According to a recent article in the Financial Times (8 October 2022) "producing three 25cl aluminium cans instead of a traditional 75cl wine bottle can reduce carbon emissions by 79 per cent". It sounds like an easy ESG win, but would a switch to canned wine be enough to allow a borrower to procure sustainability-linked finance? The answer, in theory, is yes but for Sustainability-Linked Loans (SLLs) to have a meaningful long-term effect, low-hurdles must be avoided. The canned wine example is simple but it is useful to draw out some of the themes as to whether it is appropriate to label a loan as sustainability-linked.
What is required for a loan to be an SLL?
There is no current legislation in the UK or EU that mandates minimum requirements for a loan product being badged as an SLL (other than the minimum requirements which permit an EU financial market participant to disclose that a product is in alignment with the EU Taxonomy Regulations). The basic description of an SLL is a loan under which the margin payable can be reduced (or in some circumstances increased) when sustainability targets are met (or missed). If the parties desired, this could include our canned wine scenario, with (for example) one basis point being taken from the margin if the borrower were to serve wine to clients from cans.
Guidance from the LMA, APLMA and LSTA
The Loan Market Association (the LMA) (working with the Asia Pacific Loan Market Association (the APLMA) and the Loan Syndications and Trading Association (the LSTA)) has been leading the way for the loan market in providing guidance as to what SLLs should look like. To complement the Sustainability-Linked Loan Principles (originally launched by the LMA in March 2019) (the SLLPs) and the LMA's Guidance Note on SLLPs (published in March 2022), the LMA has produced a series of short articles focusing on protecting the integrity of the SLLPs for those agreeing a loan badged as sustainability-linked. These articles home in on the selection of KPIs, calibration of sustainability performance targets and the timeline for transactions when agreeing an SLL.
KPIs in the context of the borrower's business
- The LMA guidance suggests that 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”. Without this focus, the targets set for the borrower will have little impact on the promotion of sustainability, and risk undermining the integrity of the SLL product.
- In our example, if the selling of wine is a core part of the borrower's business, then a switch to canned wine could help deliver a material carbon footprint reduction, but to consider such a switch in isolation without reference to the borrower's overall business would not make for a rigorous KPI. For some businesses, particularly those in the hospitality sector (or even more so, wine producers), this change could have a significant impact on a borrower's carbon footprint. For others, for example a property investor, toasting the opening of its newly constructed development with canned wine will be immaterial compared to the sustainability of the building.
- SLLs should reward and incentivise an overall transition to sustainability and if a business is being rewarded for cutting carbon in one area whilst increasing its carbon footprint in another this may be perceived as sustainability washing.
- KPIs must be carefully chosen; in our example, a KPI that measures overall carbon footprint (including the impact from canned wine) would be more appropriate. When the data is scrutinised, it may become apparent (for example) that procuring canned wine from South Africa (such as highlighted in the FT) is less sustainable than locally produced wine in bottles (or the overall impact could be much less than the headline 79% reduction).
Sustainability Performance Targets
- Hitting the sustainability performance target (SPT) for a KPI should not be an easy win. The improvement in a borrower's selected KPI(s) should be ambitious. The SLLPs note that an SPT should be "a target that represents a true reach for the borrower". Expanding on this the LMA advise that an SPT should be "beyond a business as usual trajectory" and ambitious targets should not be frustrated by the possibility of failure. In our example (focussing on the hospitality business) switching to canned wine would certainly represent a change from business as usual and it would be challenging for a restaurant or hotel to convince clients to choose wine from a can. The question would be what levels of change could be accepted as an ambitious target for that business.
- The SLLPs state "SPTs can be (i) internal and bespoke to the borrower’s business; (ii) external and set against a borrower’s ESG performance in relation to its peers, as determined by an external reviewer; (iii) set by reference to the science or (iv) a combination of any of these." A borrower knows its business best and understands what changes can be made and is most likely to identify the KPIs and proposed SPTs, but to ensure integrity in the SLL product, lenders should provide healthy challenge to these proposals. The use of a sustainability coordinator may help bring third party expertise to the negotiations to better inform as to what would be suitably ambitious SPTs. In our example the external reviewer could provide meaningful data and verification as to what a market-leading uptake of canned wine would be and set SPTs around being a suitably ambitious percentage ahead of the market, (with accompanying evidence of a meaningful change to the Borrower's carbon footprint).
"It's a matter of time" – LMA Article July 2022
- In its final article: "It's a matter of time", the LMA recognises that the level of support needed for an SLL "may be substantial and time-intensive" and that gathering data to set KPIs and SPTs is not a simple exercise. A borrower will hopefully already be looking at sustainability from a much wider perspective and obtaining an SLL will be part of the toolkit that helps it achieve its sustainability ambitions. The mark of a truly effective SLL must be that its existence tips the balance on investment decisions made by a borrower towards the more sustainable path. Having the data and expertise to know where this will lie over the term of the loan is a challenge that will put additional pressure on timelines for agreeing a syndicated loan.
- The LMA suggests that agreeing the right KPIs and SPTs should not be compromised by the timeframes for funding. Transactions have been completed with mechanics for KPIs and SPTs to be agreed post completion and the LMA rightly point out that such a loan is not properly an SLL and should not be badged so unless the targets are agreed and the mechanics in the loan are active.
- This does mean that the timing of a syndicated loan does not have to be fatal to agreeing an SLL and there is an opportunity for the parties to agree truly effective targets outside of the main timetable. Parties do need to consider though whether all the drivers to agree SLL terms will remain post-completion. In our example the best case is that the borrower would have undertaken its own analysis of the overall carbon impact of the change to canned wine, with external advisors providing data, and ambitious targets already having been set. It will then be for the lenders to ensure that they have the resource to engage with the proposals during the syndication timetable, with a sustainability coordinator possibly undertaking the legwork to streamline the process. Borrowers who are earlier on their sustainability pathway may need more support and input from lenders to present an effective case for an SLL.
In summary, the agreeing of an SLL is not intended to be easy. There is a recognition that this should tie-in with the hard work that is required to make real and effective change through the SLL product. A significant effort will be required from all sides to ensure that targets are ambitious and meaningful and can be properly monitored. The loan is not intended to be a stand-alone item though; it should be integrated into the sustainable ambitions of a borrower's business and the work that a borrower is doing already should provide a good basis upon which the parties can agree terms that have a sustainable benefit. We await the introduction of recently proposed FCA rules during the course of next year which will provide governance in this area, including the introduction of new consumer-friendly labels for sustainable investing.
Find out more
To discuss any of the issues raised in this article in more detail, please contact a member of our Banking and Finance team.