Sustainability-linked loans: Practical observations and thoughts

Sustainability-linked loans

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 websites¹, 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.

Sustainability-linked loan principles

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 SLL²:

1. Selection of KPIs;
2. Calibration of SPTs;
3. Loan Characteristics;
4. Reporting; and
5. 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 ambition³.

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 meaningful⁴ (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.

Consideration for Lenders

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 loans⁵.  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.

Reporting

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 SPT⁶.  Borrowers should act in a way to promote transparency, which is of particular value in the SLLs market.

Consideration for Lenders

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 Standards⁷, 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.

Review

Borrowers must obtain, on a yearly basis, independent and external verification of the borrower’s performance level against each SPT and for each KPI⁸.

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 stakeholders⁹. 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.

Consideration for Lenders

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 standards¹⁰. Carrying out an external review can demonstrate an intention to meet pledges made and protect against court actions.

Lender considerations in the SLL market

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 stages¹¹.  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 operations¹², 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 interpretation¹³.  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 Directive¹⁴ (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 Regulation¹⁵ (SFDR).  In addition, the Taxonomy Regulation¹⁶ 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 2022¹⁷.

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 monitoring¹⁸ 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 products¹⁹ 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 ratings²⁰.  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.

Application to export credit financing

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.