With the focus on sustainability by governments, businesses, investors and financial intermediaries, environmental, social and governance (“ESG”) principles are more important than ever. The explosion in net zero emission commitments by companies and countries to slow global warming under the Paris Agreement is met by a rapid increase in sustainable debt financing of US $ 160 billion in 2019 to 750 billion US dollars in 2020 to more than 2 US dollars. trillion in the first five months of 2021 alone, according to Bloomberg.1 Lenders work with national and multinational borrowers in industries as diverse as water, aviation, and food and beverage to incorporate innovative debt financing terms. This article will provide an overview of the main directions endorsed by loan market associations and discuss some of the mechanisms for using credit pricing to incentivize sustainable behavior.
OVERVIEW OF SUSTAINABLE LENDING GUIDELINES
The Sustainability Lending Principles and Guidance Notes that were jointly published by the Loan Market Association, the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association in 2019 and updated in May 2021 shape the structures and documentation of transactions worldwide. There are two methods by which a business can tap into the “green” loan market. A method is a green loan (a “GL”), which is a type of loan instrument made available to finance a green project in categories such as renewable energy, energy efficiency, pollution prevention and control, adaptation climate change, green buildings and other related categories. A GL should follow a clear framework consisting of four elements: (1) the use of funds for a specific green project reflecting the use of loan funds, (2) the project appraisal and selection process, (3) ) the management of the products that will be tracked by the borrower to maintain transparency, and (4) the reporting process by which the borrower will keep developments on the project readily available. GLs can be incorporated into various types of lending instruments, including term loans and revolving credit facilities.
Rather, the second method has a wider applicability and is called a sustainability loan (“SLL”). An SLL, which is the subject of this article, uses a behavior-based model by setting performance targets within a company’s debt instrument. This type of loan facility, which originated in European credit markets, has grown in popularity exponentially in the United States since the pandemic. Due to a green policy by President Joe Biden, ESG lending is booming in US markets, alongside greater awareness of social justice.2 Instead of specifying the use of the loan proceeds, an SLL seeks to incentivize the improvement of a borrower’s overall sustainability profile by meeting pre-determined and ambitious sustainability performance goals (“SPTs”). SPTs are measured and monitored throughout the life of the loan using predefined key performance indicators (“KPIs”). Once these SPTs are met, the business will be rewarded with a reduced price on its credit facility. Otherwise, if SPTs are not met, the borrower may face increased interest rate spreads. Although an event of default is not triggered under the loan agreement, a company could face serious reputation scrutiny from its investors or product users who wish to invest in securities. ESG-friendly companies and use ESG-friendly products.
REMAIN SUSTAINABLE THROUGHOUT THE LIFE OF A LOAN
For an SLL, one of the primary or transaction organizer banks will serve as the “sustainability coordinator” for the group of lenders to identify and monitor SPTs throughout the life of the loan. In addition, a member of the lender group can be appointed as a “sustainability structuring agent” and play a leading role for the lender group in negotiating, monitoring and validating SPTs. SPTs should be: (1) internal and tailored to the borrower’s business; (2) external and compared to a borrower’s ESG performance over time – with a minimum measurement period of three years (if possible) – against its peers, as determined by an external assessor; (3) set by reference to science or to national, regional or international objectives; or (4) a combination of any of these.3 The loan documents will then motivate a business to achieve these metrics by offering a reduction in interest rates, which is typically adjusted once a year. The price list linked to the SPTs can be agreed upon at the origination of the loan or by an amendment after the initial closing.4
Examples of SPT include environmental goals such as emission reduction, water use, renewable energy use and carbon. Social and governance objectives have also been implemented in debt instruments, offering reduced margin pricing to improve the quality of staff training, enhanced security for team members and even reduced risk. data security breach. Regardless of the type or category of target chosen, SPTs must represent an ambitious and meaningful objective for the borrower. Industry SLL guidelines recommend increased diligence and cooperation with borrowers to determine appropriate “stretch” goals to ensure that goal achievement will have an impact. In addition to leveraging a borrower’s understanding and perspective on their industry and their own performance, the guide further recommends consulting third-party sources, such as the Sustainability Accounting Standards Boards or similar ESG rating agencies. .
With the help of the sustainability coordinator, KPIs will be defined to monitor the borrower’s SPTs. KPIs can include external ratings or equivalent metrics, and they vary by industry and geography. These KPIs should be easily compared by reference to regulatory standards, industry standards, or international agreements such as the Paris Agreement. The mechanism for measuring borrower improvement can be either absolute or percentage. A borrower will report at least once a year to the sustainability coordinator to verify that the borrower is on their SPTs. For any SSL, it is important that the parties include key performance indicators in the loan agreement, with clear ratchets and targets, to facilitate syndication of the loan facility. Publication of performance is recommended so that investors receive transparent data and information. However, some borrowers may choose to keep this information private.
It is important to note that there may be consequences in the debt instrument for non-compliance with SPTs. For example, margin adjustments may grant a reduction of 5 basis points when all SPTs are met, but the margin adjustment may increase by a comparable amount if no SPT is reached during the reporting period. . While failure to comply with a SPT would not directly result in an “event of default”, in some situations, failure to report in a timely manner or reporting inaccurate SPT information may result in a violation of reporting commitments. ‘a borrower and therefore give rise to a “default event”.
These types of “green” loans currently offer unique, creative and functional strategies for a business to make environmentally friendly decisions, while generating favorable economic conditions and goodwill for its potential investors and lenders. The benefits of integrating sustainability into a company’s platform are endless: stronger, value-based relationships with investors; positive impact on reputation and credibility; strengthened ambitions for ESG performance; economic impacts that actively direct capital to investors while implementing robust sustainability strategies; a visible commitment to sustainability, long-term growth and profitability; and an increased ability to attract and retain staff who see ESG contribution as an important part of their personal and professional life. Companies should take advantage of this trending opportunity to achieve long-term sustainability while reducing interest margins.