case study sustainability linked loan

2021: The Year of the Sustainability-Linked Loan

European Leveraged Finance Client Alert Series: December 2021

The leveraged loan market has seen a significant increase in the number of sustainability linked leveraged loans issued in 2021. In this article, we will briefly discuss the recent updates to the Sustainability Linked Loan Principles ("SLLPs"), and the newly published Best Practice Guide (the "Guide"), before examining how the market has incorporated ESG provisions into leveraged loans and the related issues that borrowers and lenders will need to consider .

This article first appeared in the November 2021 issue of Butterworth's Journal of International Banking and Financial Law

• The leveraged loan market has seen a significant increase in the number of sustainability-linked leveraged loans issued since the beginning of 2021.
• Although the Sustainability-Linked Loan Principles provide a voluntary framework for market participants to adopt, we are far from reaching documentary standardisation and drafting continues to be deal-specific.

ESG is Everywhere

Such is the extent to which environmental concerns dominate the global agenda, that for some time now it has been impossible to open a newspaper and not find an article related to climate change or the transition to net zero. Greta Thunberg and Extinction Rebellion have become household names as awareness of global warming, carbon footprints and our impact on the planet has skyrocketed, meaning that you cannot avoid the E in ESG. Furthermore, after the tumultuousness of 2020, attention is by no means limited just to the environmental pillar. Events such as the global coronavirus pandemic and the Black Lives Matter movement dominated headlines and raised to the forefront issues relating to the social and governance pillars.

In a similar vein, it has also been impossible for market participants in the European leveraged loan market not to notice the momentum of ESG since the start of 2021. After a trickle of sustainability-linked loan issuances towards the end of 2020, suddenly, at the beginning of this year, the floodgates seemed to open. Almost overnight, everyone was an ESG expert and borrowers and sponsors were racing to join the cause by including an ESG-linked margin ratchet in their financings. In fact, such was the enthusiasm for sustainability-linked financings that in the second quarter of 2021, 65% of European syndicated leveraged loans reviewed by Covenant Review contained an ESG-linked margin ratchet. This is a truly remarkable figure, particularly when you consider the fact that sustainability-linked loans ("SLLs") accounted for just a 4% share of the market in the whole of 2020.

In this article, we will briefly discuss the recent updates to the Sustainability Linked Loan Principles ("SLLPs") and the way in which the newly published Best Practice Guide (the "Guide") complements them, before examining how the market has incorporated ESG provisions into leveraged loans and the related issues that borrowers and lenders will need to consider.

Updated Sustainability-Linked Loan Principles

In light of the staggering increase in the volume of SLLs and the rapid evolution in the incorporation of ESG principles into deal documentation, the APLMA, LMA and LSTA updated the SLLPs to reflect emerging market trends. This update, which also aligns the SLLPs with ICMA's Sustainability Linked Bond Principles, was published on 27 May 2021. The SLLPs were originally published in 2019 with the aim of promoting the development and preserving the integrity of sustainability-linked loan products by providing a (voluntary) framework. The most significant change was to tighten up the process of selecting Key Performance Indicators ("KPIs") and to introduce mandatory third party verification. In part, this was deemed necessary because of the perceived potential for "greenwashing" and the reputational risks for lenders and borrowers participating in SLLs where the targets were too easily achievable. (Greenwashing is the practice whereby either a company overstates its green credentials to obtain better terms or where claims made in relation to ESG performance do not match reality.)

LMA/ELFA Best Practice Guide for SLLs

On 28 July 2021, the LMA and ELFA published a best practice guide for sustainability linked leveraged loans. The Guide aims to steer market participants when applying the SLLPs to leveraged loans that seek to incorporate any kind of ESG factor or metric. The Guide addresses the following areas, some of which we will cover in greater depth later in this Alert: 

• Terminology – the Guide cross-refers to the LMA's Sustainable Lending Glossary, which was updated in August 2021, the aim of which is to assist market participants in the development of a common language. 
• Roles – the Guide provides an explanation of some of the specialised roles that have developed, such as ESG Rating Providers, ESG Consultants, Sustainability Coordinator/Agent and External Reviewer.
• Selection, Disclosure and Calibration of KPIs – the Guide discusses requirements and timing relating to the selection of KPIs.
• Reporting – the Guide discusses the requirements relating to reporting on performance against the Sustainability Performance Targets ("SPTs") and KPIs and the frequency with which it should be provided.
• Documentation – although there is no standard drafting and documentation will need to be negotiated on a case-by-case basis, the Guide summarises certain considerations for documenting SLLs.

Incorporating ESG into Facilities Agreements

Various trade associations have produced a significant amount of guidance around SLLs, which is assisting in the adoption of ESG provisions by the leveraged loan market. The guidance, coupled with the SLLPs, has provided a skeleton of standards to which participants in a SLL should aspire and has highlighted issues to consider when drafting an ESG-linked facility. Standardisation is still a way off, however, and while some market precedent is beginning to form, varying approaches are still emerging. In the sections that follow, we consider some common features when documenting a SLL. It is worth noting, however, that as with all leveraged loans, the drafting will be deal-specific and negotiation will vary on a case-by-case basis. 

The ESG-Linked Margin Ratchet

The ESG-linked margin ratchet works in a similar way to a standard financial ratio-based margin ratchet, but rather than adjustments happening on a quarterly basis, they are annual. The facilities agreement will usually set out that the relevant sustainability margin adjustment will be made within a certain number of business days following receipt by the agent of the borrower's sustainability certification, which is usually delivered alongside the annual financial statements, and the relevant adjustment will then apply for the financial year.

The ratchet is an area that has seen considerable development since the negotiation of the first SLLs. The early SLLs featured a one-way pricing adjustment that resulted in a discount, but nowadays, pricing adjustments tend to be two -way; either offering a discount on the margin if the borrower meets the relevant target(s) or imposing a premium on the margin when targets are missed.

Ratchet discounts (and premiums) in the leveraged loan market, although larger than those on offer in the investment grade space, are still minimal and typically range from 2.5 basis points up to a maximum of 15. We may, however, see these become more financially material over time as investors pay increased attention to ESG concerns.

Setting Targets: KPI or ESG score?

One of the underlying decisions to be made when documenting a SLL is whether to tie the ESG-linked margin ratchet to performance against specific KPIs or to the borrower's ESG rating. To date, the market has favoured the use of KPIs, but we have seen some transactions incorporate performance against an ESG rating, whilst others have used a combination of both.

ESG Ratings

An ESG rating is determined by an independent, external ESG rating agency which assesses the ability of the borrower to integrate and manage sustainability issues relevant to the particular sector in which it operates. The rating process will also consider the degree to which ESG risks are mitigated. The format of the score or rating varies by provider, but can be either a numeric score (typically given as a score out of 100) or an alphabetical representation (often ranging from AAA for the best-performing companies through to D for the worst performers).

In determining a borrower's score, ESG rating agencies will usually perform an annual evaluation of its performance against a number of ESG factors (sometimes as many as 200), which is verified and standardised according to the industry in which it operates. As part of the evaluation process, the ESG rating agent will usually collect publicly available ESG information, such as that disclosed in the borrower's Corporate Social Responsibility or Sustainability Reporting, as well as anything disclosed by the company on its website and any relevant information from other public sources. The ESG rating agent may also make contact directly with the company to request information. Once the ESG evaluation report has been prepared, some ESG rating agencies will give the borrower the opportunity to review, verify and comment on the ESG score and provide further data before the final report is published.

The use of an ESG rating can be advantageous for borrowers who are not ready to (or would prefer not to) have to invest in or upskill employees to create the in-house ESG expertise required to monitor and report against detailed KPIs. The downside, however, is that an ESG rating, whilst providing a holistic view of a company's ESG performance, is less bespoke to the borrower and the ESG rating result can vary depending on the chosen ESG rating agency and its particular methodology.

The alternative to an ESG rating is to use KPIs to measure the borrower's performance against SPTs, which can be external, internal or a combination of both. The advantage of using KPIs is that they are bespoke and tailored to both the business' overall strategy and its ESG-specific aspirations.

The SLLPs emphasise that the credibility of the sustainability-linked loan market is intrinsically linked to the selection of robust and credible KPIs. To avoid allegations of greenwashing, it is essential that borrowers select KPIs that are ambitious and meaningful to the business and which address any relevant ESG challenges that the particular sector may present for the borrower. Furthermore, the KPIs should be quantifiable using a consistent and methodological process and, where possible, capable of benchmarking against an external reference. Finally, as part of the recent update to the SLLPs, borrowers are now encouraged to seek external review of the KPIs to substantiate their appropriateness, which means that a requirement to provide a sustainability auditor's opinion on the KPIs can sometimes be included as a condition precedent to the SLL.

The number of KPIs against which the ESG margin ratchet is measured typically ranges from one to five, with three being the standard seen in SLLs in the year to date. The number of KPIs, however, should not be a driving factor when negotiating a SLL. In order to bolster the meaningfulness of KPIs it is important to ensure that the facilities agreement adequately defines the KPIs and sets out both the calculation methodology and any baselines, as well as any industry standards that will be used for benchmarking.

The use of KPIs, however, can present challenges to borrowers and sponsors, particularly in an acquisition scenario. Firstly, in order to adequately monitor progress against SPTs and make appropriate disclosures on performance, suitable internal expertise is required and there may be a need to upskill employees. Secondly, it is necessary to consider how it is possible to meet the demanding requirements of the SLLPs in respect of meaningful and ambitious KPIs, presented alongside detailed, methodological processes for measuring performance when, prior to the acquisition, there may be limited access to the target and the required information. The Guide referred to earlier states that the KPIs should be agreed upon before a deal is marketed for syndication and ELFA recommends that as much information as possible is disclosed at the term sheet stage. One suggested approach where there is limited access to the target is to set SPTs for year one that are based on historical data and allow for the Majority Lenders to agree further targets post-closing. Alternatively, one recent transaction started with a ratchet measured against the borrower's ESG score, but also included mechanics in the facilities agreement to allow for a smooth transition to KPIs at a later date.

Updating KPIs

Although the setting of ambitious KPIs is central to the SLLPs, equally important is that they remain ambitious throughout the life of the loan. Some early SLLs featured static SPTs, which effectively allowed the borrower's ESG efforts to plateau once the target had been achieved and the margin discount triggered. More recent SLLs include cumulative or dynamic SPTs that encourage continued endeavours by borrowers in relation to improving their ESG performance if they wish to continue benefitting from better pricing.

In order for KPIs to remain relevant and meaningful throughout the life of the loan, it is also essential that the facilities agreement allows for adjustments and/or recalculations to the targets or methodology. In order to achieve this, some SLLs have allowed for submission to the lenders of a written adjustment proposal detailing the necessary changes to calculations, whereas other SLLs allow the parties to enter into a period of good faith negotiations to agree any necessary adjustments, often following the occurrence of an "adjustment event". The requisite consent level for both of these options is usually Majority Lender and, if no agreement is reached, then any ESG-linked margin adjustments will cease to apply. Sometimes, documentation may require third party verification of either the need for the adjustment or the change to the target/methodology.

Disclosure, Reporting and Third Party Verification

Transparency is essential in the SLL market as it helps to protect against greenwashing. It is important, therefore, that the borrower is prepared to provide the lending group with certain information relating to its ESG strategy and performance, both at the outset of a transaction and throughout the life of the SLL.

As a condition precedent to the initial utilisation, the facilities agreement may require the provision of any of the following third party reports: sustainability vendor due diligence report, sustainability strategy, ESG rating report confirming the base ESG rating, or a sustainability auditor's opinion on the suitability of the KPIs and testing methodologies.

It is also common to require the provision of an annual sustainability report detailing the borrower's sustainability efforts, as well as a sustainability compliance certificate confirming whether the KPIs have been reached. A template certificate is often included in the schedules to the facilities agreement. Where the ratchet is measured by an ESG rating, there will be a requirement to provide annual ESG rating reports, as well as an ongoing obligation to notify any change in the ESG rating.

The updated SLLPs now require mandatory independent and external verification of the borrower's performance against the KPIs, which will usually be performed by a borrower-appointed sustainability auditor.

No Such Thing as an ESG Default

Given the nature of the current cov-lite, top-tier sponsor-driven market, it will come as no surprise that the consequence of failing either to meet the SPTs or to make the required disclosures is purely economic and does not result in an event of default or drawstop. As previously discussed, margin ratchets are typically two-way, with failure to meet a KPI resulting in the borrower paying a premium. Similarly, failure to deliver a sustainability report or compliance certificate will usually trigger a grace period after which the margin will increase until such time as the relevant document is delivered.

Other Documentary Considerations

Finally, below are some concepts, which although not market standard, parties may consider including in the SLL facilities agreement.

Charitable or Sustainable Uses for Margin Savings

An increasingly common feature in SLLs is to require that margin savings be either partially (for example 50%) or entirely donated to charitable causes or reinvested in sustainable initiatives. Whether or not the borrower is required to demonstrate that the savings have indeed been donated/reinvested is a point for negotiation, with some SLLs requiring the inclusion of a confirmatory statement in the annual sustainability compliance certificate. The consequences of failing to make the donation/reinvestment also varies between facilities and can range from a period of negotiation to agree on an extended period within which to comply, a financial penalty (the ESG margin ratchet ceasing to apply either on a temporary or permanent basis and/or repayment of the margin savings), or an Event of Default.

Severe Sustainability Controversy

Sometimes events (which may or may not be beyond the parties' control) can occur which have such significant detrimental ESG consequences that it is in everyone's best interests to disapply the SLL-related provisions altogether. For this reason, some SLLs in the year to date have included "Severe Event" or "ESG Controversy" drafting, meaning that should the Sustainability Coordinator (or sometimes Majority Lenders) deem that a severe event has occurred, the margin adjustment will be disapplied for as long as the event is continuing, even if the relevant KPIs have been met.

White & Case means the international legal practice comprising White & Case LLP, a New York State registered limited liability partnership, White & Case LLP, a limited liability partnership incorporated under English law and all other affiliated partnerships, companies and entities.

This article is prepared for the general information of interested persons. It is not, and does not attempt to be, comprehensive in nature. Due to the general nature of its content, it should not be regarded as legal advice.

© 2021 White & Case LLP

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Ramsay Health Care: Setting social target for our sustainability-linked loan

Sustainability-linked loans have become an established feature of loan markets around the world, and they are the second-biggest type of ESG debt by overall volume after green bonds. These loans are designed to boost sustainable economic activities and growth, with their interest rates tethered to the achievement of specific sustainability goals. These loans can enhance access to capital and also contribute to a broader positive impact. However, organizations may wonder how to establish clear targets for such loans.

Illustrating this, Ramsay Health Care, an Australian-based global healthcare provider, gives a practical example of how they set targets for a AU$1.5 billion sustainability-linked loan. This particular loan was linked to five sustainability performance indicators, aligning with the three pillars of Ramsay's sustainability strategy. The case study delves into two social performance indicators: mental health and sustainable supply chains.

To gain insights into Ramsay's approach in defining and setting sustainability performance indicators, their strategies for staying on course and reporting progress, and their subsequent steps along with valuable tips for others, download the case study.  

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ESG-Linked Loans Case Study, Lessons Learnt and Best Practices

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According to  Yvonne Wiersma (borrower) - ESG linked-loans brought an increased focus on ESG across the organization. The ESG linked loan has brought more people in the organization onboard with sustainability. Everyone is pulling in the same direction to improve ESG performance. Previously there were people with an intrinsic desire to make progress on sustainability but also a group that did not share this motivation and the ESG loan system has made sustainability a key business initiative and created real movement in the organization .

Explore the rise in sustainability-linked loans from a lender and borrower perspective through the intervention of Roland Mees, Director Sustainable Finance, ING and Yvonne Wiersma, General Counsel, Kendrion N.V. A session moderated by Sophie Bertreau, VP New Solutions, EcoVadis and Alex Garkov, Sustainable Finance Specialist, EcoVadis.

About the Author EcoVadis is a purpose-driven company whose mission is to provide the world's most trusted business sustainability ratings. Businesses of all sizes rely on EcoVadis’ expert intelligence and evidence-based ratings to manage risk and compliance, drive decarbonization, and improve the sustainability performance of their business and value chain. Its AI-powered risk mapping, actionable scorecards, benchmarks, carbon action tools, and insights guide a resilience and improvement journey for environmental, social and ethical practices across 200 industry categories and 175 countries. Follow on Twitter Follow on Linkedin Visit Website More Content by EcoVadis EN

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Brazil’s “New Sanitation Legal Framework” was established in July 2020, with the objectives that 99% of the population has access to clean water and 90% to sewage collection and treatment by 2033. Despite abundant surface freshwater, only 84% of Brazil’s 215 million people have access to potable water, and only 50% have access to sewerage. Across Brazil, more than 35% of water treated for distribution is lost in leakages, and 43% is lost in distribution in the catchment area of the state utility , Companhia Riograndense de Saneamento (Corsan).

Stakeholders involved

• State Utility: Companhia Riograndense de Saneamento (Corsan) is the main water and sanitation utility in the State of Rio Grande do Sul.
• Investor: IFC is a member of the World Bank Group and uses capital and expertise to create markets and opportunities in developing countries.
• Donor support (advisory): The Government of Japan is a key development partner for IFC, particularly in supporting quality infrastructure investment.

Insufficient public funds and limited use of private capital had resulted in limited progress in improving access to water and sanitation across Brazil. Across the country, meeting the “New Sanitation Legal Framework” would require an annual investment of USD10 billion – more than four times the average annual investment in the sector over the past five years.

• Corsan joined IFC’s Utilities For Climate (U4C) initiative to get advice from IFC on addressing losses in water distribution (advisory supported by the Government of Japan), and improve energy efficiency, obtain a loan to finance investments, and join a network of likeminded and dynamic utilities worldwide for knowledge-sharing of best practices.
• IFC is taking the first tranche of USD57 million as a sustainability-linked loan as part of a USD83 million project loan to replace obsolete pumps and hydrometers throughout Rio Grande do Sul’s water distribution network.
• Corsan will benefit from an interest rate reduction of 10bps if it can meet the 35% water loss target by 2024 .

Results and impact

The IFC loan to Corsan was one of the IFC’s first sustainability-linked loans in the infrastructure sector, and the first in Latin America . The Corsan loan contributed to the IFC’s largest fiscal year involvement with Brazil, which totaled USD2.85 billion in 2021. This included USD960 million in institutional capital mobilised through PPPs .

The 2020 Framework will likely lead to further opportunities to mobilise institutional capital in the water sector in Brazil, as it calls for public tenders for concession contracts .

Key lessons learnt

IFC can provide financing to specifically target sustainable development goals (SDGs) - in this case, SDG 6, which calls for 'availability and sustainable management of water and sanitation for all'. IFC can also leverage its financial influence to ensure greater efficiency in state utility providers. As part of the sustainability-linked loan, Corsan created a social and environmental action plan to improve governance, risk identification, grievance procedures, and more.

The liberalisation of utilities sectors – such as the  water sector in Brazil under the 2020 Framework – provides an opportunity for multilateral players to fill a larger role in funding essential infrastructure and encourage further institutional participation.

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Sustainability-linked loans: Practical observations and thoughts

Global |  Publication |  July 2022

Sustainability-linked loans

Sustainability-linked loan principles, lender considerations in the sll market, application to export credit financing.

SSLs are loans whose structure incentivises borrowers to achieve pre-agreed sustainability-linked targets (commonly known as Sustainability Performance Targets) (the SPTs ) and support environmentally and socially sustainable economic activity and growth by offering a margin reduction if those targets are achieved.  The borrower’s performance in achieving the agreed SPTs is measured through selected sustainability Key Performance Indicators ( KPIs ) that can be external and/or internal.  SLLs are based on Sustainability Linked Loan Principles ( SLLPs ), which are a set of criteria developed by an experienced working party, consisting of representatives from leading financial institutions active in the global syndicated loan markets.  SLLPs are aimed at promoting the development and preserving the integrity of the sustainability-linked loan product by providing guidelines which capture the fundamental characteristics of these loans. 

It is worth noting that unlike green loans, which are made in the context of green and sustainable lending where there is a clear requirement for proceeds to be used for a green purpose or project, the use of proceeds is not the determining factor in the categorisation of a SLL. 

SLLs are often structured as revolving credit facilities for general corporate purposes.  As at the date of this article, save for some model templates provided by official websites 1 , we are not aware of standard market templates for SLLs, although we have seen some consistent trends drafting with a general adoption of LMA and APLMA facility documentation with add ins to adapt the relevant document to SLLs.

Objective and components

The objectives of SLLs may be grouped in two categories:

• setting ambitious and meaningful core SPTs for the borrower to achieve in line with the borrower’s sustainability objectives; and
• transparency in determining whether those SPTs have been met.

There are five core components of a SLL 2 :

• Selection of KPIs;
• Calibration of SPTs;
• Loan Characteristics;
• Reporting; and
• Verification.

KPIs Selection

The selection of appropriate KPIs is key to the credibility of the sustainability-liked loan market.  The KPIs should therefore be material to the borrower’s core sustainability and business strategy, and address relevant challenges.  The calibration of the SPTs per KPI will evidence the level of ambition the borrower commits to.  KPIs should be:

• relevant, core and material to the borrower’s overall business, and of high strategic significance to the borrower’s current and/or future operations;
• measurable or quantifiable on a consistent methodological basis; and
• able to be benchmarked, i.e. as much as possible using an external reference or definitions to facilitate the assessment of the SPT’s level of ambition 3 .

The SLLPs encourage formulating a clear definition for the KPIs, which ought to include scope and parameters, calculation methodology, a definition of a baseline and be benchmarked against an industry standard.

Sustainability Strategy

The condition for borrowers being allowed access to SLLs is to have internal sustainable policies or programmes already established.  The proposed SPT will need to align with the borrower’s broader sustainability objectives, strategy, policy and/or processes relating to sustainability.  Borrowers are encouraged to disclose any sustainability standards or certifications to which they are seeking to conform, and this can be used as the basis for developing the SPT.

Consideration for Lenders

With a single borrower which is not part of a group, the sustainability strategy can be more straightforward as the borrower is the ultimate controller of the objectives, strategy, policy and/or processes relating to sustainability.

In the context of groups, it is most likely that sustainability objectives, strategy, policy and/or processes are managed on a consolidated basis and are tested at group level.  In transactions involving a borrower which is part of a group, lenders will need to consider how these consolidated tests satisfy the requirement for the borrower (being a subsidiary) to reach its SPTs.

This aspect may be even more relevant in the context of export credit SLLs where the relevant Export Credit Agency ( ECA ) will most likely require the compliance with SPTs as a condition under the relevant insurance policy/guarantee.

Sustainability Performance Targets

Any type of bilateral or syndicated loan facility can be adapted to a SLL, through the inclusion of SPTs and a financial incentive which is triggered if the SPTs are achieved.  The selection and measurement of the SPTs is key to the robustness of the product.

Examples of SPTs include reducing the borrower’s water consumption, reducing greenhouse gas emissions and improving energy efficiency.  They cover sustainability related matters, such as ensuring sustainable sourcing practices and increasing recycling rates and also measuring the borrower’s performance against an external ESG rating system, which can be reflected in the borrower’s overall ESG rating.  The test will occur on a periodical basis (semi-annual or annual basis) and will be carried out against internal objectives or external standards.

The SPTs selected for a borrower should be ambitious and meaningful 4 (i.e. core to the borrower’s business) and tied to a predetermined performance target benchmark for the entire life of the loan.  The borrower needs to have earned the financial benefit of the margin reduction tied to the SLL.

The borrower’s performance level should therefore be considered in light of a combination of benchmarking approaches, including the borrower’s performance over time (with a 3 year track record on the selected KPI(s) recommended in the SLLs), the borrower’s positioning relative to its peers and consideration of scientific developments or relevant official country/regional/international targets.

The negotiation of the parameters of the SPTs is potentially the most complicated aspect of a SLL.  In light of their importance and of the fact that SPTs must be ambitious and meaningful but also reasonable and fair, borrowers and lenders may elect to be assisted by one or more “Sustainability Coordinator(s)” or “Sustainability Structuring Agent(s)”, who is expected to participate in the negotiations.

Lenders must consider these roles as pivotal in the context of SLLs and accurately select these specialists.  Reports suggests that some lenders are in the process of developing internal departments to take over these roles.

Sometimes it may be possible for lenders to rely on the borrower’s internal expertise, subject to the borrower being able to demonstrate that its organisation is competent to validate the calculation of its performance against its KPIs and SPTs.  Factors which may be considered in making this assessment include the presence of a dedicated sustainability team or sustainability personnel, a clear sustainability strategy, the availability of historical data on the relevant metrics, and internal and/or external audit processes.  The European Leveraged Finance Association and the LMA have also published guidance on developing SPTs in the context of sustainability-linked leveraged loans 5 .  The March 2022 SLLPs guidance recommends that borrowers seek the aid of an external party such as a pre-signing second party opinion to assess the appropriateness of their KPIs and STPs.  The lenders could request this as a condition precedent to the SLL product being made available.

Some ECAs are already well organised and structured in terms of capacity to verify, manage and address environmental and social matters.  They have dedicated environmental and social departments able to assess the main concerns in relation to these issues.  Conversely, fewer lenders have the equivalent, dedicated departments and so they are likely be assisted by one or more “Sustainability Coordinator(s)” or “Sustainability Structuring Agent(s)”.  It is conceivable that, despite having the relevant internal capabilities, ECAs might prefer to take the same position as the other lenders on a transaction and be assisted by one or more “Sustainability Coordinator(s)” or “Sustainability Structuring Agent(s)” in the negotiations.

To ensure that the achievement of the relevant SPTs can be verified, borrowers must maintain, and keep readily available, up to date information on their SPTs and provide details on assumptions and methodology used (where known).

As stated above, tests will occur on a periodical basis (semi-annual or annual basis), and the relevant reporting obligations must be aligned with the same timing.  Where possible, borrowers are encouraged to publicly report information related to SPTs which might also be included in their integrated annual report or sustainability report.

The methodology will need to be determined with regard to the chosen SPTs and the nature of the relevant borrower, as the information provided by the relevant borrower alone may not be sufficient and external reports or opinions may be required (although the March 2022 SLLPs guidance also encourages borrowers to provide details of any underlying methodology of SPT calculations).  Parties will consider the effect of a change in calculation methods on the SLLs in the relevant facility.

The SLLs specify that disclosures on target setting should make clear reference to, among other things, the timelines for the target achievement, the verified baseline or science-based reference point selected for the improvement of KPIs and how the borrower intends to reach such SPT 6 .  Borrowers should act in a way to promote transparency, which is of particular value in the SLLs market.

As at the date of this article, there are not standard market report templates for SLLs.  This is probably due to the fact that the methodology may change depending on the chosen SPTs and the nature of the relevant borrower.

It would be efficient and beneficial for consistent approaches to be adopted in relation to the same SPTs.  In particular, it would be helpful to introduce uniform standards for the production and collection of data and the preparation of reports and opinions, with particular focus on the relevant methodology.

LMA guidance notes that methodologies are emerging, including:

• the Global Reporting Initiative’s Sustainability Reporting Standards 7 , providing widely adopted global standards for sustainability reporting; and
• ratings provided by the major ratings agencies, determining environmental, social and governance risk and performance (commonly known as ESG Ratings), that are developed on the basis of methodologies and assumptions that can be used as reporting standards.

Borrowers must obtain, on a yearly basis, independent and external verification of the borrower’s performance level against each SPT and for each KPI 8 .

For loans where information on SPTs is not publicly available or accompanied by an audit, it is strongly recommended that a borrower seeks an external review.  In cases where the data is publicly disclosed, it is still desirable to have the borrower’s sustainability performance verified by an independent third party, but not essential.

Once the reporting and the external or internal review is complete, lenders will evaluate the borrower’s performance against the SPTs based on the information provided.  If the required targets have been achieved, the margin reduction in the loan agreement is triggered and for the following period, until the next test date, the borrower benefits from the lower margin.

The LMA has produced guidance on external reviews in March 2022 which aims at providing information and transparency about the external review process for borrowers, lenders, external reviewers and other stakeholders 9 . The guidance details ethical and professional standards and organisation of external reviewers, as well as the content of external reviews.  Although recommended by the March 2022 guidance on external reviews, the need for a pre-signing external review of the borrower’s performance against the SPTs is to be negotiated and agreed between borrowers and lenders.  The same guidance also suggests that the borrowers obtain a post-signing external review (separate to the yearly one required by the SLLPs) in the event of any material change to the parameters, methodology or calibration of performance indicators and targets, to assess these changes.

The same considerations on the importance of the external sustainability specialist discussed above are relevant here.

Borrowers should take into account the requirement of obtaining an independent external verification on at least a yearly basis. The need for external review beyond what is prescribed by the SLLPs is to be considered on a deal-by-deal basis and the responsibilities of an external reviewer are likely to vary depending on the nature of the transaction and the scope of the external review.

Nonetheless, lenders should keep in mind the increasing trend of activist claims being brought against both lending institutions and borrowers whose actions set a trajectory that is inconsistent with meeting agreed internal and external standards 10 . Carrying out an external review can demonstrate an intention to meet pledges made and protect against court actions.

Lack of consistent approach

As stated above, at the time of writing, there are no market-standard templates for this type of financing.  The European Leveraged Finance Association and the LMA have, however, published guidance to be taken into account when documenting sustainability-linked leveraged deals, both at the term sheet and loan facility stages 11 .  These include considerations such as market flex, margin ratchets, fallback mechanisms and the need to clearly document sustainability breaches.  The guidance notes, however, that there is no established market standard as to what may constitute a breach in this case.

At present, principles are usually applied and developed on a case-by-case basis, which allows lenders to develop bespoke solutions, but may also be a concern as this lack of clarity in application impacts on a lender’s competitive edge against other lenders, especially in terms of pricing of financial products.  The LMA has produced a “diligence questionnaire” for asset managers in respect of ESG governance, data and reporting, portfolio management and internal operations 12 , and it is hoped that similar resources will be produced for lenders.

The application of any principles is likely to be informed by an in-depth understanding of a borrower’s business model and operation.  A lender may require expert advice in order to establish the sustainability targets and assess the exact financing offer that can be made. 

As noted above, the terms of any financing can be linked to the borrower’s ESG rating but the exact correlation between the two is currently not the subject of a consistent interpretation 13 .  Any loan documentation should be drafted to allow for changes in SPTs as the borrower’s business develops.

A move towards sustainable financing and refinancing

European lenders are required, pursuant to the Non-Financial Reporting Directive 14 ( NFRD ), to disclose information on the way they operate and manage social and environmental challenges.  European lenders are also required to make sustainability-related disclosures in respect of financial products pursuant to the Sustainable Finance Disclosure Regulation 15 ( SFDR ).  In addition, the Taxonomy Regulation 16 was introduced in June 2020, in order to enhance private investments into sustainable activities to achieve six core environmental objectives.  This applies from 1 January 2022 as regards climate change mitigation and climate change adaptation environmental objectives, and 1 January 2023 as regards other environmental objectives.  More recently, the European Supervisory Authorities have delivered to the European Commission their final report with draft Regulatory Technical Standards (RTS) regarding disclosures under the SFDR as amended by the Taxonomy Regulation.  The goal of the proposed RTS is to provide investors with comparable information about financial products in environmentally sustainable economic activities and establishing a single rulebook for sustainability disclosures. This will involve some level of standardisation around disclosure obligations and the methods of measuring the extent to which the activities funded by the produce are aligned with EU taxonomy.  The European Commission is to decide whether to endorse the draft RTS by September 2022 17 .

Although some development of the legislation surrounding sustainable financing is still underway, the NFRD, SFDR and Taxonomy Regulation are at present all binding and failure to comply can be sanctioned by a European court. From 30 June 2021, the European Banking Authority guidelines on loan origination and monitoring 18 have applied, requiring development of sustainable lending policies covering the granting and monitoring of environmentally sustainable credit facilities. Note that competent authorities are required to report to the European Banking Authority on whether they comply with these guidelines.

Given the above laws, regulations and guidelines, the move towards sustainable financing is becoming more prominent and lenders are now required to make certain commitments and disclosures in this regard.  However, the scarcity of products available, the lack of clarity around effectively implementing the products that are available, and the lack of market practice in relation to these products 19 may make it more difficult for lenders to offer sustainable financing options against a backdrop where green lending is encouraged.

Financing by way of SLLs can be included in a lender’s sustainable finance targets, but the interaction between this and the reporting mentioned requirements is not straightforward which leaves uncertainty around exactly how this can be achieved in practice.  However, an advantage is that a SLL may be more appealing to the market in the context of a transfer or sub-participation of a loan, as it brings potential benefits in relation to the sustainability targets of a prospective transferee or sub-participant.

Monitoring and consequences of breach by a borrower

Lenders are required to periodically monitor a borrower’s compliance with its SPTs, this being more pronounced in the case of undrawn RCFs.  This requires adequate processes and procedures to maximise efficiency and minimise risk.

ESG performance ratings can be more difficult to monitor than, for example, the credit risk of a borrower, and this therefore increases risk due to the level of reliance a lender must place on these ratings 20 .  Lenders should consider the appropriate procedures to enable them to mitigate risk as much as possible in this area.

If a borrower fails to meet its SPTs, any discount available to the borrower in connection with the fulfilment of its SPTs would no longer be available and the loan would revert to full pricing.

This would also have consequential effects on the lender both in terms of its own sustainability objectives and its reputation.  If the borrower failed to meet its SPTs, this may reduce its attractiveness of the loan on the secondary market, potentially making it more difficult to transfer or sub-participate, if any prospective transferee were concerned about compliance with sustainable financing obligations.

Certain structures contemplate a two-way pricing whereby if the targets are met, the pricing reduces, but if the borrower fails to meet its ESG targets then pricing increases.  These two-way pricing structures have been criticised as lenders will benefit from borrowers’ failure to manage their ESG strategy successfully.  In such a scenario, a potential solution would be to transfer the proceeds of any increased pricing to a separate bank account and to allow the borrower to have access to these funds for expenditure on ESG activities only.

Syndication

While SLLs are adaptable to the syndicated market, there does not seem to be a consistent approach in how this is carried out and how this would then affect each syndicated lender’s own sustainability targets.

As noted above, SLLs may be more attractive to prospective transferees and sub-participants in the secondary market as they assist in allowing the transferee/sub-participant to meet its own sustainability objectives.  A SLL where the borrower has a history of meeting its SPTs may increase the appeal of that SLL as it may assist in providing greater certainty and avoiding the risks discussed at paragraph 3.3 above.

There is currently a growing interest for the application of SLLs in the context of export credit financings.  

Sustainable lending is one of the good governance disciplines that have been, since the late 1990’s, managed by the Members of the OECD Working Party on Export Credits and Credit Guarantees.

The main practical aspects to be considered in relation to the application of SLLs in the context of export credit financings are:

• the development of a common and consistent approach (i.e. market-standard templates for ECA backed SLLs) from a documentation perspective;
• pricing fluctuation due to the application of the relevant discounted or increased cost of the loan for the Borrower; and
• the reporting requirements on the borrowers and the ability to review borrowers’ performance against the SPTs.

Approach to documentation and the negotiation stage

In an export credit facility, lenders will have to work closely with ECAs and borrowers to determine a suitable set of terms and conditions acceptable to all parties.

There is no doubt that the starting point of any future SLL export credit financing will be the LMA Single Currency Term Facility Agreement for use in Export Finance Buyer Credit Transactions.

Particular attention should be paid to the following sections:

• Interest and Changes to the Calculation of Interest , where it will be necessary to build in an increase/decrease mechanism for the purpose of assessing the potential benefit of the achievement of the SPTs;
• Prepayment and Cancellation , in relation to the failure to achieve the relevant SPTs;
• Representations from the borrower and/or the guarantor concerning the objectives, strategy, policy and/or processes relating to sustainability;
• Information Undertakings and reporting obligations from the borrower and/or the guarantor concerning the objectives, strategy, policy and/or processes relating to sustainability and in relation to the verification of the achievement of the relevant SPTs; and
• Covenants from the borrower and/or the guarantor concerning the objectives, strategy, policy and/or processes relating to sustainability and the relevant testing to occur on a periodical basis (semi-annual or annual basis).

Pricing and fluctuation of the ECA premium

As with a standard SLL, a SLL granted in an export credit financing gives the borrower a discount by way of a reduction of the margin if the SPTs are achieved.  The failure by the borrower to meet its SPTs will result in the disapplication of the discount or the application of a higher pricing.

A reduction of the margin will, in turn, reduce the exposure of the borrower vis-à-vis the lenders and, as a consequence, the potential exposure of the relevant ECA in terms of risk.  Conversely, an increase in the margin will, in turn, increase the exposure of the borrower vis-à-vis the lenders and the potential exposure of the relevant ECA in terms of risk.

Particular attention should be paid to the impact of this reduction or increase on any consequential reduction or increase of the ECA premium.  In particular, as the ECA premium rate charged by an ECA is risk-based (i.e. it is calculated, among others, as a percentage of the relevant exposure of the ECA), it is expected that any reduction of or increase in the margin would cause a consequential reduction of or increase in the ECA premium.  In light of the above, it will be necessary to introduce an adjustment mechanism aimed at aligning the ECA premium with this fluctuation of risk for the ECA.  This may be achieved in different ways, including by way of periodical calculations and adjustments of the ECA premium or by way of a final settlement of any difference in pricing due to the reduction of or increase in the risk.

The potential fluctuation of the ECA premium will be one of the main concerns for lenders, as the payment of the ECA premium is a condition of the effectiveness of any ECA insurance policy/guarantee.  Lenders must ensure that the relevant ECA premium is paid to the ECA at all times for the purpose of ensuring the effectiveness of the ECA insurance policy/guarantee.

A conservative approach should be considered here: demanding the payment of the ECA premium up-front in its entirety and then providing for any potential reimbursement only at a later stage of the financing (i.e. once the final test concerning the achievement of the SPTs is made).  However, this approach may not be as palatable to the borrower as it may be to the lenders on a transaction.

Reporting requirements on borrowers and the ability to review borrowers’ performance against the SPTs

As stated above, borrowers must maintain, and keep readily available, up to date information on their SPTs and provide details on assumptions and methodology used (where known). Additionally, borrowers will be subject to periodical tests and periodical reporting obligations.

ECAs should work together for the purposes of developing standard market report templates for SLLs.  Consistent approaches should be adopted in relation to the same SPTs and same categories of borrowers.

The need for an external review of the borrower’s performance against the SPTs that goes beyond the yearly requirement set by the SLLPs, is to be negotiated and agreed between borrower and lenders, on a transaction-by-transaction basis.

Many ECAs already have internal departments able to provide the relevant verifications in relation to the achievement of the SPTs by borrowers.  ECAs and lenders should consult to evaluate whether to appoint external specialists.

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Published: 28 July 2022

Sustainability Linked Loans: An Overview & Case Study of Kathmandu

Sustainability linked loans are good business.

The world is facing, what seems to be, an ever-increasing list of environmental, social and governance (ESG) challenges. From climate change to modern slavery to rapid biodiversity loss, business can no longer escape the role that it plays in accelerating these challenges. Likewise, the finance industry is increasingly needing to navigate exposure to a growing list of ESG risks.

Sustainable investing allows investors to not only reduce their risk exposure but put their capital to work in a way that positively and actively influences business and society to move towards more sustainable solutions.

Sustainability Linked Loans (SLLs) are one of the mechanisms with which investors can do just this. SLLs allow investors to support sustainable development by fostering environmental and socially sustainable economic activities. SLLs are performance-based loans whereby the loan is linked to specific borrower-agreed sustainability performance targets. Borrowers must commit to sustainability performance targets to access the capital or to receive a reduction in the loan interest rate.

Sustainability Linked Loans are increasing in popularity

Sustainable investing is on the increase for various reasons, not least because people are becoming more interested in investing in a way that aligns with their values and allows them to contribute to making a positive change in the world (as well as generate financial returns). Millennials make up the majority of this new wave of investors, which means this trend is likely to only increase.

Financial institutes are following this demand and increasing sustainable products on offer. Sustainable investing products can range from “doing no harm” through to products that seize on the opportunities provided by innovations in clean water and sanitation, energy generation, improved health care, and more efficient transportation. In fact, this positive screening of ESG opportunities has seen investments that generate financial performance that is, at a minimum, in line with market benchmarks.

According to the LSTA , the SLL market was $681 billion in 2021. This presented a 275% increase from 2020, when green lending and SLLs raised $181.7 billion. This indicates that the market for SLLs is increasingly more assertive and that companies are becoming intentional in their sustainability strategies. The linking of loan interest to agreed sustainability targets shows that companies are becoming aware of the benefits of improving their short to medium-term sustainability practices.

Reporting on Sustainability Performance Targets is required

SLLs usually require some form of reporting from the borrower to the lender. Reporting of SLLs is guided by the  Sustainability Linked Loans Principles (SLLP). The SLLP was developed by the LSTA, the Loan Market Association (LMA) and the Asia Pacific Loan Market Association (APLMA). The Sustainability Performance Targets (SPTs) of SLLs are measured through a selection of Key Performance Indicators (KPIs) that are material to the issuer’s business sustainability strategy. The SPTs determine the borrower’s commitment level and must be ambitious and well calibrated. The SLLPs strongly recommend an external review of the borrower’s performance against its SPTs and for the outcome of such reviews to be made publicly available where possible.

A case study of Kathmandu 

ANZ Bank New Zealand partnered with KMD Brands (formally Kathmandu Holdings Limited) to establish  the largest syndicated SLL in New Zealand valued at $100 million in May 2021 . The SLL stipulates that KMD Brands’ targets be measured against specific sustainability performance targets. KMD Brands’ borrowing costs would change depending on its performance against these predetermined targets.

ELEVATE was engaged by KMD Brands (which consists of three iconic brands: Kathmandu, Rip Curl and Oboz) to provide a third-party independent review of its performance against Sustainability Performance Target 4 (SPT 4) for the year 2022. SPT4 requires that 100% of KMD Brands Tier 1 suppliers and at least one Tier 2 supplier for each individual brand, is accountable to the KMD Code of Conduct and can supply evidence that it is being monitored for compliance with the Code of Conduct. This includes a social audit at factory level at least once every two-years. ELEVATE’s activities on the project included a review of KMD Brands’ detailed provisions of SPT4, supplier data management systems, audit schemes and monitoring tools.

ELEVATE’s review marked a milestone for the company as 2022 was their first year of verification, demonstrating their progress in complying with the requirements of the SLL agreement with ANZ Bank New Zealand.

Gary Shaw, KMD Brands Social Impact Manager, said the review was “a fantastic example of collaboration and assurance supported by independent verification”. The review fulfilled Kathmandu’s needs and showed the company’s efforts and progress since the inception of the SLL.

How can ELEVATE support you?

ELEVATE has extensive experience in assessing and reviewing sustainability quantitative and qualitative information. ELEVATE offers verification and assurance services that enhance the credibility of the reported sustainability information, which can be used to fulfil regulatory and financial responsibilities, as well as to be used internally to make informed business decisions.  ELEVATE  is an accredited AA1000 Assurance Standard (AA1000AS) v3 provider and can support your sustainability reporting and assurance journey.

These blogs are written by ELEVATE staff members or associates and the views and opinions expressed are not necessarily those of ELEVATE.

About the author

Katie Yewdall

Associate Director, Southeast Asia, Sustainability Consulting, ELEVATE

ELEVATE blogs

Our unique blog is a driving force behind elevate’s long-standing client relationships., back to basics: what is supply chain capacity building, asia pacific markets strengthen their climate-related disclosure expectations and requirements, a importância da devida diligência em direitos humanos contra o desmatamento.

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• Asset based loans as sustainability-linked loans

Sustainable financing solutions

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An asset-based lending facility (“ABL”) as a sustainability-linked loan (“SLL”) represents an innovative approach to financing that combines the traditional collateral-backed structure of asset-based lending with the performance-oriented features of sustainability-linked financing. This integration could allow borrowers to leverage their assets (such as inventory, receivables, or equipment) to secure financing, while also committing to achieving predefined sustainability performance targets (“SPTs”).

Businesses with rapid growth, fluctuating earnings, or marginal cash flows often choose ABL due to flexibility in the loan structure by way of minimal financial covenants and enhanced liquidity compared to traditional cash flow lending. ABL is prominent across a wide range of industries, particularly in:

• Distribution, logistics, and transportation
• Commodities such as forestry products, chemicals, steel, and grains
• Food processing
• Manufacturing
• Rental equipment

Many of these industries are energy and resource intensive. Firms can benefit from having a sustainability adviser identify and integrate SPTs into core business model that would also reduce borrowing costs when these targets are achieved.

According to the 2023 Secured Finance Market Sizing and Impact Study published by the Secured Finance Foundation, the total ABL commitments in the United States in 2022 was US$502 billion, an increase of 10.0% over 2021, compared to US$5.3 trillion of bank commercial loan commitment and year-over-year increase of 6.9%. 1

While statistics for Canadian ABL market is not readily available, the consensus among market participants is that ABL market in Canada is comparable to the US in market share, i.e ~9.5% of total ABL commitments compared to the total bank commercial loan commitment, and growth rate.

ABL is expected to continue to gain market share due to economic and associated credit challenges, the demand for working capital financing, business cyclicality, and restructurings and turnarounds.

Total U.S. ABL commitments

Figures expressed in billions of U.S. dollars . Source : Secured Finance Network, The 2023 Secured Finance Market Sizing and Impact Study

In the U.S., SLL issuance totaled US$222 billion between 2021 and 2023, of which only US$5.7 billion were ABLs. Approx. US$44 billion of current SLL issuances could be structured as an ABL based on industry. 2 Globally, across “ABL-friendly” jurisdictions. 3

Source: Bloomberg

While ABL is a mature product in the Canadian lending market, an ABL as an SLL is in its infancy. Approx. C$12 billion of total C$45 billion SLLs in Canada could be structured as an ABL. 4

Potential asset-based financing structures for sustainability-related borrowing in billions of Canadian dollars

For borrowers who have set out certain sustainability objectives and targets, an ABL as an SLL could be an interesting option for the business. Here’s how such an instrument could work and some initial planning considerations.

How it could work

• Securing the loan: The loan would be secured against the borrower's assets, which means the amount of credit available can fluctuate based on the value of the collateral. This is typical of ABL.
• Linking to sustainability: The unique aspect of an SLL is that the terms of the loan, particularly the loan margin or credit spread, are tied to the borrower's performance against specific sustainability-related criteria or targets. These targets can be related to environmental, social, and governance ("ESG") goals, such as reducing carbon emissions, improving energy efficiency, or enhancing labor practices. The SPTs are agreed upon at the outset of the loan and are designed to be ambitious yet achievable, pushing the company to make material improvements in its sustainability performance.
• Monitoring and reporting: Borrowers are required to regularly report on their progress towards meeting the SPTs. This reporting is often verified by an independent third party to ensure transparency and accuracy. This would be in addition to the reporting requirements under the ABL facility.
• Pricing mechanism: The loan margin or credit spread on the loan may decrease as the borrower meets or exceeds its SPTs, providing a financial incentive for the company to enhance its sustainability performance. Conversely, failure to meet these targets could result in higher borrowing costs.

Potential benefits

• Financial and environmental incentives: Companies are financially incentivized to improve their sustainability practices, which can lead to operational efficiencies, reduced environmental impact, and enhanced corporate reputation with stakeholders.
• Flexible financing: ABL provide flexible financing options that can adjust with the company's asset base and liquidity needs.
• Market differentiation: Adopting such innovative financing can differentiate a company in the market as a leader in sustainability, potentially attracting more investors and customers interested in sustainable practices and SPTs. By leveraging SLL's, a company can demonstrate its dedication towards environmental and social responsibility. This proactive approach appeals to a growing segment of consumers and business customers who prioritize sustainability when making purchasing decisions. Consequently, embracing innovative financing not only enhances a company's reputation but also opens up opportunity for increased investment and customer loyalty, ultimately driving long-term success in a rapidly evolving marketplace.

Considerations

• Developing the use case: Borrowers will need to review existing financing agreements and business / capital expenditure plans to determine eligibility for enhancing to an SLL.
• Setting appropriate targets: The SPTs must be carefully designed to be both challenging and achievable, requiring a deep understanding of the company's operations and sustainability potential and align with the lender or lending syndicate's requirements.
• Transparency and verification: Robust mechanisms for monitoring, reporting, and verifying sustainability performance are essential to maintain the credibility of the loan structure.
• Regulatory and market changes: Companies must stay informed about changing regulations and market expectations regarding sustainability to ensure their targets remain relevant and ambitious.

KPMG Corporate Finance Inc.'s Debt Advisory Team can assist management in adapting an existing or arranging a new ABL to a SLL. Combining an ABL with SLL criteria represents a forward-thinking financing strategy that aligns financial incentives with environmental and social governance objectives.

• Secured Finance Network, The 2023 Secured Finance Market Sizing and Impact Study
• ABL-friendly jurisdictions include the US, Canada, UK, Ireland, Switzerland, Germany, Netherlands, Belgium, Australia, New Zealand, Hong Kong, and Singapore.

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Sustainability-linked loans: A strong ESG commitment or a vehicle for greenwashing?

2022-07-20T08:07:00+01:00

By Sehoon Kim and Nitish Kumar, University of Florida; Jongsub Lee, Seoul National University, and Junho Oh, Hankuk University of Foreign Studies

Financing agreements between investors and firms are increasingly taking environmental, social, and governance (ESG) concerns into account, reflecting a growing demand from financial stakeholders and broader society that they do so.

Despite bank loans being the primary source of debt financing for firms around the world, little is known about their role in the rapidly evolving ESG-contingent financing space.

In our study , we document and characterise the growth of sustainable lending globally, investigate the role of loan contracts in incentivising borrowers’ sustainability commitments and highlight the importance of transparent disclosures to alleviate greenwashing concerns.

The rise of sustainable lending

In recent years, the sustainable loan market has grown exponentially, driven largely by the widespread use of general-purpose sustainability or ESG-linked loans, which have terms contractually tied to the sustainability performance of borrowing companies.

Global sustainable lending activity grew from US$6 billion in January 2016 to US$322 billion in September 2021. As of that month, sustainable lending represented more than one-tenth of the global corporate syndicated loan market, while 90% were sustainability-linked loans (see Figure 1).

Green loans, whose proceeds are earmarked for financing sustainable projects, make up a smaller segment of this market.

The proliferation of these general-purpose loans has allowed sustainable lending to spread across industries beyond just utilities, where a greater portion of green loans and bonds remain concentrated (Figure 2).

Figure 1. Rise of sustainable lending

Figure 2. Sustainable lending by industry

While sustainability-linked loans originated in European economies with more stakeholder-value oriented rules and regulations, they are now flourishing in the US and across well-developed private credit markets more generally.

What explains the growth of ESG lending?

These loans enable borrowers to credibly signal their ESG commitments to external stakeholders, who increasingly require transparency on firms’ responsible investment practices.

Lenders are also incentivised to supply sustainability-linked loans because of the downside protection that good ESG practices can provide, or in response to regulatory and governmental pressure on banks to conduct their lending businesses more responsibly.

But firms and banks may also engage in sustainability-linked borrowing and lending for greenwashing purposes to showcase an empty emphasis on ESG to stakeholders.

We analyse these possibilities in our study.

Sustainability-linked loans tend to be large – with an average deal size of US$937 million, nearly 80% larger than regular loans. They tend to be issued to larger, safer, and publicly listed borrowers, consistent with the idea that large and economically important firms have strong incentives to demonstrate ESG-friendly practices, given their high visibility and scrutiny from stakeholders.

Such loans are structured mainly through revolving credit facilities and are more likely to be syndicated by larger groups of lenders (often global banks) that have previous relationships with the borrower and have past sustainable lending experience.

They are priced similarly to regular loans at issuance, suggesting that borrowers that meet future ESG performance targets may enjoy lower spreads, according to their ESG performance pricing contracts.

Sustainability-linked loans could be used to effectively monitor, enforce, and renegotiate ESG contingencies in lending contracts – banks, after all, specialise in screening and monitoring their loan portfolio.

However, an important concern that undermines this potential is that large and visible companies and banks facing stakeholder pressure may use their relationships to facilitate greenwashing.

Contractual disclosure quality and greenwashing

We manually assessed the loan disclosures provided by Refinitiv and found that the disclosure of sustainability-linked loan contractual details is generally low, with considerable variation in the amount of information disclosed.

This reflects the difficulty of verifying the validity of ESG loan labels or gauging what real impact they may have in governing borrowers on sustainability issues.

To better understand these and to shed more light on greenwashing concerns, we examine borrowers’ ESG performance around sustainable loan issuances and investigate how this performance varies with disclosure quality.

We find that:

• borrowers and lenders with previously good ESG profiles choose to enter into sustainable loan contracts;
• borrower ESG scores deteriorate after sustainable loan issuance, particularly for loans where the disclosure of ESG-contingent contractual details is poor.

This is consistent with greenwashing – large borrowers and global lenders that both have reputational incentives use their lending relationships to enter into sustainable loan contracts and signal their ESG commitments, without putting these commitments to action .

Investors are vigilant against such greenwashing possibilities, however. We find that stock markets react positively to public announcements of sustainability-linked loan issuance only when the quality of contractual disclosures is relatively high.

Therefore, it is possible that increased public scrutiny and more established disclosure rules will enable the sustainable lending market to mature and develop a more central role in the push towards increased ESG considerations in corporate policies.

Conclusions

Our study complements recent work on the market for green bonds, whose proceeds finance specific green projects (see Flammer, 2021; Tang and Zhang, 2020; Zerbib, 2019; Baker et al., 2022).

The widespread use of general-purpose loans that are designed to incentivise firms across industries to improve their overall sustainability profiles, rather than achieve narrower objectives tied to specific projects, helps to democratise ESG contingent financing.

And banks, much like institutional investors, are uniquely positioned to effectively monitor firms’ progress on ESG considerations.

However, they – and other stakeholders more broadly – need to be vigilant about the potential for greenwashing. Transparent disclosures regarding ESG-related contract terms play an important role in alleviating such concerns.

Overall, our findings contribute to a more complete picture of how ESG concerns are reflected in loan contracts and provide guidance for regulating and instituting sustainable finance.

This full version of our paper can be found here , which was presented at the PRI Academic Network Week 2022.

The PRI’s academic blog aims to bring investors insights from the latest academic research on responsible investment. It is written by academic guest contributors. Blog authors write in their individual capacity – posts do not necessarily represent a PRI view.

Baker, M., D. Bergstresser, G. Serafeim, and J. Wurgler (2022). The pricing and ownership of U.S. green bonds.  Annual Review of Financial Economics , forthcoming.

Flammer, C. (2021). Corporate green bonds.  Journal of Financial Economics  142 (2), 499-516.

Tang, D. Y. and Y. Zhang (2020). Do shareholders benefit from green bonds?  Journal of Corporate Finance  61.

Zerbib, O. D. (2019). The effect of pro-environmental preferences on bond prices: Evidence from green bonds.  Journal of Banking & Finance  98, 39-60.

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Case study: USD89.6 million sustainability-linked loan for LNG dual-fuelled vessels

30 Mar 2023

Facilitating Vista Shipping’s decarbonisation journey.

As the maritime industry seeks to reduce carbon emissions, an increasing number of shipowners, lessors and operators are opting for LNG dual-fuelled vessels that are lower in emissions compared with traditional bunker fuel fleets.

In support of this, Vista Shipping, a JV between Hafnia and CSSC Shipping Hong Kong, ordered its’ first pair of LNG dual-fuelled vessels with delivery expected in 2023. Upon delivery, the vessels will be chartered to CSSA Chartering & Shipping Services for seven years, supporting both Hafnia and CSSC with their decarbonisation ambitions.

To finance the vessels, Standard Chartered was appointed to lead a USD89.6 million sustainability-linked loan.

Standard Chartered’s role

Standard Chartered acted as the Facility Coordinator, Sole Sustainability Co-ordinator, Mandated Lead Arranger and Facility and Security Agent for the transaction. In addition, we helped Vista Shipping secure a Second Party Opinion on this loan from DNV GL, with DNV confirming that the key performance indicators  and Sustainability Performance Targets are material and in line with the client’s sustainability ambitions.

Deal structure

The financing sets out ambitious targets on annual efficiency ratio and sulphur oxide emissions, over a 10-year tenure, and has a bi-directional margin ratchet mechanism to incentivise performance against these targets. It also includes a mechanism that allows either partner to step in for the other in the event of non-performance. Furthermore, the deal terms state that the delivered vessels must adhere to Hafnia’s Environmental Management System (“EMS”). This seeks to minimise adverse environmental effects, and ensures that contractors follow clear EMS requirements around measurement and monitoring of environmental effects. 

The transaction sets a precedent for future dual-fuel financing for the shipping industry in support of decarbonisation strategies.

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18 August 2020

• Green loans and sustainability-linked loans: what is the difference?
• Addleshaw Goddard LLP
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With an increased focus on ‘green loans’ and ‘sustainability-linked loans’, the two terms are sometimes conflated. Iain Rodley of Addleshaw Goddard explores the distinctions between the two financial products

Responding to sustainability and climate change-related risk and opportunity is already high on the agenda for many social housing organisations and funders.

We are seeing an increased focus on green loans and sustainability-linked loans – but the term ‘green loan’ is often being used to cover both financial products.

What is a green loan?

A green loan is defined by the Loan Market Association’s (LMA) ‘Green and Sustainable Lending Glossary of Terms’ as any type of loan instrument made available exclusively to finance or refinance, in whole or in part, new and/or existing eligible ‘green projects’.

While the definitions of ‘green’ and ‘green projects’ may vary depending on sector and geography, example indicative categories of eligibility contained in the LMA’s Green Loan Principles (GLP) include renewable energy, energy efficiency, climate change adaptation and green buildings that meet regional, national or internationally recognised standards or certifications.

The GLP provides a framework for green loans based on the following four core components:

• Use of proceeds : The loan proceeds of a green loan must be applied for green projects. All designated green projects should provide clear environmental benefits which will be assessed, and where feasible, quantified, measured and reported.
• Process for project evaluation and selection : Borrowers should clearly communicate to lenders their environmental sustainability objectives, their process for determining the eligibility of the GLP categories and for managing environmental risks associated with any proposed project.
• Management of proceeds : The proceeds of a green loan should be tracked in such a manner to maintain transparency and allocation of funds towards green projects.
• Reporting : Borrowers should make and keep readily available up-to-date information on the use of proceeds, including a list of the green projects to which the green loan proceeds have been allocated.

An example of a green loan might include a registered provider funding renewable energy projects relating to its housing stock or leasing.

What is a sustainability-linked loan?

A sustainability-linked loan (SLL) is defined by the LMA’s glossary as any type of loan instrument and/or contingent facility (eg bonding line, guarantee line, letter of credit) that incentivises the borrower’s achievement of ambitious, predetermined sustainability performance objectives.

A borrower’s sustainability performance is measured using sustainability performance targets (SPTs), which include key performance indicators, external ratings and/or equivalent metrics that measure improvements in the borrower’s sustainability profile.

Again, while the definitions of ‘sustainable’ and ‘sustainability’ may vary depending on sector and geography, examples of common improvements that an SPT in a particular category might seek to measure are contained in the LMA Sustainability Linked Loan Principles. They include renewable energy, affordable housing, sustainable sourcing and energy efficiency.

Addleshaw Goddard recently advised NatWest on its first SLL, which was with Bromford Housing Group .

The SPT in this case was energy efficiency and an ambitious target was agreed relating to an upgrade of existing housing stock with an energy efficiency rating of C or below, exceeding the minimum energy efficiency standard required for rented residential property (currently E). Bromford will achieve a margin reduction if it meets the SPT.

Addleshaw Goddard has advised funders including BNP Paribas and Sumitomo Mitsui Banking Corporation on a number of other SLLs, including deals with L&Q , Peabody Trust , Clarion , Catalyst and PA Housing .

The LMA Sustainability Linked Loan Principles provide a framework for SLLs based on the following four core components:

• Relationship to borrower’s overall sustainability strategy : The borrower of an SLL should clearly communicate to its lenders its sustainability objective and how these align with its proposed SPTs.
• Target-setting (measuring the sustainability of the borrower) : The SPTs should be ambitious and meaningful to the borrower’s business over the life of the loan and targets should be linked to loan terms to incentivise improvements to a borrower’s sustainability profile. One of the aims of an SLL is to encourage positive change through incentives and this should form the basis of target-setting.
• Reporting : Borrowers should make and keep readily available up-to-date information relating to their SPTs and should provide this to lenders at least annually. Borrowers are encouraged to publicly report information relating to their SPTs.
• Review : The need for external review of SPTs is to be agreed on a transaction-by-transaction basis. Where information relating to SPTs is not made publicly available or otherwise accompanied by an audit/assurance statement, it is strongly recommended that a borrower should seek external review of its performance against its SPTs.

The key difference?

The fundamental determinant of a green loan is the utilisation of loan proceeds for green projects, however the other core components of the Green Loan Principles must also be met.

The focus of the Sustainability Linked Loan Principles is incentivising the borrower’s efforts to improve its sustainability profile by aligning loan terms to the borrower’s performance against SPTs; the use of proceeds is not a key determinant in the categorisation of a SLL.

Iain Rodley , associate, Addleshaw Goddard; with thanks to Kate Cook , senior knowledge lawyer, and Jennifer Khanna , managing associate, Addleshaw Goddard.

This article was first published by Social Housing .

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Sustainability Linked Loan Principles (SLLP)

Home / Content / Legal & Documentation / Primary Market / Guidelines & Memos / Sustainability Linked Loan Principles (SLLP)

Sustainability-linked loans aim to facilitate and support environmentally and socially sustainable economic activity and growth. The Sustainability-Linked Loan Principles (SLLP) have been developed by an experienced working party, consisting of representatives from leading financial institutions active in the global syndicated loan markets.

* On April 20, 2023, the following minor amendment was made: (1) Footnote 4 updated to read: “This role may be referred to as a Sustainability Coordinator or Sustainability Structuring Agent.”

Our entire list of Sustainable Lending Library is available here .

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Sustainability-Linked Loan

"Our new syndicated loan takes full advantage of Redbridge's proven process, based on Redbridge’s expertise and in-depth discussions with each bank, who are thus able to make their best offers." Brice Fournet Chief Financial Officer

Engagement overview

• Refinancing Aegide’s syndicated loan set up in 2018 (refinancing loan + capex loan + revolving credit facility)
• Integrating ESG KPIs into a Sustainability-Linked Loan (SLL)
• Increase Term Loan and RCF amounts and extend maturities
• Integrate 3 Sustainable Performance Targets
• Optimize financial conditions and make documentation more flexible
• Expand the pool of lenders
• revolving credit facility : 115m€ (5+1 years)
• term loan : 50m€ (6 years)
• Margin grid improved
• More flexible legal terms
• Pool of lenders expanded to 4 new banks

Methodology

• Validation of the financing needs
• Consultation launched with the pool of existing banks and two new banks
• Bilateral discussions/negotiations with all potential lenders
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• Execution within a tight timing, allowing to maintain momentum
• Terms & Conditions: back and forth discussions with lenders to align them towards the objectives of Aegide
• Negotiation of a more flexible documentation

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Demonstrate your commitment to sustainability, reduce borrowing costs, and improve your overall ESG performance by leveraging GRESB scores to set Sustainability Performance Targets for Sustainability-Linked Loans.

Sustainability-linked loans have grown in popularity among both lenders and borrowers in the real estate and infrastructure sectors over the past few years as a mechanism for responsible financing.

With them, borrowers can incentivize their sustainability performance, increase access to capital, and reduce costs while lenders can better manage risk and demonstrate sustainability-related commitments to regulators and investors. And they help both parties enhance their reputations and achieve long-term sustainability goals.

GRESB is increasingly becoming a cornerstone of these loans, with scores and benchmark standings being used both to set and manage Sustainability Performance Targets and to support reporting and verification of the loan.

This is because GRESB is:

• An objective, widely recognized industry standard for measuring sustainability
• Transparent and accountable, with clear standards and methodology
• A diverse benchmark, making it possible to incorporate performance against relevant peers
• Sub-sector specific, allowing loan conditions to be based on relevant parameters
• An evolving standard that allows targets to be set based on continuous improvements

How GRESB is used in sustainability-linked loans

Typically, a firm looking to decarbonize its operations or achieve other significant sustainability goals will work with a lender to outline a framework that uses the GRESB Scores and Ratings, a specific score, or some other verifiable performance indicator found in the GRESB Scorecard.

Take, for example, Hang Lung Properties – a leading real estate developer in China that has set ambitious GHG reduction targets for 2023. To help achieve a 70% reduction compared to its 2018 baseline, Hang Lung has embraced sustainability in its financing.

In 2021, the firm signed a sustainability-linked loan for HKD 1 billion over three years with BNP Paribas for general corporate use, which features a number of predetermined sustainability performance targets that, if met, will reduce funding costs over the life of the loan.

The company’s GRESB results play a central role in this agreement, with loan terms being based on maintaining the firm’s GRESB rating as well as achieving annual reductions in energy intensities across key parts of its portfolio – information that is tracked and validated through the GRESB Assessment.

To help reach its goals, Hang Lung directs loan capital to projects such as installing solar systems on its properties, increasing the efficiency of its HVAC systems, and retrofitting aging buildings. Read more about the loan and Hang Lung’s work .

See more examples of GRESB scores in sustainability-linked loans

In January 2022, Frasers Property secured a GBP 110 million five-year bilateral sustainability-linked loan for its UK subsidiaries, Frasers Property (UK) Limited (FPUK) and Hillington Park. A reduction in interest margins from the loan’s second year is contingent on FPUK maintaining its four-star GRESB rating. Learn more

Keppel Land Limited secured a five-year SDG 150 million sustainability-linked loan from DBS Bank, with incorporated interest rate reductions, in October 2021. These reductions were based on Keppel Land achieving predetermined ESG targets, as well as a five-star rating in the 2021 GRESB Real Estate Assessment. Read our case study to learn more . 

In August 2021, Westpac secured an AUD 300 million sustainability-linked loan facility for the NSW Land Registry Services (LRS) with Sustainability Performance Targets (SPTs). The metrics of the loan focus on greenhouse gas emissions reduction, gender diversity and inclusion, and continued leadership in the GRESB Infrastructure Asset Assessment. Learn more

Colonial has signed a line of credit for EUR 1 billion, with CaixaBank acting as the agent bank. The loan is conditional on the sustainability of the company, measured by GRESB benchmarks. Colonial was recognized as a leader in responsible investment in Europe by GRESB in March 2019. CaixaBank, BBVA, BNPP, and Natixis have all acted as sustainability agents. Learn more

Subsidiaries of Frasers Property, Frasers Property AHL Limited, and Frasers Property Industrial Australia Pty Limited have secured an AUD 300 million five-year syndicated sustainability-linked loan. As an incentive, the sustainability-linked loan has a reducing pricing structure with interest cost reduction from the second year onwards if both FPA and FPIA retain a four-star rating or above in the GRESB Development Benchmark and GRESB Standing Investments Benchmark. Learn more

In April 2021, Vesteda and its banks (ABN-AMRO, ING, Deutsche Bank, Rabobank, SMBC, and Barclays) signed an agreement that has amended a EUR 700 million revolving facility agreement into a sustainability-linked revolving facility agreement. The interest margin is linked to achieving four sustainability objectives, one of which is its GRESB score. Learn more

CapitaLand obtained a SGD 500 million sustainability-linked loan from United Overseas Bank (UOB). The bilateral loan is explicitly linked to GRESB and CapitaLand’s achievements within the GRESB benchmark, with interest reductions contingent on maintaining and/or improving its GRESB rating. Learn more

Link Asset Management Limited (Link) signed an AUD 212 million five-year sustainability-linked loan with DBS. The loan incorporates a reduced pricing structure with interest cost savings. based on the company maintaining its listing on leading global sustainability indices and achieving milestones through its performance in GRESB ratings. Learn more

Frasers Commercial Asset Management, manager of Frasers Commercial Trust (FCOT), secured a sustainability-linked loan of SGD 100 million. The loan is tied to FCOT maintaining a GRESB rating of four stars or more. Learn more

New World Development Company Limited (NWD) signed a loan with DBS Hong Kong (DBS) of HKD 1 billion. The first sustainability-linked loan for NWD, a discount will become available on the interest rate of the loan when it achieves pre-determined sustainability milestones that have been agreed upon with DBS. These milestones will be determined by the company’s performance within the GRESB benchmark. Learn more

Green loan by a syndicate of four banks led by Barclays, linked to GRESB Real Estate data. Learn more

Thames Waters linked its interest payments on its GPB 1.4 billion revolving credit facility to its GRESB infrastructure score. It ran until 2023, with the option of a two-year extension, and was structured so that performing well within the GRESB benchmark would result in a lowered margin with financial gains paid into the company’s charitable fund. Learn more

ING Bank issued the world’s first sustainability-linked loan based on GRESB data.

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OUE Reit obtains $600 million unsecured sustainability-linked loan

SINGAPORE - OUE Real Estate Investment Trust (Reit) has obtained an unsecured sustainability-linked loan of $600 million.

The proceeds will be used for the Reit’s early refinancing of $540 million existing secured borrowings due in 2025 and for general corporate purposes, said its manager in a bourse filing on April 23.

OCBC was the sole mandated lead arranger and bookrunner, as well as the sustainability coordinator for the transaction.

This facility marks OUE Reit’s first sustainability-linked loan tied to its recalibrated sustainability performance targets announced on Feb 29. These new targets replace its previous goal, which was based on energy intensity, with a more ambitious aim of achieving a 40 per cent reduction in absolute greenhouse gas emissions for its commercial properties from the level in the 2023 financial year.

With the new facility in place, the Reit will have no further refinancing requirements until the second half of 2025. The average term of debt as at Dec 31, 2023 is expected to lengthen to 3.1 years, with the weighted average cost of debt to remain largely stable, on a pro forma basis.

Additionally, the proportion of unsecured debt is expected to increase significantly to 86.7 per cent post-refinancing.

“The increase in the proportion of unsecured debt enhances OUE Reit’s access to more diverse and competitive sources of funding while keeping borrowing costs stable,” noted Mr Han Khim Siew, chief executive of the Reit’s manager.

“We will continue to leverage on our investment-grade credit rating and strengthened relationships with our bankers to enhance our capital structure for the benefit of all unit holders,” he added.

OUE Reit units closed on April 23 at $0.27 before the announcement, up $0.01 or 3.9 per cent. THE BUSINESS TIMES

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