IFRS 9 Financial Instruments – Financial assets with ESG features

One of the concepts introduced by IFRS 9 Financial Instruments (IFRS 9) (effective for IFRS reporters other than insurance companies since 2018) is the “solely payments of principal and interest” (SPPI) test. This test must be met for a financial asset to be measured at amortised cost, rather than fair value. A financial asset will meet the SPPI test if its contractual terms are that of a basic lending arrangement, i.e. the interest compensates the lender for the risks of lending. Time value of money and credit risk would be the most significant elements of such a return, but could also include other basic lending risks (such as liquidity risk). The interest can also include a margin to compensate the lender for administrative costs of lending.

ESG features, which adjust the lender’s return based on the borrower’s compliance with ESG targets (i.e. lower if they are met; higher if they are not) are becoming increasingly common, with it being unclear how IFRS 9 should be applied to loans with such features, for instance does a loan with such features pass the SPPI test?

Intuitively, compliance with ESG targets feels like it would render the borrower more sustainable and hence (qualitatively at least) meeting those targets means the borrower’s credit risk is lower. A potential reduction to the lender’s margin should the ESG target be met in turn feels consistent with a basic lending arrangement because the credit risk to the lender has reduced.

On the other hand, perhaps the improvement in a borrower’s creditworthiness from complying with ESG targets would only be true over the very long term – IFRS 9’s SPPI test must be met over the contractual term of the loan, not over some undefined, long-term time horizon. When looking at the actual contractual term of the loan, meeting ESG targets might require the borrower to incur additional costs (install solar panels, switch to electric vehicles, allow employees additional time off for community volunteering, etc.). Incurring additional costs to meet a ESG target in a loan arguably increases the credit risk to the lender over the contractual term of the debt, which in turn feels inconsistent with a basic lending arrangement if the consequence is a reduction in the interest rate.

To date, most lenders have been able to account for such loans at amortised cost by demonstrating that either the potential variability in the returns attributable to the ESG feature are de minimis or that the aggregate effect of not accounting for the loans receivable at fair value is immaterial. However, this is becoming more difficult as the prevalence of such features in debt instruments increases. As part of the post-implementation review of IFRS 9, many stakeholders have expressed a desire for the International Accounting Standards Board (IASB) to look into how IFRS 9 might be amended to enable the lender to measure such loans at amortised cost when the intention is for them to be held to maturity.

The IASB have responded with a proposed amendment to IFRS 9, which expands the guidance on when contingent contractual cash flows (such as those that arise should the borrower meet ESG targets) are consistent with a basic lending arrangement and hence are SPPI:

1. The variation in the lender’s return is dependent on a contractually specified target that is specific to the borrower;
2. The resulting cash flows must neither represent an investment in the borrower nor an exposure to the performance of specified assets; and
3. A change in contractual cash flows has to be directionally consistent with, as well as proportionate to, a change in risks or costs associated with lending to the borrower.

Although the proposals are clearly intending to be helpful, it is the third criterion where it is not so obvious that a solution has been found. A contractual term which changes the lender’s return should the borrower (for example) reduce its CO₂ emissions meets the first two criteria, but the unanswered question is why the lender’s risks and costs of lending are impacted by the borrower’s CO₂ emissions. Until that has been articulated it is not possible to make a judgement as to whether the quantum of the change in the lender’s return arising from the borrower meeting a CO₂ emissions target is directionally consistent with, and proportionate to, the change in the lender’s risks or costs.

The deadline for comments to the IASB is 19 July 2023.