As the recent COP26 Summit in Glasgow demonstrated, every country and every industry has a role to play in helping to keep the impacts of climate change to a minimum. This includes the world of banking and finance.
While some financial institutions were already starting to push forward with ESG and sustainability programmes, COP26 will no doubt serve to renew efforts, which will in turn filter down to impact on borrowers and lenders alike in the mid-market and SME space.
What was announced at COP26?
An entire day of the summit was dedicated to finance, with key announcements including:
- The establishment of the International Sustainability Standards Board (ISSB)
The ISSB will develop a new global baseline of sustainability disclosure standards, which will be usable on a stand-alone basis or form the basis of regional regulatory requirements.
- FCA “Strategy for positive change: our ESG priorities”
This wasn’t technically announced at COP26, but was timed to coincide. The Strategy includes:
- Enhancing climate-related financial disclosures
- Enhancing transparency on diversity and inclusion (D&I)
- Developing a policy approach on competency greenwashing, and enhancing governance and alignment of incentives – including remuneration – in regulated firms
- Contributing to work on improving the ESG ratings market.
- UK transition pathway for the UK financial sector
The Chancellor announced the publication of a transition pathway for financial services. This will build on the Greening Finance Roadmap and set out new policies and milestones for the sector leading up to 2050. The policy is expected to be published in 2022.
- Network for Greening the Financial System (NGFS) Glasgow Declaration
The NGFS, a network of 100 central banks and prudential supervisors across the globe committed to:
- Deepening its existing workstreams on climate scenarios, integration of climate financial risk into macroeconomic policy, bridging data gaps and facilitating improved supervisory capacity
- Continuing its work on the financial stability implications of biodiversity loss, as well as risks associated with climate-related litigation.
- Working with policymakers and stakeholders on best practice on climate and environmental risks.
What does this mean for mid-market borrowers and lenders?
The agenda around ESG and sustainability is moving fast and is rapidly cascading down to impact borrowers and lenders of all sizes. This is only expected to increase with the new commitments made during the COP26 Summit.
Indeed, ESG and sustainability factors are an increasingly common feature of the loan market globally and on their way to becoming a standard feature of many loan products. Typically, sustainability loans come under two categories – green loans and sustainability linked loans.
So called green loans were developed out of the long established green bond market. Simply put, they are loans made expressly for specific environmental projects.
Sustainability linked loans (SLLs) are different as they can be used for a wider range of purposes, but will contain clauses setting out KPIs where the performance of the borrower is measured against specific sustainability metrics. Performance against these metrics will then have an impact the loan pricing.
These features are proving to be popular and are used to incentivise the sustainability performance of the borrower. The idea of linking a pricing mechanism to a set of ESG KPIs is quite straightforward and can be added to loan documentation with relative ease. In addition, they can be made available to the majority of borrowers.
Here is what borrowers and lenders should consider when looking to incorporate sustainability elements into their loan agreements:
- Pricing adjustment: as mentioned above, margin ratchet is a common feature of SLLs. Complying with certain pre-agreed KPIs will result in margin reduction for the borrower, working in a similar way to the normal margin ratchet, where pricing is linked to financial performance
- Sustainability targets: there are usually what you would expect them to be, for example focusing on recycling and reusing of materials or reduction of energy consumption or greenhouse emissions, but the parties are encouraged to be creative and ambitious, particularly in SME sector, provided that the targets are not mere window dressing
- Certification requirements: there is no market standard for these in the SME sector. Most commonly the borrowers self-certify the achievement of certain targets (although the lender need to be satisfied that borrower’s methods are satisfactory and that self-certification can be verified)
- Failure to meet the KPIs: the way most loan agreements are drafted at the moment, this will lead to a higher margin and not to an event of default or drawstop. However, providing inaccurate information to the lender will most probably give rise to an event of default
- Mergers and acquisitions: M&A activity or indeed any business or events outside the borrower’s control will undoubtedly have an impact on the borrower’s ability to comply with sustainability KPIs and that is why a continuous dialogue between the parties is essential, as the territory of SLL is still an unfamiliar one for many borrowers.