Sustainability in banking and finance

Sustainability has been at the forefront of financial planning for many firms for a good while now, our recent article introduced the concept of sustainability–linked loans (SSL) and the ways in which both lenders and borrowers can integrate sustainability into the finance documents.

This article focuses on how sustainability Key Performance Indicators (KPIs) and Sustainability Performance Targets (SPTs) are dealt with in a finance agreement.  The market practice is developing in terms of how best to approach the selection and deployment of KPIs in loan agreements as without a settled market standard there is a risk of diverging approaches being taken as to what can be classified as an SSL.  We are keeping a close eye on developments in the loan market as it is anticipated that sustainability-linked banking products will become commonplace in the SME market.

There are growing concerns in the loan market regarding “greenwashing”, the use of the SSL products to appear sustainability conscious but without any meaning or purpose in practice.  The Loan Market Association (LMA), an organisation that leads the way in sustainability market development, regularly publish articles and guides in an attempt to support the credibility of the SSLs, emphasises that the sustainability covenants should be true, ambitions and material to the borrower’s core sustainability and business strategy.

The provisions in SSL which are most keenly negotiated are margin adjustments and reporting requirements.

KPIs and SPTs in sustainability linked loans

The KPIs are used to measure the borrower’s progress towards the SPTs at regular intervals during the life of the loan, examples of such targets include the reduction of greenhouse gas emissions and energy consumption, increasing the use of recycled materials and compliance with insulation targets.  Those are, of course, adapted to suit a particular borrower and the sector in which it operates.

The loan market has seen a significant trend in sustainability related margin ratchets, this is usually a pricing adjustment that is structured on a two-way basis, so that achieving a target will result in interest reduction (usually between 2.5 – 5 bps) but a failure to comply with the relevant target may also result in an increase in the margin (such failure is not usually an Event of Default or a drawstop).  The calculations are straightforward and similar to a margin ratchet based on financial ratios, we have also seen we have seen documents which provide for a year to year ramp-up to keep the borrower’s sustainable goals ambitious.

There is usually a requirement to provide the relevant KPI data on a regular basis, in most cases, the borrower would deliver to the lender a sustainability compliance certificate at the same time as it delivers its annual reports.   The compliance certificate can either be self-certified by the borrower or, as is increasingly the case, be certified by an external provider.  It is helpful if the loan agreement provides some flexibility as to who is able to provide the review and verification going forward.   However, more often than not an external review of the borrower’s sustainability position is required as a condition precedent to utilisation.

What does the LMA say about sustainability linked loans?

The LMA has published a set of sustainability-linked loan principles (SLLP), which require that KPIs should be relevant and material to the borrower’s overall business, and of high strategic significance to the borrower’s current and future operations.  The KPIs need to be material enough to deliver material improvements in sustainability performance, and should be ambitious, in a sense that they should go beyond any regulatory requirements.  Recalibration mechanics can be included to ensure that the borrower’s SPTs remain challenging throughout the life of the loan.   Lenders are now increasingly seeking the rights to instigate a review of KPIs if they believe that an adjustment is necessary, whereas borrowers seek similar rights to be flexible and to adjust the targets as the business strategy evolves.

The future is interesting in SLL, we anticipate documentation to become more standardised and fine tuned, and the rise of ESG ratings requirements.  Such ratings are relatively rare at the moment and are provided by only a few agencies, and there is some concern about robustness of such rating.  No doubt that the range of sustainability products will continue to evolve.