Sustainability-linked loans: Aiming high and delivering

In-depth analysis

Benefits and challenges of ESG related lending

The focus on ESG issues in the lending sphere continues to grow, with many banks involved in investments in renewable energy, circular financings and integrating "sustainability" into lending practices and investment decisions. Banks and financial institutions are becoming increasingly mindful of the benefits of supporting companies with a robust sustainability strategy and of how capital can be actively directed towards encouraging such strategies via green, social or sustainability-linked loans (SLLs).

This increased focus is greatly assisted by the guidance that has grown up around ESG in the context of lending transactions in various forms including the below:

The Principles and Guidance produced by the Loan Market Association (LMA), Loan Syndications and Trading Association (LSTA) and the Asia Pacific Loan Market Association (APLMA) on green loans, social loans and SLLs (the Principles and Guidance) continue to evolve in line with developments and market practice in this area and to provide an extremely helpful backdrop to negotiation of such loans. They were most recently updated in February 2023, with the latest version of the Principles and Guidance applying to loans originated, amended or extended from March 9 2023.
A starting point for discussion and negotiation has been provided by the LMA in the form of its draft SLL provisions, published in May 2023 (the LMA Draft SLL Provisions).
The LSTA produced "Drafting Guidance for Sustainability-Linked Loans" in February 2023 which provides helpful drafting and guidance for SLLs.
The APLMA produced a term sheet in September 2022 incorporating an SLL appendix.

These resources, coupled with the development of internal drafting and standards by banks and financial institutions should assist in reducing the drafting and negotiation time involved in putting together a green loan, social loan or SLL.

This article focuses on SLLs which involve the selection of Key Performance Indicators (KPIs) and the setting of sustainability performance targets (SPTs) in relation to those KPIs. While a growing focus on SLLs is to be applauded, there is still concern as to how best to ensure first that the targets in an SLL represent both a "stretch" for the company and aims that go beyond "business as usual" and second that a loan is genuinely going to deliver on its ESG targets in a meaningful way. SLLs can present a concern where the targets put in place may not be ambitious or where externally set measures are not available to be relied on to track progress. The Financial Conduct Authority (FCA) has expressed concern in this area and the European Banking Authority ("EBA") has also provided guidance on when the drafting of an SLL may present an issue. These, coupled with a general desire to ensure SLLs deliver on their targets mean that SLLs should be drafted to incorporate targets that are strictly set and scrupulously monitored.

Concerns expressed by the FCA

In June 2023, the FCA sent a letter highlighting its concerns in relation to SLLs to the heads of ESG at firms involved in the SLL market. It is important to note that while the FCA does not currently regulate SLLs, it is keen to maintain and improve the integrity of the product. In short, the concerns highlighted in the letter were:

The need to strengthen the expectations of SPTs and KPIs with clearer alignment to borrowers' published transition plans
The fact that borrowers may be deterred from entering into SLLs due to the costs and negotiation time involved in putting them in place
The heightened scrutiny of borrowers' affairs which comes with specifying SPTs and KPIs
The potential for conflicts of interest to arise given the linking of remuneration in banks to the achievement of ESG financing targets, and therefore a potential consequence being that banks may accept weak SPTs and KPIs.

It is important to note that the LMA Draft SLL Provisions, which were shared with the market following the research undertaken by the FCA, do address some of the FCA's concerns. Specifically, it is hoped that the anticipated costs and negotiation time involved in putting together an SLL (particularly considering the fact that these factors may deter borrowers from entering into SLLs), will be addressed at least to some extent by the LMA Draft SLL Provisions: they provide a very useful starting point from which drafting can be tailored to the requirements of the individual transaction.

The European Banking Authority's May 2023 report

In May 2022, the European Supervisory Authorities (ESAs) including the EBA received a request for input from the European Commission on greenwashing, to be delivered in the form of a progress report, by May 2023. The report produced by the EBA describes the adverse impact that greenwashing can have on the financial risks of banks and investment firms, noting the highest impact is likely to be felt in terms of reputational risk, followed by operational and strategic or business risk.

The progress report also put forward the ESAs understanding of what greenwashing means, in the form of the following high-level understanding of the term: "a practice whereby sustainability-related statements, declarations, actions, or communications do not clearly and fairly reflect the underlying sustainability profile of an entity, a financial product, or financial services. This practice may be misleading to consumers, investors or other market participants."

The report highlighted various issues in terms of greenwashing in the SLL, green and social loan arena including the following:

at product level, there are no binding standards on SLLs, which may lead to unharmonised practices in terms of setting KPIs and SPTs, and impact how penalties are set and implemented
while noting that SLLs/green and social loans "tend to be private contracts", the report noted that there are differing approaches within financial institutions in terms of how KPIs and SPTs are scrutinised
SLLs may be presented as having real world impact, where their structure does not necessarily allow for it
SLLs may be drafted with a "low quality of contractual commitments" eg a margin step up may be included without a step down for failure to meet set targets.

While Brexit means the UK is no longer bound to EU legislation, the EU and UK banking spheres remain very closely interlinked, with many UK banks having branches in the EU and vice versa. The issues highlighted by the EBA therefore remain relevant and useful in terms of guidance to UK banks as to how to approach this area.

What is a sustainability-linked loan?

An SLL is drafted to incorporate material, regularly monitored and externally verified sustainability linked targets through KPIs and SPTs. The KPIs may include a variety of challenges for the borrower's business, and may incorporate both social, green and other ESG related targets. Pricing incentives, usually in the form of a margin ratchet provision, are included and are based on whether the borrower hits or misses those ESG targets.

The Principles and Guidance for SLLs focus on the need for KPIs to be credible. They state that KPIs must be:

"Relevant, core and material to the borrower's overall business and of high strategic significance to the borrower's current and future operations
measurable or quantifiable on a consistent methodological basis
able to be benchmarked (ie as much as possible using an external reference or definitions to facilitate the assessment of the SPT's level of ambition)."

The borrower must provide a clear definition of the KPIs and should include the appropriate scope or parameters, the calculation methodology and a definition of a baseline. The Principles and Guidance also note that the setting of SPTs is crucial and key to structuring SLLs. They must "be set in good faith and remain relevant and ambitious throughout the life of the loan." The SPTs should represent a genuine challenge for the borrower, which goes beyond "business as usual" and should, where possible, be benchmarked against (i) the borrower's own performance over time (going back a minimum of 3 years); (ii) performance by the borrower's peers and (iii) industry standards. The SPTs should be set before or concurrently with origination of the loan and structures in which they are set post origination (sleeping SLL structures) should be avoided other than in exceptional instances.

The LMA Draft SLL Provisions also incorporate:

a "rendez-vous" clause whereby the lender and borrower can discuss amendments to the KPIs/SPTs or calculation methodology, following the occurrence of specified events
specified trigger events, on the occurrence of which the loan will be declassified as an SLL (which will not trigger an Event of Default)
detailed reporting mechanisms including the regular deliver of a sustainability compliance certificate, a sustainability report and an externally prepared verification report, plus a representation which repeats on the date of submission of the compliance certificate as to the accuracy of the sustainability information delivered to the lender.

While the LMA Draft SLL Provisions are a very welcome step forward, this is very much a developing area in terms of drafting (evidenced by the optionality remaining within the drafting by way of footnotes and square brackets) and the type of borrower, sphere in which it operates and selected KPIs will determine the detail of each SLL.

How can we encourage the SLL to deliver on its aims?

The Principles and Guidance (within the Guidance produced for SLLs) highlight that, in the context of SLLs, greenwashing can occur in three key ways:

the KPIs are not material and core to the business of the borrower
the SPTs are not sufficiently ambitious or meaningful

through inaccurate or insufficient monitoring, measuring, benchmarking and/or disclosure of borrower's performance against SPTs.

Various options are available to assist a lender in satisfying itself that the factors above are being addressed including reporting by the borrower, expert input, "rendez-vous" clauses and declassification provisions, each of which is discussed below.

Reporting

Reporting obligations allow a lender to take an active role in monitoring the performance of the SPTs in relation to the loan. A suite of information giving provisions are included in the LMA Draft SLL Provisions:

A sustainability confirmation certificate is to be provided to the lender, at regular intervals and at least annually, attaching an externally prepared verification report, and outlining the performance of the loan against the SPTs for the relevant year, and the impact of meeting such SPTs (or not) on the loan's economic characteristics.
Borrowers are encouraged to publicly report information relating to their SPTs, including details of any underlying methodology of SPT calculations and/or assumptions. The Global Reporting Initiative’s Sustainability Reporting Standards provide widely adopted global standards for sustainability reporting.

Expert input

A Sustainability Co-Ordinator may assist at the drafting stage, to encourage a productive dialogue between the borrower and the lender in which the borrower agrees meaningful ESG targets, and to put the targets into the context of what is currently seen in the market in this area. This role is often undertaken by a specialist sustainability team in a bank/financial institution.
A Pre-Signing KPI/SPT Assessment may be undertaken by an external reviewer if it is considered to be required in the context of the transaction. This can be used to assess the KPIs, SPTs, benchmarks and baselines and to assess whether the loan itself meets with the LMA Draft SLL Provisions and the Principles and Guidance on SLLs. The assessment can also look at the SPTs in the context of the borrower's overall ESG performance to ensure SPT achievement is not overshadowed by the negative effects of the borrower's other activities.
Independent external verification of the borrower's performance against each SPT at regular intervals post signing should be built into an SLL. This should be conducted by a qualified external reviewer with relevant expertise, such as an auditor, environmental consultant and/or independent ratings agency. Verification must be shared with the lenders regularly, appended to the sustainability compliance certificate and, where appropriate, should be made publicly available. The external verifier should also be asked to consider any changes to the standards in accordance with which the KPIs have been set and the impact on those KPIs and SPTs.

Rendez-vous clauses

These provisions address "amendment events" ie changes to the borrower's business during the term of the loan (for example due to disposal of assets, mergers, acquisitions etc) or changes to the ESG standards by which the KPIs and SPTs were set , which mean the SLL provisions need to be re-considered. They refer to the coming together of the parties to discuss how to address such a change given the loan's characterisation as an SLL, and the expectations and requirements that accompany that.
If a trigger event occurs under the clause, a negotiation period between the borrower and lender will start, during which they will work together in good faith for a set period to agree appropriate changes to the loan agreement. If, after the prescribed negotiation period, the parties have been unable to reach agreement this is often deemed to be (and under the LMA Draft SLL Provisions will be) a “declassification event", which is explored below.
The inclusion of a rendez-vous clause demonstrates that the parties to the loan will take an active approach to addressing events that occur during the loan's term which may have a significant impact on the original analysis undertaken in relation to the KPIs and SPTs and how much of a challenge they represent for the borrower.

Declassification provisions

These provisions address the circumstances in which a loan will cease to be classified as an SLL and the consequence of such circumstances i.e. that the parties agree not to publicise it as such (and to potentially remove historic references to it being an SLL). The trigger for such process is drafted very narrowly in the LMA Draft SLL Provisions, only to apply where an amendment event occurs, but the LMA notes the triggers could be drafted to include "consecutive non-achievement of SPTs" and/or "Sustainability Breaches that continue unremedied for an extended period". Further extensions could be built in including where the loan no longer meets the requirements of an SLL.
The occurrence of a declassification event does not usually (and does not in the LMA Draft SLL Provisions) constitute an Event of Default but the inclusion of declassification events assist a lender in demonstrating, where the loan fails to meet the set criteria on which it agreed it would constitute an SLL, it will no longer be marketed or publicised as an SLL and the borrower will no longer have access to the rewards offered by the margin ratchet provision.

Recommendations

The following suggestions may assist a lender in terms of monitoring the SLL's aims and delivery:

Require the borrower to clearly communicate its rationale for each KPI and motivation behind each SPT and incorporate robust, transparent calculation methodologies into the loan itself.

Engage a Sustainability Co-Ordinator to assist with putting together the sustainability provisions pre-launch, and particularly to encourage a conversation between the borrower and the lender in which the SPTs are interrogated and justified.
Draft the margin ratchet provision so it provides for a "reward" for the borrower where it meets its targets, but also a "penalty" where it fails to, providing it with a clear incentive not to fail, as well as to be rewarded.
Only consider sleeping SLL structures in exceptional circumstances where the borrower has a clear sustainability strategy in place, time is pressured and KPI targets will be set no later than a year after origination. Until the provisions are "woken up" they should not be included in a lender's sustainability calculations.
Publicise the sustainability aims and whether or not they have been met.
Consider the consequences of failing to deliver on the sustainability provisions and widen the "declassification events" as is appropriate in the context of the loan.
Consider whether the representation as to the sustainability information delivered should be a full repeating representation, i.e. one which repeats on each interest payment date.
Consider the extension of the information undertaking to include information the lender requires for its own reporting requirements, or broader information about the borrower's overall ESG strategy.

Conclusion

Accusations of greenwashing in connection with SLLs threaten the product as a whole and may cause serious reputational risk to the financial institution involved. This is clearly an important area for lenders, and there are numerous ways in which a lender can strive to ensure the loan both incorporates robust and ambitious targets, and that it is kept fully up to date as to whether the targets are being met during the loan's term.