With the rising emergence of environmental, social and governance (ESG) initiatives globally in recent years, lenders and borrowers have collaborated to create new financial instruments that incentivize borrowers to achieve the ESG-related goals of their business. The sustainability-linked loan (SLL) product is one of these financial instruments, and takes the form of bonding lines of credit, guarantee lines of credit and letters of credit. SLLs are structured to permit borrowers to use the loan proceeds for general business purposes as the terms are tied directly to the borrowers’ ESG-related performance. Furthermore, SLLs may be an attractive option to companies that have “green initiatives” in their business plans and are looking to cash in on what they are already doing by accessing the growing market for SLLs, as well as commercial and investment bank clients who are looking to show their commitment to their corporate customers geared towards green initiatives and sustainability. The following is a brief overview of this new loan product.
SLLs are different than traditional “green loans.” SLLs are more inclusive than green loans and open the sustainable loan market to companies that lack green assets and projects, but have the ability to decrease their environmental footprint. SLL borrowers will earn a discount or be charged a premium, respectively, on loan pricing based on whether their ESG related goals are met.
The Loan Syndications and Trading Association published SLL principles (SSLP) in March 2019, fostering credibility to the rapidly expanding SLL market. Since that time, SLLs have exceeded green loans in volume. There are four (4) main components to SLLP. The first component of the SLLP is the borrower’s selection of predetermined key performance indicators (KPI). Some of the most common KPIs consist of the following: energy efficiency, greenhouse gas emissions, affordable housing, employee health and safety, business ethics, and the relationship of the borrower’s ESG goals to its overall corporate social responsibility. KPIs should be aligned with both the borrower’s sustainability goals and business strategy.
The borrower’s performance is then measured using predetermined sustainability performance targets (SPT) agreed upon by the borrower and lender. SPTs are the second core component of the SLLP. SPTs can be internal and defined by the borrower; or external and defined by independent providers against external rating criteria.
The third and fourth core components of SLLP are reporting and verification. SLL borrowers must report their sustainability performance annually and show their compliance with the SPTs. Further, borrowers must obtain independent verification of their performance against each SPT for each KPI. Reporting and verification are often required to be public information. The lender then evaluates borrowers’ performance based on the information provided.
The failure to meet SPTs and/or report performance will not be considered a default under the SLL. Rather, the only consequence of reaching or failing to meet the SPTs is a change in the margin. The formulation in adjustment is a matter of negotiation with the lender during the outset of the loan process. The adjustment in the margin is typically de minimus. As such, the driving factor for choosing a SLL loan facility is the alignment of the financing in forwarding the company’s commitment to its ESG goals and sustainability objectives.
Currently, Europe accounts for 70% of the global ESG-linked loans every year. Bloomberg News reported in May 2021 that U.S. loans with terms tied to sustainability goals have increased in volume by 292% since 2020. SLL issuance did slow down during the coronavirus pandemic as companies’ attention was diverted to urgent matters. However, between January and May 2021, $52 billion in SLLs have been funded. The funding of green loans has remained stagnant. As the world moves towards more green initiatives, the issuance of SLL loans is expected to continue to rise.
Nevertheless, there have been some concerns in the U.S. regarding fund managers trying to capitalize on the popularity of ESG investing. In an attempt to address these concerns, the U.S. Securities and Exchange Commission (SEC) is considering enhanced reporting requirements for ESG investments in order to minimize “greenwashing,” that is, deceptive reporting of ESG targets and compliance. Whatever the outcome from a legislative or regulatory perspective concerning ESG related matters, SLLs allow businesses to demonstrate their readiness to meet ESG-related targets. Further, SLLs provide businesses experience in tracking, monitoring and reporting their progress on sustainability targets, which in turn could provide greater transparency and accountability to investors. Ultimately, the SLL loan market appears poised to make huge strides as it matures into a leading asset class here in the U.S.
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