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Sustainability Linked Loans

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Recently, Norsk Hydro ASA signed a USD 1,600 million revolving multi-currency revolving credit facility. This facility had a twist – the margin is linked to Hydro’s progress in reducing greenhouse gas emissions by 10% by the end of 2025. In this article, we will have a closer look at these types of Sustainability Linked Loans (“SSLs”) and the related Sustainability Linked Loan Principles (“SLLP”) that were launched earlier this year.
Monday, December 30, 2019

Authors: Ylva Cornelia Axelsen and Friedrich-Maximilian Scriba

What are Sustainability Linked Loans?

SSL’s are a fairly recent addition to the sustainable finance products family. The first SSL was issued to Philips in 2017. The interest on this €1 billion loan was linked to Philips’ ESG rating by the rating firm Sustainalytics.

SLLs are loans that incentivise borrowers to improve either their overall Environmental, Social and Governance (“ESG”) performance, or certain aspects of ESG.

Whereas green loans are given to finance green projects, SLLs do not limit the purpose of the loan to certain projects or investments – typically SLLs are used for general corporate purposes.

SSL’s also have a wider scope than green loans. Whereas green loans are linked to environmental benefits, SSL’s are used also for a wider range of sustainability objectives, including social and governance related benefits. The positive effect on sustainability is reached by linking the interest rate to so-called Sustainability Performance Targets (“SPTs”). The loans typically have a margin ratchet linked to the level of fulfilment of SPTs, whereby the loan may become cheaper or more expensive depending on to what extent and how quickly the company is able to meet the relevant target thresholds.

Why use the Sustainability Linked Loan Principles?

To prevent “green-washing” and preserve the integrity of SSL’s, it was necessary to develop a common framework for such loan products. The Sustainability Linked Loan Principles (“SLLP”) were published in March 2019 by the Loan Market Association (“LMA”) (covering Europe, Middle East and Africa), the Asia Pacific Loan Market Association (“APLMA”) and the Loan Syndications and Trading Association (“LSTA”) (covering the U.S.).

As voluntary, non-binding principles, the SLLP give guidance regarding the use and the structure of SLLs. They aim at a broad market use but should always be applied deal-by-deal. Being developed jointly by the three major Loan Associations demonstrates a broad market acceptance which gives the principles credibility.

What is the content of the Sustainability Linked Loan Principles?

The SLLP’s framework focuses on four core components:

1. Borrowers CSR strategy

2. Target Setting

3. Reporting

4. Review

1. CSR Strategy

Firstly, the borrower must clearly communicate to its lenders its sustainability objectives, integrated in its corporate and social responsibility strategy (“CSR strategy”), and how these align with the proposed Sustainability Performance Targets.

2. Target Setting

Secondly, the SLLP propose some measures for setting the SPTs right, which is crucial for a successfully arranged SSL.  The SPTs should be ambitious, meaningful to the borrower’s business, and shall apply for the life of the loan.

Further, SPT’s should be tied to sustainability improvement based on predetermined performance target benchmarks. Such benchmarks should be linked to recent (previous 6-12 months) performance of the borrower.

The Borrower may either define its own SPT’s (based on its overall sustainability strategy) or the SPT’s may be set by external, independent providers against external rating criteria. The SLLP also introduce the concept of “Sustainability Coordinators” that may support the borrower in negotiations. The SLLP emphasise the importance of third-party opinion to determine the appropriateness of the SPTs.

3. Reporting

Reporting is an essential part of the SLLP. Transparency itself often is a part of CSR strategies – that’s why the borrower should give regular updates regarding the its performance in relation to the SPTs - at least once a year. The borrower should also make and keep readily available up to date information concerning its SPTs (such as any external ESG ratings). When appropriate, relevant information can also be reported privately to the company’s lenders.

4. Review

Fourthly, the SLLP focus on external review of the borrower’s performance. Where information is publicly available, lenders might find it sufficient relying on this information. The SLLP recommend independent third-party review. If external review is not sought, borrowers need to demonstrate their internal expertise and capability to validate the calculation of its performance against its SPTs. The information provided will then be evaluated by the lenders.

What are common categories of SPTs?

In its Appendix 1, the SLLP list the following examples of SPTs:

Category Example

Energy efficiency

Improvements in the energy efficiency rating of buildings and/or machinery owned or leased by the borrower.

Greenhouse gas emissions

Reductions in greenhouse gas emissions in relation to products manufactured or sold by the borrower or to the production or manufacturing cycle.

Renewable energy

Increases in the amount of renewable energy generated or used by the borrower.

Water consumption

Water savings made by the borrower.

Affordable housing

Increases in the number of affordable housing units developed by the borrower.

Sustainable sourcing

Increases in the use of verified sustainable raw materials/supplies.

Circular economy

Increases in recycling rates or use of recycled raw materials/supplies.

Sustainable farming and food

Improvements in sourcing/producing sustainable products and/or quality products (using appropriate labels or certifications).

Biodiversity

Improvements in conservation and protection of biodiversity.

Global ESG assessment

Improvements in the borrower’s ESG rating and/or achievement of a recognised ESG certification.

What do the SLLP not provide?

The SLLP do not provide a set of definitions or taxonomy related to what is “sustainable”. Neither does it contain a template for an SSL loan agreement, or specific SSL clauses or riders. There is ongoing comprehensive work with developing and finalising the EU Taxonomy Regulation, which seeks to provide a common language for what is “green” (see our previous newsletters [1]). This is likely to also be used by SSL borrowers and lenders in relation to SPTs with environmental scope. However, there is at present no globally accepted taxonomy for wider sustainability concepts.

Why is Sustainability Linked Loans attractive?

  • Flexibility: As the SSL is for general corporate purposes, the use of proceeds is not restricted to a specific project or purpose. Further, it is not only for environmental causes, but links to wider sustainability objectives. This gives SSL’s a wider range of use than traditional “green” loans, and may thus be attractive for a broader scope of borrowers as well and lenders.

  • Beneficial pricing and risk: As loan margins will reduce when SPT’s are met, this type of loan gives the borrower the opportunity to reduce its financing costs. To lenders, a two-way margin grid could ensure that failure to meet SPT’s sanctioned by higher margins (and/or mandatory prepayments of the loan). More recent studies also indicate a correlation between high ESG performance and high financial performance, which would mean lower credit risk for lenders [2]. As sustainable lending is to an increasing degree becoming part of bank’s lending strategies, SSL’s may be an attractive product.

  • Regulatory pole position: Generally, there is increasing pressure from legislators, lenders, the public and shareholders to focus more on sustainability. For both borrowers and lenders, SLLs may contribute to increased expertise, procedures and risk assessment capabilities in relation to ESG and sustainability, which will be advantageous as new laws and regulations on marketing, reporting and transparency related to sustainable financial products are introduced and come into force.

  • Reputational advantage and investor attractiveness: Sustainable investing has grown significantly over the last decade. The ability to detect and manage climate related risks and commit to a broader sustainability shift can have a real impact on a company’s reputation. Both borrowers and lenders can reduce reputational risk and increase their attractiveness with existing and potential investors by having established clear objectives, defined policies, measurable targets and transparent, verifiable performance measurement in relation to sustainability. Sustainability linked loans, based on the SLLP, may be a valuable component for an enhanced sustainability profile.

What development are we expecting?

In just one year, from 2017 to 2018, the volume of the global SSL market increased eightfold, from around USD 5bn to USD 40bn. Mid-November 2019, the total issuance of SSL’s had rocketed to USD 108 billion. This rapid embrace by the market of the SSL strongly indicates it will continue to be an important instrument in sustainable finance going forward.

SLLs are an attractive possibility for both borrowers and lenders, and variations of the SSL have been developed by the market in forms of capital call financings and sustainability derivative products. With common taxonomy standards being adopted by the markets, and increased legislation in respect of transparency and marketing, market participants’ confidence in the product is likely to increase, with increased demand to follow.

Examples of other recent SSL issuances:

 

Shipping:

  • NYK Line
  • JPY 50bn
  • MUFG Bank Ltd. and others

Retail:

  • Prada
  • EUR 50m
  • Credit Agricole

Real estate:

  • Optivo
  • GBP 50m
  • BNP Paribas

Agriculture:

  • Yara
  • USD 1.1 bn
  • Citibank and others

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Ylva  Cornelia Axelsen
Ylva Cornelia Axelsen
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Oslo
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