Sustainable finance: New guidance on Sustainability Linked Loan Principles
Sustainable finance is becoming an increasingly significant aspect of the finance market. New guidance has now been produced by the Loan Market Association to support the Sustainability Linked Loan Principles published in 2019.
The Sustainability Linked Loan Principles (SLLP) were originally published in 2019 to provide a framework to this growing area of finance. New guidance was published in May 2020 to provide clarity on the application of the SLLP, in order to promote a harmonised approach and to assist the development of sustainability linked loans (SLLs).
Sustainability linked loans - summary
SLLs can be any type of loan financing (e.g. term loan, revolving credit facility) where there is an economic impact linked to the borrower's achievement of pre-determined sustainability performance targets (SPTs).
There are a number of advantages for borrowers and lenders to entering into SLLs, including (but not limited to):
- promoting sustainable long term growth and profitability;
- positive impact on reputation and creditability; and
- incorporating economic, social and governance (ESG) performance into lenders’ credit assessments.
Four core components of the SLLP
A SLL can be made to any entity that may borrow in the bilateral or syndicated loan market and which has a sustainability strategy, provided it is aligned with the four core components of the SLLP.
1) Relationship to borrower's overall sustainability strategy
SLLs are intended to enhance a borrower's existing sustainability strategy. They are seen as a good 'transition tool' as they seek to incentivise more sustainable business models.
A SLL will reward a company for achieving the goals set out in its sustainability strategy. However, should the company fail to meet these targets then any previously achieved incentive ceases to be awarded from that point and a margin premium may be payable.
2) Target setting
The relevant metrics and SPTs will be negotiated and decided between the borrower and the lender. Metrics to be used in the SLL need to be suitably meaningful, measurable, core to the borrower's overall business, externally verifiable and able to be benchmarked.
SPTs (which will be set against key performance indicators (KPIs)) will be tied to one or more ESG considerations.
SPTs can be either (1) internal and bespoke to the borrower's business or (2) external and set against a borrower's ESG performance (or a combination of both).
An important way to ensure that SPTs are core to the borrower's business is to map targets against a materiality assessment of the borrower, or at least of its industry.
There is currently no globally accepted method for reporting on SPTs, however borrowers should report on their SPTs at least once a year and may decide to make their methodology available. The guidance highlights that public reporting is encouraged.
Several sustainability reporting methodologies exist in the market (e.g. Global Reporting Initiative's Sustainability Reporting Standards) which provide widely adopted global standards for sustainability reporting.
4) Review of SSLs
External reviewers can intervene pre-signing or post-signing and the need for external review is considered on a deal-by-deal basis.
Pre-signing in relation to a SLL: parties may wish to seek externally an opinion to:
- confirm the alignment of their SLL with the core components of the SLLP;
- assess the meaningfulness, credibility and ambition on the selected SPT(s); and
- put SPT(s) in the wider ESG picture to ensure that SPT achievement is not overshadowed by the negative effects of other practices by the borrower.
Post-signing in relation to a SLL: it is strongly recommended that borrowers seek external review of their performance.
Where a review is required, parties will negotiate on a case-by-case basis whether the relevant external report needs to be re-issued with each borrowing.
What is the difference between a SLL and a green loan?
The guidance clarifies that the fundamental determinant of a green loan is the use of loan proceeds for 'Green Projects' (e.g. renewable energy, energy efficiency in buildings), whereas the focus for SLLs is incentivising the borrower to improve its sustainability profile. This is done by aligning the terms of the loan with agreed, material and ambitious, pre-determined SPTs. Use of proceeds in SLLs is not a key factor.
A loan can follow both the Green Loan Principles and the SLLP, however such transactions are rare in the market.
ICMA high-level definitions
The International Capital Market Association (ICMA) has highlighted the need for consistency on terminology in a paper published in May 2020 ('Sustainable Finance: High-level definitions').
The paper provides helpful summaries of key terms linked to sustainable and green finance and stresses that these are required in order to encourage consistency in terms used and to prevent dilution of the urgency and progress made in various green and sustainable growth policy goals.
Of particular interest are the following definitions:
- Sustainable finance is defined as incorporating climate, green and social finance while also adding wider considerations concerning the longer-term sustainability of the borrower organisations, as well as the role and stability of the overall financial system in which they operate.
- Social finance is defined as involving actions that mitigate against specific social issues, including in the affordable housing and healthcare sectors, which will be of particular significance to both borrowers and lenders in those sectors.
The new guidance produced supports the Sustainability Linked Loan Principles and helps to explain how borrowers and lenders will approach sustainability linked loans in practice. As this becomes an ever more important focus in the finance market, there will be more clarity on target setting, reporting on and reviewing sustainability targets and incentivising borrowers to implement meaningful sustainability strategies into their business plans.