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ESG Focus: Linked Finance The Next Big Thing – Part 6

ESG Focus | Oct 22 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: The Next Big Thing Part 5

Sustainability-linked loans are about to flood the world in a bid to ensure all those who don’t qualify for other forms of sustainable finance are drawn into the transition: big, medium and small companies; not-for-profits; SMEs; and mums and dads – every man and his dog.

-Statistics for green loans and sustainability-linked loans (SLLs)
-Recap on SLL basics and principles
-Mandatory verification upends the once private relationship-driven loan market

By Sarah Mills

Sustainability-linked loans (SLLs) are one of the more fascinating areas of sustainable finance, given the breadth of the market and its direct implications for every corporation, not-for-profit, charity, business, household and individual.

The financialisation net will draw all of the above into the sustainability drive.

S&P Global Intelligence says sustainability-linked debt has become a new asset class for investors.

For companies, it’s a mind-shift.

SLLs are expected to become the norm in the corporate and business lending market, replacing much of the existing revolving finance facilities.

While SLLs are sourced primarily from banks and private capital, there have been hints that institutions might enter the market as lenders to large companies.

The next three articles in our series on sustainability-linked finance (SLF) examine loans for big corporations and large not-for-profits and charities.

This, the first, is the 101 version, and offers a recap on SLL fundamentals, principles, and frameworks.

The second examines the entrance of institutions as SLL lenders; large issuances from different sectors; trends and innovations, such as SLLs in leveraged loans for M&A and dividend recapitalisations, the growing demand for change management; and emerging markets.

The third examines SLLs in the context of decarbonisation, checks out securitisation of carbon credits (not quite an SLL but it seemed like a good place to include it); industry challenges and the Australian market.

From there, FNArena moves to the small end of town, finalising the entire finance series with an examination of SLL for medium-sized organisations, SMEs, households and individuals. 

Massive global debt market opportunity

It is very difficult to get an accurate grip on the size of global debt and loan markets and estimates vary sharply. 

So we have included a few figures from different sources, starting with loan markets given this article is about SLLs, followed by bonds.

To provide some context, global loan issuance for 2021 is expected to roll in at nearly US$7trn, representing a compound average growth rate of 14.8%, over 2020, according to Cision PR Newswire. 

This sharp growth reflects the flow of cheap funds into the economy, thansk to covid.

Annual loan issuance in 2025 is expected to hit US$9trn, representing a compound average growth rate of 6%.

The corporate loan market typically constitutes about one third of the US$7trn figure (my estimate).

Against this backdrop sit sustainability-linked finance forecasts. 

Knowledge Sourcing Intelligence expects SLF (including bonds) to rise at a compound annual average growth rate of 98.32% to US$17trn within five years.

Global bond markets total  (outstanding debt) roughly US$120trn, according to the Securities Industry and Financial Market Association.

Global green bond issuance hit US$305.5bn in 2020, according to Sustainalytics, a drop in the ocean, compared with the total global bond market.

The Institute of International Finance in its Global Debt Monitor says broader annual global sustainable debt issuance is on track to surpass $1trn this year, up 30% from 2020, despite covid.

Nordea says the total green, social and sustainable (GSS) debt market breached $2tn in first quarter and is fast approaching $3trn.

Bloomberg Intelligence’s Global ESG 2021 Outlook forecasts more than US$3trn in global fiscal stimulus will be devoted to a green recovery, while ESG assets could top US$53trn by 2025.

Together, these figures illustrate just size of the market opportunity for sustainability-linked finance. 

SLLs shoot from the gate

SLLs are hitting the big end of town first before swiftly heading down to mid-sized corporates, SMEs and mortgages and personal loans.

More than a quarter of European leveraged term loans now have a pricing mechanism with ESG language included, according to S&P Global Market Intelligence.

Martin Hutchings from Freshfields says: “I see over the next 12 months, two years, that most loans, most corporate revolving facilities at least, will start to include an ESG adjustment.”

Nordea reports that SLL volumes are already outpacing that of green loans (their predecessors which are dedicated specifically to eligible environmental projects).

Green loans averaged less than US$10bn each year between 2017 to first half 2020.

International Finance Review reports US$158.7bn green loans were completed in May 2021. In 2020 it was US$229.3bn, according to Refinitive Deals Intelligence.

Nordea says this in part reflects the fact that green loans are competing for the same asset pool as green bonds.

And because green bonds are public instruments, most borrowers prefer to use their limited green projects for bond issuance, given the latter often yields a greenium as well as branding benefits.

“They (issuers) can then complement the bond with a sustainability-linked loan facility to further push the entity’s overall sustainability strategy,” says Nordea.

There doesn’t seem to be much of a race between green loans and SLLs, reflecting on the broader applications for SLLs.

Close to 90% of green loans are raised by only five sectors (utilities, transportation and logistics, chemicals, other industrial, food & beverage) while that number is only 40% for SLLs, reports Nordea

Globally green and sustainability bond and loan issuance totaled US$809.5bn in the first half, nearly tripling year on year.

Europe dominates the SLL market as it does with most sustainable finance.

But the US hit the market in force this year, borrowing US$122bn in the first half compared with US$19bn in the 2020 full year, according to Bank of America.

Global issuance hit US$350bn in the first six months of 2021, according to Bank of America, up from US$197bn in 2020, while green loans issuance was basically static, totaling US$42bn in the first half.

A recap on the basics

Observers believe SLLs offer huge opportunities for the smartest and most sophisticated players in the market.

SLLs allow corporations to tailor their loans to their industry, business and strategy.

SLLs have similar characteristics to sustainability-linked bonds (SLBs), which we examined in previous stories, but are in a loan format rather than a bond format.

Sustainability-linked loans have a broader application than green loans and can be used for any general corporate purpose, any sector, and can be directed to either social or green endeavours.

Like SLBs, the coupon/interest rate is linked to achieving certain green and social key performance indicators (KPIs), and specific performance targets (SPTs), largely as set by the United Nations Sustainable Development Goals (SDGs).

SLLs are loan facilities which incentivise the borrower through loan pricing to meet targets, and can involve interest-rate step-downs and interest-rate step-ups.

There is a higher probability of the inclusion of step-down coupons for outperformance in SLLs than for SLBs, particularly for large borrowers.

KPIs are written into the loan contract to ensure the company progresses against its targets.

SLLs are not required to be applied to specific projects – they can be used for any general corporate purposes so long as KPIs are met.

The loan will not default if corporations fail to deliver on sustainability metrics, only upon repayments.

SLLs are typically granted by financial institutions such as banks, or private financiers, and may require collateral in some instances but generally not at the high end of the market.

SLLs can be accessed through large syndicated finance or bilateral arrangements.

Rates and penalties and targets

SLLs may be more likely to include a step-down coupon for high performance, as well as the standard step-up penalty for failing to meet a loan’s ESG targets, but don’t get too excited.

Variations in step-down margins are limited given the low interest-rate environment to between 5-10 basis points and low credit margins for corporations.

While this can equate to hundreds of thousands of dollars for big deals it is less material for smaller loans.

This suggests the stick (usually 25bp incremental increases in rates) will be more influential than the carrot, particular for smaller lenders.

On the upside, SLLs are likely to be priced attractively for borrowers in the first instance to encourage uptake, as lenders parse out central-bank issued covid funds.

Observers expect that higher compliance costs will be offset by cheaper loans.

Regulators are being asked to incentivise SLLs by recognising that loans made to fund green assets are less exposed to climate risks, thereby requiring less capital for these loans.

At the moment though, there is no any regulation on how lenders will apply that increased margin. 

Nor is there any way for lenders to enforce judgments for breach of covenant, but this is likely to be developed over time as the financial consequences of lagging on sustainability rise. 

Structuring the contract

The loan contract agrees on the sustainability-related provisions of the loan agreement, in particular the SPT.

Large corporate and not-for-profit SLLs generally rely on the borrower’s ESG framework, and its sustainability performance as reported in its audited financial statements to ensure the borrower is meeting SPTs. 

For example, Italian oil company Eni SpA recently published an SLL framework that fully integrates the UN SDGs across several funding solutions.

Corporate SLLs are usually structured as a revolving credit facility (RCF) for general purposes.

To qualify the borrower must:

– set ambitious and meaningful core SPTs (terms of the loan); and
– have a sufficiently transparent accounting process to be able to held accountable for meeting SPTs.

SPTs must be genuine, rigorous and measurable, and focused on significant incremental improvements beyond the current baseline.

From a lenders perspective, targets should be compared to an external benchmark and margin premiums should be set at a high enough level to ensure there is a realistic prospect of them being triggered. 

Borrowers should update SPTs at least once a year and have them externally verified.

SPTs are likely to change over time, depending on a society’s progress towards sustainability. At the moment, they are likely to include the following targets:

– reduction in greenhouse emissions;
– percentage of women in senior positions;
– employee training on diversity, anti-harassment, and culture;
– provision of education;
– utilisation of renewable energy;
– reducing workplace injuries;
– creating a “do the right thing” corporate culture; and
– promoting innovation

Plenty of wriggle room exists to negotiate updates to the covenants should extraordinary events occur such as mergers and acquisitions, or changes to ratings or regulations.

Future proofing for such events is likely to become more common as sustainability demands on corporate borrowers rise.

When it comes to meeting SPTs, companies can sometimes amend ESG targets for any reason provided they gain an industry specialist or external firm to confirm the amendments maintain equivalency in term of the loan agreement.

“While it was common in early transactions to use an overall ESG rating as the sole KPI, the market has been moving toward using more specific and targeted KPIs,” says Gemma Lawrence-Pardew, legal director at the Loan Market Association.

Reporting certificates

Reporting generally takes the form of a sustainability certificate, which is delivered with the annual audited accounts and financial covenant compliance certificate.

The certificate sets out the targets and actual performance against SPTs.

The certificate also sets a margin adjustment that applies as a result of performance. They are likely to include a netting-out of average performance. 

Penalty payment provisions to rise

Increasingly, contracts are likely to contain prescriptive payment provisions in the payment of step-downs. 

These might include demands on corporates to direct the margin gains to charity, or to reinvest step-down margins into more SPTs or other ESG goals. 

In the event of sustainability misses and a step-up in rates, it may be lenders that will be expected to direct their increased margins to charities or other ESG goals, to prevent the perception that lenders have benefited.

Alternatively, the corporate borrower may be required to direct their own penalties to sustainable causes – or to invest in meeting the SPTs that it has just missed, which sounds a little bit like a rate holiday, or even double dipping.

Amazon recently established a charity to fund its own greening and social improvement, as have many other corporations.

Some contracts allow investors to reinvest penalties into ESG within a specific timeframe although some investors criticise this as double-dipping; and as undermining the transition.

Lenders and investors will be keeping a keen eye to such practices when assessing borrowers (a company’s credit quality is likely to decline in a user-pays environment if it hasn’t transformed its business swiftly enough). 

Europe links loan principles to its EU taxonomy, which reduces opportunities for cheating.

It’s the principle of the matter

Most of the above is outlined in the sustainability-linked loan principles (SLLP), which are likely to be updated over time and guide the direction of the market.

The principles were originally launched in March 2019 by Asia Pacific Loan Market Association, Loan Market Association the Loan Syndications and Trading Association.

They were updated then published by Climate Bonds Initiative in June 2020 and have been adopted by the the International Capital Markets Association.

The SLLP says a SLL should include four components:

– relationship to borrower’s overall sustainability strategy (it must be material to the business;)
– target setting – measuring the sustainability of the borrower;
– reporting; and
– review.

Targets should be ambitious and meaningful, based on recent performance and the loan should include a process to independently verify the borrower’s sustainability performance.

Targets are supposed to be meaningful to the borrower – it shows they are thinking through the ESG element of the loan and how to translate their strategy into KPIs. In order to support a company on an ESG journey, parties need to know what that journey is.

Borrowers should have a clear, meaningful and verifiable sustainability strategy.

IFR reports leading global loan associations are planning to include a list of common KPIs in an appendix. 

For now, these are exclusively environmental but are likely to be expanded to include social and governance KPIs. Based on the Sustainability Accounting Standards board’s materiality map.

Frameworks can outweigh principles

While the principles set broad standards, sustainability terms within a loan contract are generally focused on an organisation’s own ESG framework and targets.

This is partly because the principles are weighted towards green factors.

This gives corporations considerable flexibility around the structure of an SLL loan contract. So corporations will need to develop sustainability strategies and frameworks (most of the big players already have).

EU taxonomy on sustainable finance

Borrowers would do well to align these frameworks with the EU taxonomy.

The taxonomy requires large companies and issuers of securities and other financial market participants in Europe examine their economic activities and report publicly on their sustainability exposures. 

The taxonomy should begin in earnest in 2022 and the affects are expected to hit Australian corporations and banks (and other global players). 

Banks operating in the EU will have to disclose their global sustainability loan assets, and these will have to comply with the taxonomy. 

The carbon-border adjustment mechanism will also affect multi-national corporations and exporters into Europe.

The reporting and structuring of loan assets via SLL contracts should help Australian companies meet EU reporting requirements with greater ease.

Mandatory verification upends private relationship-driven market

In May 2021, global updates to the SLL principles were finalised determining that mandatory external verification of performance will be required against some ESG targets.

This represents a big departure for the private, relationship-driven syndicated loan market.

International Finance Review (IFR) reports that in the past, corporations have wielded considerable power within the relationship-driven private loan market but mandatory external verification is likely to shift this dynamic.

“Mandatory verification is where the entire industry is heading,” Maarten Biermans, head of sustainable capital markets at Rabobank tells IFR. 

“In a few years you won’t be able to get a loan without assurance on your sustainability profile.”

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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