Wojciech Herchel, Sam Taylor, Clarence Er and David Devlin consider whether sustainability-linked lending is the answer to changing corporate behaviour
Financial regulators around the world have acknowledged climate change as a key source of risk for insurers and other regulated firms. Asset managers, asset owners (such as insurers and pension funds) and individual investors are demanding that investee firms adopt strategies that align with the Paris Agreement and be transparent about their environmental, social and governance (ESG) policies.
Sustainability-linked lending (SLL), one of an increasing number of ESG-related financing products, is already approaching green bond volumes in the syndicated market; in 2021 the global issuance of green bonds and SLL was US$1.1trn and US$580bn, respectively. While SLL’s flexibility is one reason for its popularity, this flexibility might lead to accusations of greenwashing from more cynical corners.
SLL in practice
There are currently two distinct types of ESG lending: green, social and sustainable lending (GSS), and SLL. In GSS, the proceeds are to be used for a defined ESG purpose, such as green and social bonds. This is an established market that dates back to 2007 and has its own well-defined labels, standards and taxonomy. In SLL, on the other hand, the proceeds may be used for general corporate purposes. The cost of borrowing depends on performance measured against specific sustainability performance targets (SPTs) – which could include things such as greenhouse gas emission reduction.
The standard economic incentive for the borrower to deliver on SPT commitments is through a ratchet on the margin. Sustainability-linked bonds will typically have an increase (malus) in the coupon if SPTs are not met, whereas sustainability-linked loans may have either a malus or a bonus in the form of a reduced margin. The malus has a perverse incentive in that the lender benefits if the sustainability target is not met. For many sustainability-linked loans, therefore, the lender will often commit to paying the malus amount to a sustainability project or charity so that there is an ESG benefit attached to the loan regardless of whether the target is fulfilled.
The SPTs can cover a range of items and, crucially, the expectation from the principles is that the SPTs are material versus the baseline position. For example, they could include: a reduction in greenhouse gas emissions; improved employee health and safety; improved diversity and inclusion; use of more efficient energy and machinery; and reduction in workplace injuries.
It is important to understand that not delivering on the SPTs in the context of SLL is unlikely to be an event of default. However, a covenant breach may be triggered if the borrower does not deliver on its reporting obligations. This is in contrast with GSS lending, where it is more likely that not deploying the proceeds in line with the GSS target would trigger an event of default.
Before we hail SLL as the solution that will change corporate behaviour, we must ask questions about every deal (public or private, every deal is different).
While GSS financing has a defined taxonomy and rules around the strict use of proceeds, the sustainability-linked lending principles (see ‘Sustainability-linked lending principles’, below) are more flexible, and key performance indicators (KPIs) may be privately defined by the lender and borrower. This leads to questions around whether an SPT is sufficiently ambitious, material, transparent or rigorously evaluated, and whether the KPIs truly address the core issues facing that industry.
While the margin ratchets for sustainability-linked bonds typically range from 25 to 50 basis points, the equivalents in private loan markets are smaller, ranging from two to 10 basis points. This alone may be insufficient to influence ESG policies and result in limited corporate behaviour change.
As a relatively fledgling market, SLL is yet to achieve standardisation, which could lead to greenwashing. In the sub-investment grade market, there are examples of loans and bonds being called or refinanced before the SPT assessment date. SLL’s current flexibility and lack of transparency may hamper them from being accepted as transformational instruments rather than a way to opportunistically reduce funding costs, or to simply achieve publicity for the borrower.
The rapid increase in SLL can be at least partially attributed to their wide applicability. GSS lending requires funds to be used for green projects, which limits the types of companies and industries that can use them. In contrast, the broad nature of SPTs (not just ‘E’, but also ‘S’ and ‘G’) allows for many more industries to be able to use SLL. Sustainable Finance Disclosure Regulation is broadening, compelling many more companies to report on their sustainability practices. This is providing additional impetus to the burgeoning SLL market.
Furthermore, investment industry stakeholders are increasingly demanding ESG-compliant funding platforms. Originating banks must satisfy shareholders and regulators that their operations are sustainable; institutional investors such as insurance companies and pension funds are applying scientifically measurable sustainability targets for their holdings; and private equity firms are increasingly viewing ESG as value accretive, and seeing that making the whole value chain sustainable can create bigger exit multiples.
SLL provides investors with an additional avenue through which they can engage with companies on critical sustainability topics. It also gives borrowers and lenders the ability to publicise their ESG credentials as they improve their sustainability footprints. This all points to continued growth in this market.
A positive development
Green bonds and loans are the most established form of sustainable lending, and there has been rigorous attention paid to defining a credible and standardised framework. SLL is barely five years old, but volumes rival those of GSS. Work is being done to establish similarly robust standards, but the broad nature of SPTs makes this challenging.
As with other forms of sustainable lending, greenwashing is a credibility risk (whether real or perceived). Our view is that the margin ratchets for private debt will converge towards those of public debt as investors’ ESG concerns continue to grow. Lenders must be vigilant to ensure that the targets are sufficiently well-defined, material and core to their industry.
However, we believe that SLL is an overwhelmingly positive development. When it is used properly, it can align incentives between borrowers and lenders and provide an additional route by which investors can engage with companies. It offers a valuable way for both borrowers and lenders to deliver a clear message about their sustainability ambitions.
With investors increasingly demanding investee company adherence to SPTs as part of their normal investment process, SLL may be rendered transitional; only time will tell. In the meantime, it allows borrowers and lenders to meet ESG demands from regulators, investors and other stakeholders in a meaningful and objective way.
Sustainability-linked lending principles
Sustainability-linked lending principles are voluntary recommended guidelines that aim to improve the borrower’s sustainability profile over the term of the loan. They provide a framework for all market participants, based around five core components:
1: Selection of KPIs – KPIs should be material to the borrower’s business, measurable and able to be benchmarked.
2: Calibration of SPTs – SPTs should be ambitious and consistent with the firm’s ESG strategy, and should reference climate science and targets. Disclosure, reporting standards, and interim and final-stage achievements must be clear.
3: Bond/loan characteristics – What economic outcome is linked to fulfilment of the KPI (for example increased or decreased borrowing rates)?
4: Reporting – Lenders should receive transparent and suitably frequent and detailed reporting to allow monitoring.
5: Verification – Borrowers must obtain independent and external verification periodically for each SPT. Verification of the performance should be made public where appropriate.
Wojciech Herchel is head of insurance advisory EMEA at Schroders
Sam Taylor is head of the Investment Solutions team at NN Investment Partners
Clarence Er is director in the Life and Alternative Credit team at Leadenhall Capital Partners
David Devlin is annuity investment lead at Scottish Widows
All authors are members of the IFoA Private Credit Further Developments Working Party