Much has been written about sustainable finance and sustainability-linked loans (SLLs) in particular are seeing significant growth with the increasing popularity of ESG targets. To recap, SLLs are similar to normal credit facilities, but typically the interest payable is linked to selected sustainability key performance indicators (KPIs), i.e. ESG targets. Borrowers that achieve their sustainability targets benefit from lower interest rates, whereas failure to meet the targets can lead to higher interest rates. The borrower is incentivised to ensure that its loan terms and its sustainability objectives marry up to achieve the favourable interest rates.
In recent years, we have seen a significant increase in the number of SLLs being issued, echoing the growing importance companies are placing on ESG related practices. The Loan Market Association (LMA) and European Leveraged Finance Association have responded to the rise by publishing a best practice guide (the Guide), which explains the application of the sustainability-linked loan principles (SLLPs) to sustainability-linked leveraged loans that incorporate an ESG metric.
Recommendations in the Guide
A borrower’s sustainability performance can be measured using pre-agreed sustainability performance targets (SPTs) that are linked to predefined KPIs. The Guide lists the criteria for SPTs to ensure they are ambitious and clearly linked to the borrower’s core business and sustainability strategy. In short, SPTs should:
- Focus on KPIs that impact the company the most, ensuring targets go beyond "business as usual"
- Be consistent with borrowers’ overall ESG strategy
- Be discussed and devised with assistance from sustainability co-ordinators and an ESG consultant (where appointed as discussed below) and
- Be determined on a predefined timeline, set before or concurrently with the origination of the loan.
The Guide also sets out key recommendations for borrowers to ensure they are meeting their SPTs, for example through use of external reviewers. External reviewers such as auditors, environmental consultants and/or independent ratings agencies can be appointed by a borrower and act as an independent third party when reviewing a borrower’s performance against each SPT for each KPI. External reviewers can play an ongoing role throughout the life of the loan, where typically performance level assessments are required at least once a year.
When it comes to the selection of KPIs, the LMA recommends that borrowers use an ESG consultant. An ESG consultant can, among other things, provide a second opinion when it comes to the selection of a borrower’s KPIs and help determine how much a borrower can improve on its ESG performance. As well as consulting on a borrower’s potential ESG performance, they can also ensure that suitable SPTs are set and recognise KPIs which are material to a borrower’s sustainability and business strategy.
There is currently no LMA template wording for SLL documentation so a case-by-case approach will be required. The Guide provides important considerations to bear in mind when putting SLL documentation in place, covering sustainability-linked margin ratchets, fallback mechanisms for SPTs and sustainability-related events of default.
With the increase of SLLs, new terminology and roles have emerged, meaning finance market professionals have had to adapt to new language. The Guide provides a useful starting point for understanding the key terminology, specialist roles and the selection and disclosure of KPIs. The LMA has also produced a "sustainable lending glossary of terms" to promote the development and use of a common language surrounding sustainable lending worldwide.
The LMA states SLLs should help borrowers achieve “ambitious, pre-determined, sustainability performance objectives” through methods such as ESG ratings, agreed targets or other KPIs. That said, the variety of target indicators and lack of standardisation as regards to measuring SLL sustainability targets may leave lenders concerned over the lack of clear vigorous targets that can easily be monitored.
Whilst we have seen an increase of borrowers benefiting from cheaper debt due to ESG-linked margin ratchets, there are also concerns within the market about the transparency of these margins and the threat this places on the credibility of SLLs. Although the market for SLLs has grown significantly in recent times, there is still a way to go to ensure confidence in the products on offer to safeguard the future of sustainable finance.