Awareness of the environmental and social challenges facing society has increased over the past few years. Lenders are now responding by bringing both green and sustainable finance into the mainstream, offering "sustainable loans" loans which incentivise businesses to improve their environmental behaviours and sustainability performance. How do these "sustainable loans" or "sustainability linked loans" work and what are the benefits for borrowers?
What is sustainability?
Defining what "sustainability" is, is the first challenge. Sustainability means different things to different people and the same is true when talking about sustainability in business. What all sustainable businesses have in common though is a desire to make a positive impact on the environment, society or both. Many sustainable businesses adopt a three pronged strategy placing equal emphasis on the people, planet and profit:
- Preserve the environment and conserve natural resources
- Build social equity, support employee well-being and promote fair trade
- Maximise long-term profitability and promote growth.
Sustainability linked loan principles
The sustainability linked loan principles (SLLPs) were issued in March 2019 jointly by the Loan Market Association (LMA), the Asia Pacific Loan Market Association and the Loan Syndicated and Trading Association. The SLLPs define sustainability linked loans as: "any types of loan instrument and/or contingent facilities (such as bonding lines, guarantee lines and letters of credit) which incentivise the borrower's achievement of ambitious, predetermined sustainability performance objectives".
Like the green loan principles which were issued in 2018, the SLLPs are based around 4 key elements, but unlike green loans, how a business uses the proceeds of the loan does not determine whether it is a sustainability linked loan. Provided the loan documents include a pre-agreed set of sustainability performance targets the loan proceeds can be used for general corporate purposes. The targets should be ambitious and meaningful to the borrower's business and, when satisfied, result in an improvement to the borrower's sustainability profile over the life of the loan.
So what are the key characteristics of sustainability linked loans?
The SLLPs provide a framework which is based around 4 key elements:
- Relationship to a business's overall corporate social responsibility (CSR) strategy
- Target setting – measuring the sustainability of the company
- Reporting
- Review
CSR strategy
The SLLPs state that borrowers must clearly explain how the sustainability objectives set out in their overarching CSR strategy align with the performance targets set out in the loan documents. Borrowers must consider, for example, how their CSR strategy promotes community engagement and whether they have energy, carbon and waste reduction policies which could be aligned to performance targets.
Targets
Borrowers must agree a set of performance targets with their lenders, possibly with the assistance of a sustainability coordinator or a sustainability structuring agent who will help negotiate the targets. These targets should be tied to improvements against agreed benchmarks in its sustainability performance over the life of the loan. The loan terms will be aligned to performance against those targets and benchmarks. Typically, borrowers will benefit from a reduction in the margin payable on their loans when they satisfy those agreed targets. On the other hand, failing to meet those targets or going backwards can result in the margin going up. Linking sustainability performance to the terms of the loan means borrowers are incentivised to make improvements to their sustainability profile over a number of years.
The SLLPs set out a number of examples of categories and measures which could form appropriate targets including:
- Affordable housing – increases in the number of affordable housing units being developed by the borrower
- Circular economy – increases in recycling rates or the use of recycled raw materials
- Sustainable sourcing – increases in the use of verified sustainable raw materials or supplies
- Biodiversity – improvements in conservation and protection of biodiversity
- Renewable energy – increases in the amount of renewable energy generated or used by the borrower
- Energy efficiency – improvements in the energy efficiency rating of buildings and/or machinery owned and/or leased by the borrower
Reporting
To benefit from the incentives in the loan terms it is essential to report on performance at least once a year. The SLLPs state that details of performance against the pre-agreed targets should be kept up to date and be readily available to lenders. Ideally this information will be made public by a borrower via its annual reporting or through a separate CSR or sustainability report but the SLLPs acknowledge that competition and confidentiality concerns may make this difficult for some borrowers.
Review
Lenders should consider whether to require third party review of a borrower's performance. This can be negotiated on a case by case basis but the SLLPs strongly recommend this is done, especially if the borrower does not publically disclose information about its sustainability performance. External review should be carried out once a year and the results made public. If there is no external review borrowers must demonstrate that they have the appropriate internal expertise to validate performance against the targets. Borrowers must give lenders details of the process by which they will measure and report on progress and the qualifications of the person within the business who is responsible for doing this. If confidentiality and competition concerns permit, borrowers should publish the methodology for measurement in their annual report, sustainability or CSR report or via their website. Improvement in performance must be measured in both a qualitative and a quantitative way.
The cost of meeting the disclosure requirements outlined above should not be underestimated but this cost may be offset by savings arising from reduced borrowing costs under an SLLP linked loan. Studies have shown that in addressing environmental and social issues businesses can "achieve better growth and cost savings, improve their brand and reputation, strengthen stakeholder relations and boost their bottom line".
