The severe warnings on climate change starkly documented by the IPCC report and others demonstrate why urgent action to meet the goals of the Paris Agreement is needed. The public, governments, and legislators are taking notice and taking action. Much of the legislative effort to date has been focused on the financial system but there is an increasing emphasis on non-financial entities and the requirements that are beginning to be expected of them. These requirements stem from legislation, public pressure, and possible litigation.

Our publication GROWING THE GREEN ECONOMY reflects the breadth and depth of the impact of these environmental and sustainable factors. Amongst other things, it looks at the developments in “green” and sustainable financial products across the world. In this article, we focus on the growth of sustainability linked loans.

What is a sustainability linked loan?
The growth of sustainability linked loans has been the success story of the European loan markets over the last 12 months. But what does this mean and how has the market developed?

Whilst the term “green loan” has for some time been used as a generic reference, two distinct products have emerged. A true “green loan” is one where the proceeds of such loan are utilised to finance a green purpose or project. The “sustainability linked loan” is a more recent development – there is no green use of proceeds requirement but the loan includes a pricing adjustment if the borrower achieves specified sustainable or ESG (environmental, social and governance) targets.

There are various factors driving growth:

  • Increase in legislation and non-legal recommendations;
  • ESG issues rising to the top of board agendas;
  • Flexibility;
  • Market standardisation;
  • Lower pricing.

Pricing
Sustainability linked pricing adjustments have become more sophisticated.

  • Discount and premium – some of the first sustainability linked loans only applied a discount ie the margin reduced if targets were met. However, most loans now apply a discount and a premium, whereby the margin increases if targets are missed. This may be on a sliding scale so the margin ratchets up as more targets are missed.
  • Adjustment – at the time of writing pricing adjustments remain modest. Certainly, for investment grade lending, 2.5 to 3bps is common. However, there are examples of larger redeterminations.
  • ESG benefit – we have seen some loans require the sustainability premium to be paid into a borrower’s specific ESG account where it may be used by the borrower but only for ESG purposes. The thinking here is that lenders should not benefit from a borrower’s failure to meet sustainability targets. This provides an incentive for the borrower to consider other sustainable projects or ways of improving on its sustainability performance.

Borrowers typically have the right to opt-out of sustainability linked margin adjustments. We have also seen the right to opt-in at a future date. Additionally, borrowers may be able to change KPIs if lenders consent (the voting threshold will need to be agreed and we have seen both all lender and majority lender consents).

Sustainability Metrics
The Sustainability Linked Loan Principles sets out a list of some common criteria but these are suggestions rather than requirements and we are seeing various metrics used in loan facilities:

  • Bespoke key performance indicators (“KPIs”) – there has been a marked increase in entity-specific KPIs. Borrowers have set their own targets linked to a wide range of ESG factors, in conjunction with sustainability coordinators (a bank or banks appointed to this role to establish sustainability targets with the borrower). We have seen KPIs dealing with carbon emissions (which are probably the most common), water usage, women on boards, fatalities in the workplace, traceability of products and sales of zero/low- calorie drinks. Often multiple KPIs will be tested.
  • ESG Scores – we have seen deals where there is an overall ESG score provided by a third-party rating agency either as a standalone test or combined with other KPIs.

A pricing adjustment in relation to sustainability performance can be directly linked to the financial risks to the borrower’s business of non-compliance with sustainability goals. It will be interesting to see if comparisons will start to be made between borrowers in the same sectors – and whether the required level of consistency of disclosure, testing and reporting will exist for that to happen.

Conclusion
The growth in sustainable financing has been a marked high note in a challenging market. This is particularly the case in the investment-grade space and real estate financing and many commentators think this may also become a more prevalent feature of the leveraged loans market in the year ahead. Recently we have also seen the first capital call financing for a fund documented on this basis which is an interesting development. The ESG and sustainability agenda is centre stage around the world and it seems clear that the loans market will continue to innovate in structuring the terms of financings to play its part in this development.

For more information, please visit www.cliffordchance.com/greeneconomy to read our full publication.

About the authors

Jackie Jones
Jackie Jones has experience across all aspects of bank lending, acquisition finance and syndicated lending with a particular emphasis on trade and commodity finance and asset-based lending.

 

 

 

 

 

 

Boudewijn Vermeer
Boudewijn Vermeer specialises in domestic and cross-border leveraged finance and general corporate lending. Boudewijn acts for lenders as well as borrowers. He is also involved in corporate treasury initiatives and is a board member of the Dutch Association of Corporate Treasurers (DACT) since March.

Jackie and Boudewijn are key members of the Clifford Chance Amsterdam team, leading various initiatives relating to sustainability issues and more particularly their impact on finance products.