Sustainability linked loans (SLLs) contain provisions which incentivise borrowers to achieve improvements in their own ESG targets. Typically these incentives are implemented by way of a margin ratchet, either symmetric or downwards only, meaning that the borrower pays less interest if it can hit certain predetermined metrics or sustainability performance targets (SPTs) showing improvement in Key Performance Indicators (KPI’s) for measuring selected ESG goals.
Unlike green loans or green bonds, it does not matter what the proceeds are used for – the intention is that whatever the business does, the SLL can be used as a means of driving a measurable improvement in the ESG performance of the borrower. This is the concept of additionality. Although a green loan or green bond can be for a sustainable purpose, where a business is in a green industry already then arguably the refinancing of its borrowings for its sustainable purpose does not really achieve anything. However an SLL, assuming it incentivises a meaningful ESG improvement, will likely change things for the better. It can also assist businesses who are looking to move away from activities which are environmentally or socially damaging or looking to overhaul an archaic governance model.
SLLs are typically based on the SLL Principles originally published by the LMA in 2019, and recently updated in May 2021 in a joint publication by the LMA, the Asia Pacific Loan Market Association (APLMA) and the Syndicated Loans Trading Association (STLA). The LMA’s original examples of SPTs focused exclusively on the “E” of ESG, but the updated SLL Principles (the Principles) include social and governance goals as well.
The Principles have also been toughened up to avoid the risk of green-washing (see further below), to avoid soft, irrelevant targets and insufficiently rigorous or subjective verification.
The Principles describe five core components: KPIs, SPTs, Loan Characteristics, Reporting and Verification:
KPIs selected by a borrower should be clearly defined and relevant, core and material to the borrower’s business, and of high strategic importance to its future operations. They should be measurable or quantifiable on a consistent methodological basis, and capable of being benchmarked, against an industry standard where feasible;
SPTs should be ambitious i.e. representing a material improvement in the relevant KPI and going beyond a business as usual trajectory. They should be benchmarked on the basis of one or more of three methodologies: self-improvement over a period of at least three years, peer-comparison, or measured against absolute scientific outputs or official targets;
Loan characteristics refers to economic outcomes associated with meeting SPTs, most commonly the cost of the loan;
Reporting should be at least once per annum and provide up to date information to allow lenders to monitor progress and confirm that targets remain ambitious. Where possible underlying calculations and methodologies should be made available; and
Borrowers must obtain independent external verification of their performance level for each SPT at least once a year, typically by auditors, environmental consultants or independent ratings agencies.
Impact on mid-market financing
We are still in the very early days of SLL’s and SLL principles impacting mid-market loans. The principles are gradually trickling down from the AAA investment grade borrowers through to the investment grade borrowers and into the leveraged market.
There is still very little harmonisation of SLL metrics and measurability. With smaller borrowers, the ability to obtain external ratings and the cost of independent monitoring and verification of SPTs can potentially outweigh financial incentives attached to the SLLs. If internal verification is permitted, despite this being a derogation from the newly updated Principles, lenders will at least be keen to see borrowers demonstrate that they have the internal expertise and qualifications to carry out a meaningful verification exercise. Lenders will want to be able to review and interrogate verification procedures and not to simply rely on a compliance certificate. In case of uncertainty, lenders will want the ability to allow reference to independent experts for cooperation
In almost all cases, hitting SPTs is rewarded by a reduction in interest payable. Loan agreements will also often contain representations as to certain baseline ESG targets and compliance, plus set out reporting and compliance mechanisms to underpin measurability of the KPIs and SPTs.
For now, SLL provisions are still relatively rare in mid-market loans and there is still considerable variation in the content and drafting of these provisions. But this is changing rapidly.
Setting ESG KPIs and SPTs
The Principles suggest metrics relating to environmental goals such as energy efficiency, emissions, use of renewable energy, water consumption, recycling, and sustainable sourcing and production. The new Principles now include social goals such as improvement in human rights and community relations, community engagement, employee engagement and diversity and inclusion and employee health and safety. Governance goals include business ethics and strong governance procedures.
On a more practical level, environmental goals are relatively easy to devise and test – selected KPIs should be in areas where the business’s footprint is relatively high or its performance is capable of improvement, and SPTs selected which go beyond a trajectory of gentle improvement in line with most peers. .
Social and governance targets are rather harder to devise and measure, but examples can include:
- Adopting diversity equality and inclusion metrics e.g. for management and overall workforce that could be measured by an external organisation
- Metrics as to how employees are treated e.g. benefits offered, minimum pay levels, fair remuneration structures and reduction/elimination of the gender pay gap
- Flexible working (this can also have a carbon footprint impact)
- Ethical sourcing and supply chain monitoring, going beyond requiring suppliers to sign up to codes of conduct/policies and extending to interviewing and evidence of compliance
It is important that SLL functionality is used in a meaningful and sincere way. In other words, It is not helpful if KPIs or SPTs are soft. The danger is that more cynical lenders and borrowers achieve a mutual reputational boost through the positive optics of agreeing SLL targets and meeting those targets, but allow the borrower to demonstrate achievement of those SPTs with minimal effort and little or no change to its business. Although such sustainability washing is rare in our experience, there is no doubt that it does exist. The revised SLL Principles aim to reduce this risk by prescribing a more robust framework to be followed to ensure the integrity of the process.
In fact, although lenders and borrowers will derive some benefit from being seen to promote ESG goals by virtue of SLLs, there are many other benefits. Borrowers and mid-market lenders are recognising that genuine progress towards ESG goals is likely to have positive effects on consumer behaviour, attraction and retention of staff, regulatory compliance, selection for the supply chain of (larger) customers, and availability of financing.
In addition, current thinking is that there is a genuine correlation between businesses that are driving improvements in ESG and stronger business performance. Management behaviour which includes a willingness to innovate and to change the business with long-term goals in mind is a reliable indicia of sound management and good business practice. It is this correlation, rather than measurable financial benefits resulting from improved ESG KPIs (which are not always immediately apparent) which is proving attractive to lenders promoting SLL lending.