Do you remember when Green Bonds first appeared back in 2008? Since then, the loan market has seen the emergence of Sustainability Linked Loans, or SLLs – also known as ESG (Environmental, Social and Governance) loans. These facilities have rapidly grown in the European Loan Market, with an annual increase of a whopping 250% in 2019, with similar growth expected in 2020, before the onset of Coronavirus (Source: FT).
The growth in this market has been principally driven by an evolving social conscience amongst consumers, employees and investors, who are increasingly considering sustainability to help guide their decisions. Deloitte’s Shifting Sands research found that 34% of consumers are choosing brands based on their ethical credentials and 43% are already actively choosing brands due to their environmental values. Publicising the use of sustainable finance is an innovative way of communicating this.
In response to this, there is a growing expectation that banks take a more active role in combating climate change too, with Deutsche Bank recently pledging to double green financing to €200bn by 2025 (Source: FT). Sustainability is not limited to environmental commitment, social ethics are also a high priority, including the treatment of employees.
Authentic ESG: credible, quantified and verifiable
This growing pressure to embrace sustainability & subsequent explosion in popularity of sustainable finance has led to claims, particularly in the bond markets, that this type of finance is yet another attempt of social or greenwashing by large corporations; with questions raised as to whether the proceeds are going towards worthy, sustainability-linked causes.
When it comes to the loan market, it is crucial to understand the difference between the available financing. Where lenders are providing capital for Green Loans, they must make sure the intended purposes by the borrower are grounded in a genuine ESG impact. They should require lenders to determine a baseline, answering, ‘What would happen without the finance?’ Borrowers should have clear frameworks in place that transparently indicate how the proceeds will be used to improve the baseline, establishing impact metrics that are grounded in science, answering, ‘How are we improving our ESG impact?’. Regular reporting between both parties on performance should be a condition of this transaction and the information should be verified independently.
Green or Sustainability Linked Loan?
A “Green Loan”, as its name suggests, is made available for directly financing environmental projects; like investing in solar panels or wind turbines, for example.
An SLL, on the other hand, is no different from the usual corporate loan facility, except it comes with expectations & future requirements about your company’s overall sustainability strategy.
So, even though you don’t have to use the loan for sustainable purposes, its provision requires your company to meet & maintain established Sustainability Performance Targets (SPTs), or face an economic penalty through increased interest costs.
The Loan Market Association developed four core Sustainability Linked Loan Principles (SLLPs) to govern these targets.
1. How do the SPTs relate to the company’s overall sustainability strategy?
2. Are they ambitious enough and linked to improvement?
3. Are STPs in some way quantifiable?
4. What is the reviewing process?
Structuring a successful SLL
The SPTs should not be a simple box-ticking exercise; these performance targets need to be both ambitious and meaningful to your business, and importantly, easily measurable. What is more, they should have a natural fit with your corporate DNA and existing sustainability strategy.
It is the collective duty of both borrowers & lenders to ensure that an SLL is structured appropriately, to avoid any concerns of lip service to the fundamental principles of the product. Borrowers should establish a framework outlining the relationship between lender and borrower. The use of proceeds would stipulate what the finance is for (sustainability or green impact), connecting this to comprehensive impact metrics that transparently report on performance.
Unlike the bond market, the LMA principles are designed to avoid ambiguity over whether the provision of an SLL is an authentic part of a borrower’s commitment to sustainability.
If structured correctly, the additional provisions contained in the agreement should ensure that the borrower strives to maintain & improve their commitment to sustainability and are tested periodically against an agreed set of KPIs.
Though both serve as a strong starting point for the market, there is a clear indication that all stakeholders would benefit from at the start agreeing how the Borrower’s ESG impact will be measured, monitored and reported. Over time verification of the impact will likely become critical and beneficial for all parties.
Overall, if you are considering an SLL as part of your next financing exercise, don’t let the recent noise in the press put you off. An SLL can be an excellent way of highlighting your company’s commitment to sustainability to consumers, employees and investors alike.
Our Sustainable Finance team would be delighted to discuss your sustainable finance considerations, as well debt financing requirements generally, please reach out to the authors for further discussion.