2019 was a boom year for the growth of Sustainability Linked Loans. Here, we explore why they are so popular, and what 2020 holds for this relatively new kid on the block.
What is a Sustainability Linked Loan?
First of all, Sustainability Linked Loans (SLLs) are not the same thing as green loans. The term 'green loan' refers to a loan that is used to finance a specific green purpose. SLLs, on the other hand, can be applied for any purpose (whether 'green' or not), but an in-built pricing mechanism means that the loan is cheaper if the borrower achieves certain sustainable or ESG (environmental, social and governance) related targets. The use of SLLs grew rapidly in 2019, with particular popularity in Europe (where around 80% of all SLLs were issued), but examples can be seen across the globe. According to Bloomberg data, companies raised $62 billion of sustainability-linked loans worldwide in the first nine months of 2019, surpassing 2018’s full-year total.
How does the pricing work?
Initially, SLLs were structured simply so that if the ESG targets were met, the pricing reduced (albeit, not by much). There was no penalty for the borrower failing to hit the prescribed targets.
This structure has evolved and more recent deals have used a two-way pricing structure whereby if the targets are met, the pricing reduces, but if the borrower fails to meet its ESG targets then pricing increases. This two-way structure incentivises the borrower to meet its ESG targets. However, it has attracted criticism, as ultimately the lender will benefit from the borrower's failure to manage its ESG strategy successfully. One possible solution is that instead of the lender receiving the proceeds of any increased pricing, these funds are transferred to a separate bank account and can only be accessed by the company for expenditure on ESG activities.
How are targets set and monitored?
In March 2019, the Loan Market Association (LMA) published the Sustainability Linked Loan Principles (SLLP), which set out a list of suggested criteria. The critical factor is that the criteria chosen are ambitious and meaningful to the borrower’s business. Metrics such as target CO2 emissions are common, but more bespoke examples are also prevalent. Typically, in real estate finance deals, the sustainability covenants are set by reference to outcomes from an environmental report commissioned by the borrower. These might include a minimum capital expenditure per year to reduce the carbon footprint of the building and for all electricity and gas to be obtained from renewable energy sources.
The SLLP state that the need for external review should be negotiated and determined on a case-by-case basis. For public companies, public disclosures may be sufficient to verify performance for the purposes of the loan agreement.
Why are SLLs so popular?
The potential for lower pricing is a clear incentive, but the reductions in margin are often fairly modest at the moment. So what else is driving the boom in SLLs?
SLLs are flexible. A standard corporate revolving credit facility can be sustainability linked. There is no need for the borrower to apply the proceeds towards green activities. This makes SLLs much more attractive than more restrictive green loans. In 2019, we even saw this model used in the bond market (which traditionally favours the green loan approach).
There is no doubt that the climate crisis, together with broader ESG issues, are at the top of the boardroom agenda as we move into 2020 and beyond. There are risks associated with ignoring these issues, such as litigation and getting on the wrong side of public opinion. SLLs are a good way of demonstrating the company's ESG credentials.
The positive desire to address climate change risk was key in the establishment of green and sustainability linked loans. But this voluntary approach to what the Governor of the Bank of England, Mark Carney, called a 'defining issue for financial stability' is now being overtaken by regulation.
The European Commission's Action Plan on Financing Sustainable Growth (which recognises the Paris Agreement of 2015) has three broad goals:
- to re-orient capital flows towards sustainable investment;
- to manage the financial risks stemming from climate change, environmental degradation and social issues; and
- to foster transparency.
The result is a raft of both legislative and voluntary initiatives that push, pull and encourage financial institutions and corporates alike to move towards sustainable finance. The UK has endorsed the objectives of the EU Action Plan in its UK Green Finance Strategy published last year, suggesting that the UK will retain or implement similar initiatives after the end of the Brexit transition period.
The 'equator principles' have long been used by lenders for managing ESG risks in the project finance market, but their application was limited in the wider loan market. In March 2018, the LMA launched its green loan principles, with the SLLP following a year later. The principles are voluntary but reduce the risk of 'green washing'.
Over the coming months, we expect various legislative changes to take effect, which will add to the recent step-change we have seen in the move towards sustainable finance. There are too many to cover in detail in this insight but some key pieces to look out for include:
- the formal adoption of the Taxonomy Regulation, which will introduce an EU-wide taxonomy of environmentally sustainable activities;
- the coming into force (mainly from March 2021) of the provisions of the Disclosure Regulation, which will impose new transparency and disclosure requirements on certain firms;
- the Low Carbon Benchmark Regulation, which entered into force on 10 December 2019 and, amongst other things, lays down minimum requirements for EU climate transition benchmarks, to ensure that these benchmarks do not do harm to other ESG objectives; and
- the development by ESMA, during 2020, of technical standards on the disclosure provisions for sustainable investments.
- These initiatives have a much wider remit that the loan markets, but it is easy to see how the principles contained in the new regulatory framework will be used by banks and corporates alike to continue to develop robust sustainable lending products.
There have always been compelling environmental reasons for sustainability-linked financial products. It is only recently that the economic rationale for such investments has come to the fore. The attention is coming from all sides: from activists such as Greta Thunberg; from regulators, with Mark Carney recently pronouncing on the integration of climate-related financial risks into day-to-to-day supervisory work of the regulators of the financial sector; and from investors such as BlackRock. Indeed, BlackRock's CEO, Larry Fink, committed to integrating sustainability into BlackRock's investment offering, with ESG assessed with the "same rigour" as liquidity and credit risk. With the focus on sustainability only increasing, the appetite for these products is set to continue to increase in 2020 and beyond. We will continue to see a focus on the robustness of the criteria used to assess what constitutes a sustainable investment and avoid undermining those standards by "green washing."