Sustainability linked loans – Will recent LMA changes affect their popularity?
The social housing sector has enthusiastically embraced green, social and sustainable financing. Over the past few years sustainable financing has gone from being a niche area of funding to one of the most prevalent sources of funding for housing providers.
Banks, eager to showcase their ESG credentials to their stakeholders, have been keen to build up a portfolio of green, social and sustainability linked loans (SLLs) in the sector. Of the ESG finance products available to registered providers SLLs have, to date, proven to be the most popular.
Why have sustainability linked loans proved popular?
Under a sustainability linked loan the proceeds of the loan may be used by the borrower for any purpose (contrasting to a green loan where the proceeds must be used for a green purpose) and the margin under the SLL is linked to ESG metrics and sustainability performance targets (SPTs) set by the borrower. If the borrower meets the required metrics/SPTs for the year the margin under their SLL will reduce. In the sector one way margin ratchets are usual as banks have indicated an unwillingness to be seen to be profiting off housing providers failing to meet their targets by introducing two-way margin ratchets (where if the metrics under the facility are not met the margin would increase). SLLs must be drafted in accordance with the Loan Market Association Sustainability-Linked Loan Principles (SLLPs).
SLLs were very popular (to the extent that the vast majority of new 5-7 year money in the sector was sustainability linked) as the borrower could set its own targets and the banks were happy to sign up to SLLs and allow borrowers time to come up with the best set of metrics for them. However, at the beginning of March the LMA revised the SLLPs to make them much more stringent.
What is charging?
Under the new SLLPs any ESG metrics set by a borrower under an SLL must now be (a) material to the borrower’s core sustainability/business strategy, (b) measurable on a consistent methodological basis, (c) be able to be benchmarked and (d) have high strategic significance to the borrower’s current/future operations as well as address the relevant ESG challenges of the borrower's sector. The ESG metrics must be seen to be "credible" so as not to undermine investor confidence in the product.
The SPTs under an SLL must be set in good faith and remain both relevant and ambitious throughout the life of the loan. Annual SPTs should be set and should represent a material improvement in the ESG metrics chosen by the borrower. The borrower must aim for stretching targets which are beyond mere “business as usual”. Again, the SPTs need to be capable of being benchmarked and need to be core to the borrower's sustainability strategy. Science based SPTs are recommended.
The SLLPs now recommend that borrowers seek a second party opinion (from an ESG rating agency or second party opinion provider) or an assessment of their chosen metrics/SPTs before signing up to an SLL. Post signing verification is also required. External reviewers will be asked to assess the relevance, robustness, and reliability of the chosen ESG metrics, the rationale and level of ambition of the proposed SPTs, the relevance and reliability of the selected benchmarks, and the credibility of the organisation's ESG strategy.
How might this impact on their property in the future?
This is all a far cry from the more relaxed SLLs housing providers initially entered into in the sector. Those loans required ESG metrics and SPTs but were much more flexible as funders understood that the sector's approach to ESG was evolving and that not everyone had an ESG strategy in place yet. The recent change in the SLLPs will result in funders needing to include much more stringent provisions in their sustainability linked arrangements so as not to fall foul of the new guidelines. The requirement for both pre signing and post signing verification by an external third party of the metrics/SPTs also potentially significantly increases the cost of the product.
This is likely to affect the popularity of SLLs in the sector. While they come with a pricing benefit in terms of annual margin reduction that pricing benefit is very small. It may be that funders in the sector will need to offer a "Greenium" - a much higher margin reduction or pricing benefit in order to maintain borrower interest in sustainability linked loan arrangements in the future.