The future of green finance: sustainability-linked loans

Answer

Working towards a greener and more sustainable future

Climate change has been at the top of the agenda for many in recent years. Increasingly, the shift in attention to ensure that we live in a more sustainable world also means that businesses, governments, and individuals have been held more accountable for their actions. For example, a quarter of all climate change litigation has been filed between 2020 and 2022. Environmental, social and governance (ESG) issues are now more than ever at the forefront of corporate decision-making for a variety of reasons.

The banking and wider finance market has itself been impacted by this shift in behaviour and willingness to work towards a greener economy. Consequently, climate-related finance products have grown rapidly in recent years. Although not a new concept, climate-linked finance products have become increasingly popular as they allow financial institutions as well as borrowers to integrate their respective ESG policies within the standard course of business lending.

Sustainability-linked loans (SLL) have proved particularly popular with large corporates. Notably, the global aggregate of SLLs in 2022 sits at approximately $400 billion. SLLs allow borrowers and lenders to send a signal to the market that ESG is at the core of their business. This trend may therefore continue as additional regulation and the shift in societal values swings towards a greener economy.

What are SLLs?

SLLs are loans that are tied to borrowers’ performance in meeting certain ESG targets. This presents an innovative way of lending, as this incentivises a borrower to work towards hitting pre-agreed targets to reduce the cost of the loan. More specifically, a borrower’s performance will be measured against sustainability performance targets (SPTs) set against various key performance indicators (KPIs), which measure the borrower’s sustainability performance. Each SLL will be unique as the SPTs and KPIs will be agreed between the borrower and lender on a case-by-case basis.

The Loan Market Association (LMA), Loan Syndications and Trading Association (LSTA) and Asia Pacific Loan Market Association (APLMA) published the Sustainability Linked Loan Principles (the SLPs) to provide clear guidance on the requirements for a loan to be categorised as such. As the remits of the LMA, LSTA and APLMA span across the world, SLLs have gained international recognition within the debt markets.

SLLs operate to incentivise a borrower to meet targets by offering a reduced interest rate on the relevant loan where certain SPTs are met. SPTs are targets set in respect to specific KPIs, the most commonly used KPIs sit within the ‘environmental category of ESG but ambitious targets are also being set within the social and governance area. Examples include:

• environmental – reducing CO2 emissions, recycling and waste management targets or reviewing supply chain performance levels to increase the use of sustainable raw materials or supplies of the business;

• social – improving a borrower’s community engagement, board diversity and impact on local businesses; and

• governance – ensuring a borrower builds strong corporate governance and transparency policies.

Whether it’s lowering greenhouse gas emissions, contributing positively towards local communities, or improving diversity in senior management positions, the core of SLLs helps to keep sustainability and accountability at the forefront of the parties’ minds.

To ensure market confidence in SLLs, the SLPs recommend borrowers obtain external verification of performance against each SPT by “a qualified external reviewer with relevant expertise, such as an auditor, environmental consultant and/or independent ratings agency”.

Benefits of an SLL?

SLLs can be used for any corporate purpose allowing SLLs to be drawn by a wide variety of corporate borrowers including those that don’t operate in typical ‘green’ industries.

SLLs offer more flexibility, as the overarching SLL guidance and SLPs don’t set out a list of specific SPTs or KPIs. This means that borrowers are able to agree ESG targets that fit their business with the lender. This bespoke approach ensures an SLL is tailored towards what’s achievable from the borrower’s perspective.

In contrast, alternative climate-linked finance products such as green loans are restricted to use for specific ‘green projects’. An example of which includes a green building project to retrofit existing real estate or construct a building an exceptional energy efficiency rating.

SLLs benefit borrowers by way of positive publicity, sending a strong signal to the market about their commitment to achieving a sustainable future.

Potential challenges

Strategy, resource and suitability

SLLs may not be suitable for every borrower despite the benefits they offer. A smaller business may lack the resources to ensure accurate monitoring and compliance with SPTs.

It’s key for borrowers to understand that SLLs involve ongoing commitments (running for the term of the loan). It’s therefore important a borrower has agreed viable SPTs considering how such ESG targets may affect daily operations of business. The cost of implementing such strategy should therefore be carefully modelled and considered. If a borrower isn’t well prepared to enter in an SLL, the SLL could be detrimental if the loan is structed with a two-way pricing adjustment (ie, whereby the borrower’s interest rate may increase if it performs badly against the SPTs).

Lack of ambition?

It’s important that the SPTs set are ambitious but achievable. SPTs should also be meaningful to avoid ‘greenwashing’ claims. SPTs should therefore go above and beyond what’s already being achieved by the borrower in the normal course of its business and sustainability strategy.

A lender must therefore ensure SPTs are scrutinised and challenged before formalising such arrangements in loan documentation. There may also be scope for the SPTs to be recalibrated if a borrower has reached all of SPTs earlier than expected, to ensure the integrity of the SLL product.

The future of SLLs

The SLL market continues to grow and is an important financing tool in encouraging companies to take sustainability seriously. The SLPs remain broad in nature to allow flexibility for companies to participate in furthering their sustainability journey. However, it’s important for each borrower to note that SLLs acts as extensions to existing ESG policies and aren’t a substitute for an internal sustainability framework.

As the energy crisis dominates headlines, the outlook for 2023 is anticipated to be focused on changes to the energy market. We hope that climate-related finance products (such as SLLs) will continue to play an increasingly instrumental role in working towards a sustainable future.

Dixson Lee is a trainee at TLT LLP.