’s greenhouse gas emissions The instrument is a loan with an interest rate that is periodically adjusted by a specified number of basis points if the debtor achieves a contractually specified reduction in greenhouse gas emissions during the preceding reporting period. |
The SPPI requirement is met The occurrence of the contingent event is specific to the debtor. The resulting contractual cash flows are SPPI in all circumstances. |
|
Debt with interest linked to carbon price index The instrument is a loan with an interest rate that is periodically adjusted when a market-determined carbon price index reaches a contractually defined threshold. |
The SPPI requirement is not met The contractual cash flows change in response to a market factor (the carbon price index), which is not a basic lending risk or cost. |
The IASB will consider the comments it receives on the Exposure Draft and will decide whether to proceed with the proposed amendments. The comment deadline is 19 July 2023.
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