In December 2019 we published an article entitled “Sustainability-Linked Loans – a sign of things to come” which provided an insight into sustainability-linked loans and explained how interest payable under those loans is linked to selected environmental, social and governance (ESG) key performance indicators, with the interest rate and interest amount payable reducing if those ESG targets are met.
This ratchet mechanism provides a further incentive for a borrower to lessen the environmental impact of its business. As we pointed out, ESG targets should be genuine, rigorous and measurable to avoid the risk of “greenwashing” (i.e. the setting of targets which if met would not reflect material improvements beyond current performance and as a result may prove misleading).
ESG targets may include:
- Reducing greenhouse gas emissions
- Increasing the percentage of women in senior management positions
- Using renewable energy
A borrower will be required to report to a lender on its ESG KPIs where it has borrowed a sustainability-linked loan. That reporting will commonly take the form of a sustainability certificate (setting out ESG targets against actual performance and any interest adjustment which applies as a result of that performance), together with annual consolidated audited accounts of the borrower and a financial covenant compliance certificate. If the relevant ESG targets form part of the borrower’s audited financial statements, separate testing/reporting to a lender is typically not necessary.
We also commented that lenders tend to look at a borrower’s ESG rating as a way of structuring the loan. ESG factors have quickly grown to be a critical part of credit analysis in the European leveraged finance market with a number of lenders recently announcing plans to divest away from carbon-intensive borrowers and to stop financing certain fossil fuel projects in the medium-term.
The rising prominence of ESG is not just driven by lenders or indeed governments. ESG is becoming a hot boardroom topic and many borrowers are now of the view that ESG makes economic sense too. Those borrowers who prioritise ESG may potentially have access to the large pool of ESG capital.
The Loan Market Association (LMA), Asia Pacific Loan Market Association and Loan Syndications and Trading Association jointly produced the Sustainability-Linked Loan Principles in May 2020. The principles are a set of high-level market standards. The principles aim to encourage a consistent approach towards sustainability-linked loans across the loan market, although the report recognised that:
- Some flexibility in sustainability-linked loan principles is required on account of sectoral differences
- Notwithstanding the increasing importance and focus on ESG, there was still a lack of consensus among market participants on the type and level of ESG disclosure that should be imposed on borrowers
We now have more clarity and consensus on ESG disclosure. Read on….
ESG disclosure: what is new?
The LMA and the European Leveraged Finance Association (ELFA) published on 19 January 2021 the Guide for Company Advisers to ESG Disclosure in Leveraged Finance Transactions (the Guide).
The Guide is designed to serve a practical tool for borrowers alongside their advisers to use in support of their efforts to provide ESG discourse in bond offering materials and financial reports, and is split into five chapters, covering:
- Why leveraged finance investors now require more ESG disclosure from borrowers and the reasons for that
- Regulatory implications of ESG from a borrower's perspective ranging from mandatory to voluntary principles with varying level of application
- Due diligence processes and disclosure differences in the leveraged loan market versus the bond market
- Drafting considerations and ESG roadmap
- Contractual provisions (including ESG-specific wording)
Market practice in this area is still at a very early stage, and it is likely that the LMA and ELFA will publish revised iterations of this Guide to incorporate feedback from market participants as practice evolves and trends develop.
The LMA and the ELFA have also published several ESG Fact Sheets covering three initial sectors (debt repurchases, paper and packaging and telecoms) and they intend to publish additional Fact Sheets covering a whole host of sectors. In addition, a general ESG Fact Sheet for use by any leveraged finance borrower in any sector has been prepared, and it serves as a guide on the issues that lenders will focus on and would expect to see addressed in market-leading ESG disclosures.
ESG disclosure: public companies
Borrowers listed on the London Stock Exchange’s Main Market will need to include a statement in their annual report confirming if they have made climate-related disclosures consistent with the recommendations of Task Force on Climate-related Financial Disclosures (TCFD).
In addition to these requirements the Financial Conduct Authority has published new guidance on ESG matters and borrowers’ existing obligations under the Listing Rules, Disclosure Guidance and Transparent Rules, Market Abuse Regulation and Prospectus Regulation.
The new Listing Rules will also need to considered by any borrowers planning an initial public offering, or move from AIM to the Main Market.
The new requirements of Listing Rule 9.8.6 apply to all borrowers on the Premium Segment of the Main Market of the London Stock Exchange for accounting periods beginning on or after 1 January 2021. Some borrowers may have already opted to voluntarily include climate-related disclosures which follow the TCFD recommendations in their annual reports. Officially the first annual reports subject to the new rules will be published in spring 2022.
Andrew Dodds, a partner in the banking and finance team at Stevens & Bolton, comments that:
“We anticipate that lenders will continue to place increasing importance on borrowers adopting and adhering to an ESG strategy. The Sustainability-Linked Loan Principles, the Guide and the related Fact Sheets are steps in the right direction to ensure that borrowers and their advisers have access to the right tools when ESG Disclosures are a requirement in a transaction”.
Nicola Broadhurst, head of the ESG and sustainability practice at Steven & Bolton, comments that:
“As the most recent World Economic Forum’s white paper on the Future of the Corporation points out, for a business to succeed in the long term it must provide profitable solutions that positively affect all stakeholders. Therefore when assessing existing or potential funding opportunities and risk, it is not surprising that many lenders are starting to require borrowers to show their commitment to ESG and sustainability principles. The increasing demand for greater transparency and accountability in the way a business conducts itself and its impact on the environment is not simply a trend but a real reputational risk”.