In the later stages of the global pandemic, the importance of a green recovery has been emphasised across the globe, and ESG principles have permeated almost every aspect of life, including the financial markets. However, the acronym ESG has an enormously wide scope: where the move to net zero carbon emissions may be a longer term aspiration for some industries, movement towards smaller scale environmental improvements and on the social and governance side may be far more achievable.
As Mark Carney said in 2019: “Achieving net zero emissions will require a whole economy transition – every company, every bank, every insurer and investor will have to adjust their business models…this isn’t about funding only deep green activities or blacklisting dark brown ones…We need fifty shades of green to catalyse and support all companies toward net zero.”
This sentiment is being reflected in the nuances of much of the legislation, regulation and “soft law” being established now. The development of sustainability-linked loans to sit alongside the more mature green loans market has been one of the success stories of recent years. These are loans for general corporate purposes, which usually have a relatively small incremental pricing benefit for reaching certain targets. In contrast, the narrower green loan products are intended for use in a dedicated ESG project, with a mandated ESG-related use of proceeds.
The need for private investment in creating a green economy
Sustainable finance will be a key part of creating a green economy. There are two fundamental questions in sustainable investment:
- How do you determine if an economic activity is environmentally sustainable in an objective way?
- How do you ensure that there is some accountability for companies and financial institutions in relation to their sustainability activities?
The raft of legislation across jurisdictions can provide the means to answer these questions and assist in developing a robust scaffolding for sustainable finance which will stand up to scrutiny.
The EU set out its Green Deal in December of last year: this is a plan for making the economy sustainable. It recognises that private investment will be needed, alongside public funds, in order to meet the EU’s sustainability goals and, to assist this, the EU has developed a Sustainable Finance Package which applies to financial market participants and addresses the questions above.
The EU Taxonomy Regulation sets out how a decision is made as to which economic activities are environmentally sustainable. It goes some way to contemplate the numerous shades of green that Mark Carney referred to: an activity will be assessed as to whether it substantially contributes to at least one of six environmental objectives, being climate change mitigation; climate change adaptation; protection of water and marine resources; transition to a circular economy; protection and restoration of biodiversity and ecosystems; and pollution prevention and control. Further, that activity must do no significant harm to any of the other five environmental objectives mentioned, and must comply with minimum safeguards, for example the UN guiding principles on business and human rights. There are also various pieces of EU legislation aimed at disclosure and reporting requirements to address the transparency issue.
In the UK’s Green Finance Strategy there is a real commitment to wide-ranging sustainable finance and an understanding of the importance of the “green spectrum”. The UK has committed to match or exceed the EU sustainable finance plan in terms of its concepts and its function in preventing greenwashing and is pressing ahead with a number of more detailed strands of the Green Finance Strategy. Further, the Bank of England has recognised (in common with many financial institutions) that the risks from climate change are financial risks like any other, and the need for an orderly market transition to a low-carbon economy is key. This means that there is increasingly regulatory pressure, as well as governmental and societal, to maintain the sustainability improvements already started.
More recently, UK Prime Minister Boris Johnson has set out a 10-point plan for a “green industrial revolution”. The government-funded numbers put forward in that plan indicate a need for considerable private sector funding, a large part of which will be debt.
The development of sustainability-linked loans
It is crucial that loans which are badged as sustainability-linked are not at risk of accusations of greenwashing (or sustainability-washing), and are sufficiently robust to stand up to external scrutiny. The LMA, APLMA and LSTA have jointly produced the Sustainability-Linked Loan Principles, which are a set of high-level market standards to promote the development and integrity of the new loan products by encouraging consistency while recognising the importance of flexibility, which have provided a helpful starting point in this area.
Sustainability-linked loans are generally structured as a revolving credit facility for general corporate purposes, with a small incremental pricing benefit to the borrower for meeting certain sustainability targets in its business.
They have four main objectives, which broadly fall into two categories:
- the requirement for the borrower and its lenders to set ambitious and meaningful sustainability performance targets (SPTs), which are core to the borrower’s business, for the borrower to meet and which should fit in with the borrower’s own broader CSR objectives and strategy; and
- the need for transparency in determining whether those SPTs have been met, through both the borrower’s reporting obligations and an external review or audit to verify the borrower’s performance against the SPTs.
The examples of SPTs which are suggested in the Principles are wide-ranging in scope, though generally quite focussed on the “E” rather than the (arguably harder to measure and quantify) “S” and “G”:
- improvements in the energy efficiency rating of buildings or plant owned or leased by the borrower;
- reductions in greenhouse gas emissions in relation to products manufactured or sold by the borrower or
- to the production or manufacturing cycle;
- increases in the amount of renewable energy generated or used by the borrower;
- water savings made by the borrower;
- increases in the use of verified sustainable raw materials and supplies in sustainable sourcing;
- promoting a circular economy by increases in recycling rates or use of recycled raw materials or
- improvements in conservation and protection of biodiversity; or
- improvements in the borrower’s ESG rating or achievement of an ESG certification.
It is important that the targets are seen to be stretching for the borrower in order for the Principles to be adhered to, and are not just business-as-usual incremental improvements. They need to be material to the borrower’s business, and to have scope for improvement, so may take some consideration.
The performance targets (and the KPIs by which they are measured) may be externally set, as sectorspecific or industry-wide metrics. And this approach may be more suitable for loans which might be at a greater risk of challenge as to their sustainability credentials. For example, SBM Offshore’s RCF, announced in March 2019, was linked to the company’s ESG performance rating as measured by Sustainalytics, an independent third party ESG ratings provider.
Where a company has a sophisticated sustainability strategy, and is borrowing at a corporate level for use as a backstop facility, it may prefer (and the banks may be willing) to link any relevant facility to its own strategic goals. Shell’s USD 10 billion facility from December 2019, as well as including a switch to near risk-free rates, was notable because it was also linked to Shell’s existing short-term Net Carbon Footprint targets, which are a measure of the emissions intensity of the products that they sell, including greenhouse gas emissions. Other examples include, for a food and drink manufacturer, the use of more energy-efficient refrigerators or the percentage of packaging collected for recycling.
The lenders will, of course, need to agree that the SPTs and metrics are appropriately stretching to justify a decrease in margin.
If the targets are not met, the margin will increase. One question, if it increases above the original level, is whether there is a penalty for failure to meet the targets. If so, it is possible that the additional cost of servicing the facility could be diverted into improving the borrower’s ESG performance, since many lenders may not think it appropriate to benefit from a borrower’s failure to meet its sustainability targets.
It would not be usual for the failure to meet a sustainability-linked target (or KPI) to constitute a default in a sustainability-linked loan, though of course the provision of inaccurate information or a breach of a general reporting obligation may be a standard breach of covenant leading to an event of default.
In longer-term facilities, there may be the ability to update targets over time, or where there is a significant change to the borrower’s business by way of acquisition, large asset disposal, or significant regulatory change, for example.
Recognition of the many shades of green
It is important to note that sustainability-linked loans are not limited to what might classically be considered green or renewable energy companies and projects. Indeed, companies and projects which are clearly in those sectors are more likely either not to require the badge of a particular financing product (a wind farm is inherently linked to sustainability) or to access the separate green loan or green bond markets or designated government support. As will be apparent from some of the examples above, sustainability-linked loans have been raised by oil and gas, shipping and manufacturing companies. The product, focussing as it does on identifiable incremental improvements to businesses, rather than on their particular type or sector, is very well suited to such borrowers.
There is a widely held misperception that oil and gas companies have no place in the development of a lowcarbon future. The truth is that for many years to come, the world will remain heavily reliant on oil and gas even if every effort is made to reduce that reliance. Some of the greatest gains in reduction of emissions can be made by improvements in the oil and gas sector, such as operational efficiency, reduction in flaring of gas or other associated emissions and electrification of offshore operations. Oil and gas companies are also fundamental to the development of hydrogen production and transmission and carbon capture and storage. The transition to being a more sustainable business as part of a rapidly changing energy sector is central to the agenda of many oil and gas companies and the sustainability-linked loan product provides a useful opportunity for stakeholders in those businesses, and other energy-intensive industries, to encourage that agenda and hold such companies to account.
Transparency, reporting and disclosure
Transparency is also key. The satisfaction of the reporting requirement for the loan ESG metrics is clearly much more straightforward where the company is obliged to report on its sustainability in any case. Many companies are already subject to a number of non-financial reporting requirements relating to ESG issues, some dictated by industry bodies and voluntary codes and others prescribed by law. Coupled with increasing investor demand for enhanced disclosure of sustainability-related information, these requirements will affect private companies as well as public. Both the UK and the EU have already expressed an intention to impose reporting requirements pursuant to their respective sustainable finance strategies, and the UK has gone further by this month publishing a roadmap to mandatory Taskforce on Climate-Related Financial Disclosures (TCFD)-aligned disclosures across financial and non-financial sectors. Disclosure requirements and other regulatory requirements will, of course, also affect lenders and the loan products that they offer.
There is, so far, no single globally accepted methodology for reporting on SPTs, though several exist in the market. The one chosen will depend on the nature of the SPTs and the borrower. However, the usual position is that borrowers should be required to report on their SPTs at least once a year, if not twice, and to provide details of any underlying methodology and assumptions (and an analysis of how the methodology differs from any previous years, analogous to frozen GAAP). This reporting may sit with the audited financial statements, and public reporting is encouraged.
The borrower’s internal expertise in determining the satisfaction of its KPIs and sustainability targets will be a consideration for lenders. Where there is a requirement for the borrower to report publicly in the ordinary course, for example to a regulator, the lenders may not require third party verification.
Where the sustainability performance criteria are linked to an independent ESG rating or other externally moderated criterion, the verification will form part of the process in any event. There will also be some loans that are linked to the borrower’s own internal SPTs, but where a third party review or audit is thought to be necessary or helpful in evidencing the genuine sustainability-linked nature of the financing. The use of a third party will add to the cost and time burden on the borrower of servicing the loan.
A lender will usually be appointed as an ESG co-ordinator or agent, to help the borrower set the sustainability performance targets and monitor compliance with them, and performance of this role will attract a fee.
An adjunct to progress in sustainable practices
Sustainability-linked loans are interesting in that they increase focus on improving sustainability in the business: the relatively small increments in margin at stake mean that they are unlikely to be chosen solely for financial reasons. Few companies would want to admit to their lenders (or investors) that they had failed to meet the relevant target, so they have an important moral imperative if not a significant financial one. They also provide a mechanism for independent review by third parties of the satisfaction of sustainability criteria, and may be a useful demonstration of the commitment of a company to improving its ESG performance.
We expect to see this market develop considerably in the next 12 months, particularly in light of the raft of policies being announced by the UK government and the EU, including the highly anticipated UK Energy White Paper and Hydrogen Strategy, and of course the green recovery driving sustainability to the front of the minds of businesses, lenders and investors.
Please do speak to one of our team to discuss if helpful, and to see how sustainability-linked loans, or other ESG requirements, may be relevant for your business.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2021