When Interest Stops Being Just Interest: IFRS 9, Credit Risk and the Emerging ESG Frontier

Last Updated on 01/04/2026 by 75385885

IFRS 9 SPPI ESG loans – There was a time when a loan was, conceptually at least, a relatively simple financial instrument. A principal amount, a contractual interest rate, a maturity date, and a credit risk that could be assessed with a combination of historical data and forward-looking judgment. IFRS 9 codified this simplicity into something more structured, but not fundamentally different. The cornerstone of that structure — the SPPI-test — rests on a deceptively straightforward premise:

cash flows must represent solely payments of principal and interest.

For years, that definition held. It proved robust across floating rates, inflation-linked structures, step-ups, and credit-driven repricing. But that apparent stability masked something deeper: IFRS 9 was built on an implicit assumption that interest is a financial concept. It is compensation for time, for risk, and for liquidity — all measurable, all anchored in financial economics.

That assumption is now under pressure.

The rise of ESG-linked lending has introduced a new dimension into contractual cash flows. Interest is no longer always determined by financial variables alone. It can now depend on carbon emissions, diversity targets, supply chain metrics, or externally assessed sustainability scores. At first glance, this appears to be a marginal innovation — a few basis points up or down, contingent on performance. In reality, it challenges the conceptual boundaries of IFRS 9.

To understand why, we need to return to first principles.

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The Economic Meaning of Interest Under IFRS 9

IFRS 9 does not define interest in abstract philosophical terms. It anchors the concept in economic components:

• time value of money
• credit risk
• other basic lending risks (such as liquidity)
• a profit margin

This composition matters. It defines what qualifies as a “basic lending arrangement” and, by extension, what can be measured at amortised cost.

The SPPI-test is therefore not a mechanical checklist. It is a filter designed to exclude instruments whose cash flows are exposed to risks unrelated to lending — equity exposure, commodity price risk, leverage effects, or other non-linear features.

What is often overlooked is that even within this framework, credit risk is not a static or binary concept. It exists on a spectrum, and that spectrum already introduces nuance into the notion of “interest”.

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Credit Risk — Clear in Theory, Subtle in Practice

At its most basic level, credit risk is the risk that a borrower fails to meet its contractual obligations. In practice, however, the way this risk is priced — and therefore embedded in interest — can vary significantly.

Case 1 — The Classical Credit Spread

Consider two loans:

• Loan A: issued to a sovereign borrower with a AAA rating
• Loan B: issued to a start-up with no established cash flow

The difference in interest rates — say 2.5% versus 8.5% — is almost entirely attributable to credit risk. The probability of default is materially higher in the second case, and the lender demands compensation accordingly.

From an IFRS 9 perspective, this is straightforward. Both instruments pass the SPPI-test. The variability in cash flows is fully consistent with the concept of interest. The pricing reflects a pure credit risk premium, embedded in a linear, predictable structure.

This is the world IFRS 9 was designed for.

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Case 2 — The Subtle Layer: Sensitivity to Economic Conditions

Now consider a more nuanced comparison.

Two companies present similar balance sheets and leverage profiles:

• Company C operates in a cyclical construction sector
• Company D operates in a regulated utilities environment

Both have comparable credit ratings today. Yet their borrowing costs differ: 5.0% versus 4.2%.

The difference is not driven by current default risk alone, but by exposure to future economic volatility. Company C is more sensitive to interest rates, housing demand, and economic downturns. Company D benefits from stable, regulated cash flows.

Here, interest incorporates a forward-looking dimension of credit risk — not just the likelihood of default today, but the resilience of the business model under stress.

IFRS 9 accommodates this seamlessly. The SPPI-test still holds. The variability remains economically linked to credit risk, even if that link is indirect and probabilistic.

But something important has changed:

credit risk is no longer a fixed attribute — it is a function of the broader economic environment.

This observation becomes critical when we move beyond traditional financial drivers.

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Case 3 — ESG-Linked Pricing: Where the Boundary Begins to Blur

Now consider a third structure:

A borrower with a strong credit profile enters into a loan with the following terms:

• Base interest rate: 4.0%
• Reduction of 25 basis points if CO₂ emission targets are met
• Increase of 50 basis points if targets are missed

At first glance, the adjustment appears modest. It resembles a typical step-up or step-down feature. But the underlying driver is fundamentally different.

The variability in interest is now linked to non-financial performance metrics.

This raises a critical question:

Is this variability still compensation for credit risk?

One could argue that sustainability performance influences long-term financial resilience. Poor environmental performance may lead to regulatory penalties, reputational damage, or increased operating costs. In that sense, ESG factors can indirectly affect credit risk.

But the relationship is neither direct nor immediate. It is mediated, uncertain, and often subject to management judgment.

This is where the SPPI framework starts to experience tension. The further interest moves away from direct financial drivers, the more difficult it becomes to argue that it represents “consideration for credit risk” in the traditional sense.

Read more on this subject in ‘Climate-related risk drivers and their transmission channels‘ on bis.org (The Bank for International Settlements).

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A Structural Insight: Credit Risk Is Not the Same as Risk in General

The three cases illustrate a progression:

1. Direct credit risk — probability of default (clear, measurable)
2. Indirect credit risk — sensitivity to economic conditions (still financial, but forward-looking)
3. Behavioural or strategic factors — ESG performance (potentially linked, but not inherently financial)

This progression is subtle but profound.

IFRS 9 is built to capture the first two categories. It assumes that interest reflects risks inherent in lending — risks that ultimately affect the borrower’s ability to repay.

ESG-linked features introduce a third category: risks (or behaviours) that influence the borrower’s profile, but are not themselves lending risks in a strict sense.

That distinction is not merely academic. It goes to the heart of how financial instruments are measured under IFRS 9 — and therefore how volatility enters the financial statements.

If a financial asset passes the SPPI-test and is held within a business model aimed at collecting contractual cash flows, it can be measured at amortised cost. In that case, the accounting outcome is relatively stable: interest income is recognised using the effective interest method, and changes in market conditions do not directly affect profit or loss. Volatility is largely confined to expected credit losses.

However, once contractual cash flows are deemed to include exposures beyond a basic lending arrangement — in other words, once they fail the SPPI-test — that measurement basis is no longer permitted. The instrument must then be measured at fair value through profit or loss (FVTPL).

This is not a subtle shift. It fundamentally changes how performance is reported:

• changes in market expectations, discount rates, and risk perceptions are immediately reflected in profit or loss
• valuation becomes sensitive to inputs that may have little to do with realised cash flows
• earnings volatility increases, sometimes significantly

In practical terms, two loans that are economically similar — and even generate nearly identical cash flows over time — can produce very different accounting outcomes depending on whether their contractual features are considered “pure” interest or something more complex.

That is why the boundary defined by the SPPI-test matters. It is not just a classification exercise; it determines whether the financial statements reflect a cost-based lending model or a market-based valuation model.

And it is precisely at that boundary that ESG-linked features begin to create tension.

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The Macro Layer: When the World Changes the Meaning of Credit Risk

Before turning to ESG in more detail, it is essential to introduce another dimension — one that operates above individual contracts: the macroeconomic environment.

Consider a scenario in which geopolitical tensions escalate significantly, for example through a conflict affecting global energy markets. Oil prices rise, inflation increases, and central banks respond by tightening monetary policy. Interest rates move upward across the yield curve.

At first glance, this appears to be a simple market phenomenon. Borrowing costs increase. Discount rates adjust. Financial markets reprice risk.

But within IFRS 9, this development has a very specific implication:

it does not change what a loan is, but it fundamentally changes how that loan is expected to perform.

This distinction is crucial.

The contractual structure of the loan — and therefore its SPPI status — remains unchanged. The cash flows are still payments of principal and interest. There is no new exposure to non-lending risks embedded in the contract.

However, the economic environment in which those cash flows must be realised has deteriorated.

Higher interest rates increase debt servicing costs. Inflation pressures margins. Supply chains may be disrupted. As a result:

• probabilities of default increase
• loss given default may worsen
• forward-looking scenarios become more pessimistic

In IFRS 9 terms, this does not trigger a reclassification. Instead, it affects the expected credit loss (ECL) model.

This leads to a structural observation that is often underappreciated:

The SPPI-test is about the nature of contractual cash flows.
The ECL model is about the world in which those cash flows are realised.

In stable conditions, these two dimensions align. In periods of stress, they can diverge significantly.

A loan can remain perfectly SPPI-compliant — and yet experience a substantial increase in expected credit losses, potentially moving from Stage 1 to Stage 2, with a corresponding shift from 12-month to lifetime ECL.

This divergence becomes even more pronounced when non-financial factors — such as ESG performance — begin to influence contractual cash flows themselves.

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Towards a New Question

At this point, the traditional boundaries of IFRS 9 are clearly visible:

• interest as compensation for time and credit risk
• SPPI as the gatekeeper for amortised cost
• ECL as the mechanism for incorporating economic reality

The introduction of ESG-linked features forces a new question into this framework:

When interest starts to reflect behaviour rather than risk, does it remain interest in the IFRS 9 sense?

Answering that question requires a deeper examination of both the SPPI-test and the specific guidance emerging around ESG-linked instruments.

That is where we turn next.

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If the boundary between interest and “something more” determines whether an instrument is measured at amortised cost or at fair value through profit or loss, then the logical next step is to examine that boundary under pressure.

ESG-linked lending is precisely such a pressure point. It introduces variability into contractual cash flows that does not originate from time value of money or credit risk in a traditional sense, but from performance against predefined sustainability metrics. The question is not whether these metrics are economically relevant — increasingly, they are — but whether they are consistent with what IFRS 9 considers a basic lending arrangement.

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From Principle to Application: How ESG Features Interact with SPPI

The emerging IFRS guidance does not prohibit ESG-linked features. On the contrary, it allows for the possibility that such features can still result in SPPI-compliant cash flows. But this is conditional.

The key consideration is whether the variability in cash flows remains consistent with consideration for lending risks, or whether it introduces exposure to risks that are external to lending.

This sounds straightforward, but in practice it requires careful dissection of the contractual terms.

A small adjustment in margin — say 10 to 25 basis points — linked to a sustainability KPI may, in many cases, still be viewed as part of a broader pricing mechanism. Particularly if the KPI can be plausibly connected to long-term creditworthiness, the argument can be made that the feature does not fundamentally alter the nature of the instrument.

However, the further one moves away from that baseline, the more difficult that argument becomes.

Also read the older SPPI testin working – IFRS 9 The SPPI test explained by exampleor reda moer on – Not the End of the World? Governance Lessons from CSRD and ESG.

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Where the Analysis Becomes Critical

There are several dimensions along which ESG-linked features can begin to challenge SPPI.

First, the strength of the economic linkage. If the sustainability metric has only a remote or indirect relationship to the borrower’s ability to repay, then the connection to credit risk becomes tenuous. A carbon reduction target, for example, may influence regulatory exposure over the long term, but it does not directly determine near-term cash flows or default risk.

Second, the magnitude of the adjustment. A minor pricing incentive may still fall within the boundaries of interest. A significant step-up or step-down begins to resemble a performance-based return, rather than compensation for lending risk.

Third, the structure of the trigger. Linear adjustments are easier to justify within SPPI. Binary or non-linear outcomes — where missing a target results in a disproportionate penalty — start to introduce option-like characteristics.

Finally, the degree of management discretion. If the underlying metric can be influenced through accounting choices, policy decisions, or subjective interpretation, then the resulting cash flow variability may reflect managerial behaviour rather than economic risk.

Individually, each of these factors introduces nuance. In combination, they can shift an instrument across the SPPI boundary.

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A Concrete Comparison: Amortised Cost versus FVTPL

To illustrate why this boundary matters, consider the following simplified case.

A company issues a €100 million loan with a five-year maturity. The base interest rate is 4.0%. The loan includes an ESG-linked feature:

• if sustainability targets are met: interest decreases to 3.75%
• if targets are missed: interest increases to 4.50%

At inception, the loan is priced at par.

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Scenario 1 — SPPI Passed (Amortised Cost)

Assume that, based on the specific design of the ESG feature, management concludes that the variability remains consistent with a basic lending arrangement. The instrument is therefore measured at amortised cost.

The accounting outcome is relatively stable:

• interest income is recognised using the effective interest method
• fluctuations in expected ESG performance do not lead to remeasurement of the asset
• the carrying amount evolves predictably over time

Changes in market conditions — including shifts in discount rates or investor sentiment — do not directly affect profit or loss. The only significant source of volatility arises from expected credit losses.

In this model, the financial statements reflect a hold-to-collect perspective. The focus is on contractual cash flows, not on their market valuation.

Read more by the Loan Market Association – External Review Guidance For Green, Social,and Sustainability-Linked Loans.

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Scenario 2 — SPPI Failed (FVTPL)

Now assume that the ESG feature is assessed differently. Perhaps the adjustment is considered too large, or the linkage to credit risk too weak. The instrument fails the SPPI-test and must be measured at fair value through profit or loss.

At that point, the accounting model changes fundamentally.

At each reporting date, the loan is remeasured based on:

• current market interest rates
• updated expectations regarding ESG performance
• changes in credit spreads
• broader market risk perceptions

Suppose that, after one year:

• market interest rates have increased
• investors expect the borrower to miss its ESG targets
• credit spreads have widened slightly

Even if the borrower continues to make all contractual payments on time, the fair value of the instrument may decline. That decline is recognised immediately in profit or loss.

The result is a financial statement that reflects a market-based valuation perspective, rather than a contractual one.

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The Practical Consequence: Accounting Divergence Without Economic Change

What makes this particularly relevant is that the underlying economics of the loan may not have changed dramatically. The borrower is still solvent. Cash flows may still be realised largely as expected over the life of the instrument.

And yet, the accounting outcome diverges:

• under amortised cost: stable interest income, limited volatility
• under FVTPL: potentially significant swings in profit or loss

This divergence is not driven by cash flows themselves, but by how those cash flows are interpreted within IFRS 9.

That is why the SPPI assessment carries so much weight. It determines whether financial reporting emphasises realised performance over time or current market expectations.

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Returning to ESG: A Structural Tension

ESG-linked features sit uncomfortably within this framework because they blur the line between:

• compensation for lending risk
• and incentives designed to influence borrower behaviour

If the adjustment in interest is effectively a pricing tool to encourage sustainability outcomes, then it begins to resemble a contractual feature that is not purely financial in nature.

At that point, one could argue that the instrument contains an embedded exposure to non-lending risk — even if that exposure is modest.

This is where practice becomes fragmented. Some structures are clearly within SPPI. Others clearly fall outside. But a significant number sit in a grey area, where judgement plays a decisive role.

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An Emerging Pattern: The Expansion of “Interest”

Taken together, these developments point to a broader trend.

Historically, interest has been understood as a function of financial variables: time, credit risk, liquidity, and margin. IFRS 9 formalised that understanding and built a classification model around it.

ESG-linked lending expands that concept. It introduces variables that are not inherently financial, but that are increasingly seen as economically relevant.

The accounting question is therefore not simply whether ESG matters — it clearly does — but whether it belongs within the definition of interest, or alongside it as a separate component.

That question cannot be answered in the abstract. It must be resolved contract by contract, feature by feature.

And that is precisely where the current guidance begins to draw lines.

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If ESG-linked features force a re-examination of what constitutes “interest”, then the logical question is where the line is ultimately drawn in practice.

IFRS 9 does not offer a bright-line test. It provides principles, supported by examples and increasingly by interpretative guidance. That leaves room — and responsibility — for judgement. And it is precisely in that judgement that divergence begins to emerge.

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Where Practice Draws the Line

In applying the SPPI-test to ESG-linked instruments, practitioners tend to converge around a set of implicit thresholds, even if they are not formally codified.

The first is proportionality. When ESG-related adjustments are small relative to the overall interest rate, they are more easily interpreted as part of a broader pricing mechanism. The argument is that such adjustments do not fundamentally alter the nature of the instrument; they merely fine-tune compensation within a lending relationship.

The second is economic coherence. If the ESG metric can be linked, even indirectly, to the borrower’s long-term financial resilience, then the variability in cash flows can still be seen as connected to credit risk. This argument is often invoked in sectors where regulatory exposure, transition risk, or environmental liabilities are material.

The third is linearity and symmetry. Features that adjust interest in a gradual and balanced way — for example, a modest step-up or step-down — are easier to accommodate within SPPI. By contrast, features that introduce discontinuities, asymmetry, or leverage begin to resemble embedded derivatives.

The fourth is observability and robustness of the metric. Where ESG performance is measured using externally verified, clearly defined indicators, the resulting variability is more defensible. Where metrics are subjective, internally determined, or prone to revision, the link to “interest” becomes harder to sustain.

Individually, none of these factors is decisive. Together, they form a practical framework through which SPPI assessments are made.

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When ESG Features Tip the Balance

Despite this emerging consensus, there are clear situations in which ESG-linked features are likely to fall outside SPPI.

One such situation arises when the adjustment in interest becomes economically significant. If the variability in pricing is large enough to dominate the overall return, then it is difficult to argue that it merely reflects lending risk. At that point, the instrument begins to take on characteristics of a performance-linked investment.

Another situation occurs when the feature introduces non-linear payoffs. Binary outcomes — where a target is either met or missed, triggering a disproportionate change in interest — can create option-like behaviour. This is conceptually closer to a derivative than to a traditional loan.

A third situation involves weak or absent linkage to credit risk. If the ESG metric is unrelated, or only marginally related, to the borrower’s ability to repay, then the variability in cash flows cannot be justified as compensation for lending risk. In that case, the feature introduces exposure to a different type of risk altogether.

Finally, there is the issue of contractual flexibility. If ESG targets can be renegotiated, reset, or interpreted with significant discretion, then the resulting cash flows may not represent a stable, predictable return. This undermines the notion of “interest” as a function of predefined risk factors.

In each of these cases, the conclusion tends to be the same: the instrument fails the SPPI-test and must be measured at fair value through profit or loss.

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The Role of Judgement — and Its Consequences

What becomes evident is that the SPPI assessment for ESG-linked instruments is not a mechanical exercise. It requires a structured analysis of:

• the nature of the underlying risk
• the design of the contractual feature
• the magnitude and symmetry of its impact
• the robustness of the measurement basis

Different entities, auditors, and regulators may place different weights on these factors. That creates the potential for divergence in practice, even when underlying transactions are similar.

This is not unique to ESG. IFRS 9 has always required judgement, particularly in areas such as modified time value of money, leverage, and prepayment features. But ESG-linked lending introduces a new dimension: the integration of non-financial variables into financial contracts.

As a result, the boundaries of SPPI are no longer tested only by financial engineering, but also by strategic and behavioural design.

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Reconnecting with the ECL Model

At this stage, it is worth returning briefly to the earlier distinction between SPPI and expected credit losses.

Even where an ESG-linked instrument passes the SPPI-test and is measured at amortised cost, the presence of ESG factors does not disappear from the accounting model. Instead, it re-emerges within the ECL framework.

If sustainability performance is genuinely linked to financial resilience, then it should be reflected in forward-looking credit risk assessments:

• companies that fail to meet environmental targets may face higher regulatory costs
• reputational damage may affect revenue streams
• transition risks may impair asset values

These effects influence:

• probability of default
• loss given default
• scenario weighting

In other words, ESG factors may be excluded from the definition of “interest” — but they remain relevant in assessing whether that interest will ultimately be paid.

This reinforces a broader insight:

IFRS 9 separates the structure of cash flows from the uncertainty of their realisation — but ESG increasingly connects the two.

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A Broader Shift in Financial Reporting

Taken together, these developments point to a gradual but significant shift.

IFRS 9 was designed in a world where financial instruments were driven by financial variables. Even when complexity arose, it tended to do so within that domain — through leverage, optionality, or hybrid features.

ESG-linked lending represents a different kind of evolution. It brings external objectives — environmental, social, strategic — directly into the contractual fabric of financial instruments.

This creates a tension that IFRS 9 was not originally designed to resolve:

• should accounting follow the economic substance of sustainability-linked incentives?
• or should it maintain a strict boundary around what constitutes “interest”?

There is no single answer. The current framework attempts to balance both perspectives, allowing flexibility while preserving conceptual integrity.

But that balance is becoming harder to maintain as ESG considerations become more deeply embedded in financial markets.

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Conclusion — The Expanding Boundary of Interest

What began as a technical question — whether ESG-linked features affect the SPPI-test — turns out to be part of a much broader development.

The definition of interest under IFRS 9 is being tested, not by exotic derivatives or complex financial engineering, but by the integration of non-financial performance metrics into lending arrangements.

At one end of the spectrum, the traditional model remains intact. Loans with clearly defined credit risk premiums continue to fit comfortably within amortised cost.

At the other end, instruments that incorporate significant, non-linear, or behaviour-driven features move into fair value measurement, with all the associated volatility.

Between those extremes lies a growing grey area — where ESG-linked features are modest, economically defensible, and structurally simple, yet conceptually distinct from traditional interest.

It is in this grey area that judgement becomes decisive.

And it is precisely here that IFRS 9 reveals both its strength and its limitations:

• its strength, in providing a principled framework capable of accommodating new developments
• its limitation, in relying on concepts that were not designed with ESG in mind

The practical implication is clear. The SPPI-test can no longer be treated as a routine classification step. It requires a deeper analysis of what interest represents in a changing economic landscape.

Or, put more directly:

when interest starts to reflect behaviour as much as risk, the boundary of IFRS 9 is no longer fixed — it becomes something that must be interpreted, case by case.

FAQ’s – IFRS 9 ESG loans