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ESG Focus: Linked Finance The Next Big Thing – Part 7

ESG Focus | Nov 12 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 7

The big end of town is weighing up its options for extracting value from SLLs, starting with massive revolving credit facilities.

-Companies weighing options and jumping in
-First stop: revolving credit facilities
-Streamlining the adjustments process

By Sarah Mills

Sustainability-linked loans are set to experience a huge surge in demand as corporations examine funding options for the green transition.

The next four articles focus on the adoption of SLLs by the big end of town and cover revolving credit facilities; sustainability transformations; M&A and capital management; and the entrance of big institutions and private equity into the bank-dominated corporate-loan market.

Observers believe SLLs offer huge opportunities for the smartest and most sophisticated companies, given they allow corporations to tailor loans to their industry, business and strategy.

On the table are improved interest margins, strategic leverage, and funding leverage. 

Many of the world’s major corporations are getting in early, gaining the triple advantage of cheap, relatively lenient SLL funding; while gaining experience in driving the loan deliverables through the company; and benefiting from the green-halo derived from early-mover status.

These advantages can be significant.

Companies weighing their options

But there are risks in being first movers, as Germany found with its early transition, which in retrospect, proved more costly and perhaps provided less of a competitive advantage than hoped. 

In fact, much of that investment served to support the green ambitions of manufacturing rival China.

But the world appears far more aligned on environmental transition now than 15 years ago; the financial infrastructure, such as sustainability-linked debt and green bonds, are in place; and the world is flush with funds post-covid.

Every incentive is there for corporations to hit the SLL market, and many are jumping in.

Corporations' first stop: SLL revolving credit facilities

The main demand for SLLs to date has been for revolving credit facilities (RCF).

This section quickly examines SLL RCFs and syndicated loans struck across a range of industries, to give investors a feel for market dynamics.The world’s first SLL transaction was struck in April 2017 – a E1bn syndicated five-year loan for Royal Phillips (a diversified health and well-being company with a technology focus) maturing on April 21, 2022 for general corporate purposes.

Pricing was linked to the upside and downside of the ESG ratings assigned by Sustainalytics (SLLs are more likely to include coupon step-downs to reward outperformance than are sustainability-linked bonds). 

The company planned to become carbon neutral, grow green revenue to 70% of sales and generate 15% of revenue through circular economy initiatives – those products that, for example, contain at least 30% recycled plastics in its personal health division, over which it has full control.

These are three specific targets/KPIs (two to three being the norm) and it will be interesting to see how Royal Phillips has performed against their targets, as maturity looms.

Given their three-year head start, if executed correctly, the company could be well-positioned to outcompete peers with the next round of funding.

The big deals first

The world’s largest SLL to date was a E$10.1bn RCF for brewer Anheuser-Busch InBev (one of the largest publicly listed companies in the alcohol sector).

A consortium of 26 major global financial institutions provided the five-year loan.

Struck in February 2021, the loan was linked to water efficiency, recycling of more PET packaging, renewable electricity useage, and lower greenhouse emissions.

From a strategic perspective, water and packaging are key business inputs for brewers so the loan is exemplary of industry/business tailoring.

Prudential has signed a $4bn five-year SLL RCF in July, with margins linked to its decarbonisation and leadership diversity.

The deal was provided by a consortium of 22 major global financial institutions.

This is the first deal of its kind by a major US insurer and pressures others to follow suit.

Italian energy company Enel, sourced a E10bn SLL RCF last March; and a French biopharmaceutical company signed for an E8bn facility in late 2020.

A social SLL is used to support market dominance

Spanish telecommunications company Adamo has secured a E600m SLL refinancing to connect rural Spain to the internet.

The company was also awarded a government grant in 2020 to do just that, so it appears Adamo is doing quite well out of the deal. 

Both the government grants and low-interest loans, which would have been derived at least partly from the covid printing spree at the public’s expense, will help Adamo establish dominance in the Spanish market through rural expansion.

Given SLLs can also be used for general purposes, Adamo also benefits from cheap general funding and the green/social halo affect.

The lenders also gain a windfall from the margins wrought on virtually free money on a relatively low-risk investment with green halo benefits.

Adamo is another example of the importance of ensuring SPTs (specific performance targets) are aligned with a company’s core business. 

Of the E600m, E250m will be used to refinance existing activities and E350m will be directed to the roll-out and acquisitions.

Dubai giant pitches a gender-equity SLL

Arabian Business reports Dubai’s retail giant Majid Al Futtaim has signed a $1.5bn SLL – a five-year RCF. 

Interestingly, in a region renowned as a bastion of male privilege, the deal has included gender diversity targets – KPIs to lift female board members and senior management roles to 30% – a first for the region.

Energy company goes all in on decarbonisation

Italy’s first SLL from the European Investment Bank was signed off in July 2021 and linked to decarbonisation.

The E660m deal was struck by E-Distribuzione (part of Italian diversified energy company Enel, which recently declared all borrowings would be converted to sustainable finance).

The company aims to cut Scope 1 emissions (its own emissions) to or below 148 grams of carbon-dioxide equivalent kilowatt hours by 2023.

The agreement will support the company’s e-Grid project, which is renewing and developing the power grid to enable the network to host a higher proportion of renewable generation and electric mobility, and to improve consumer innovation.

It contains both a step-up and step-down mechanisms and complies with ICMA’s SLB (sustainability-linked bond) Principles and the LMA’s SLL Principles.

Norway is stocking up on ships

As an example of a high-emissions industry deal, Norwegian shipping group Klaveness Combination Carriers (KCC), agreed to a SLL US$60m term loan and RFC for the financing of vessels with delivery in 2021.

The company will also be taking the opportunity to offload its oldest and dirtiest vessels, all at historically low interest rates.

As a critical carbon point within most of the world’s supply chains, the shipping industry is under intense pressure to switch to clean fuel. Cleaning up its fleet could position KCC well, in the early days of the transition.

“We strongly believe in the greening of capital and that access to competitive funding going forward will be based on the ability to deliver green transformation,” says KCC, which aims to be carbon neutral by 2030.

The credit margins on the KCC deal include step-ups and step-downs, based on the company’s progress to cutting CO2 emissions per ton of transported cargo per nautical mile and reducing absolute CO2 emissions per vessel to be carbon neutral by 2030. 

Reporting is quarterly and external audits are annual.

It is also an example of how first-movers in various stages of the supply chain are likely to benefit as multi-nationals turn their focus to reducing Scope 3 (supply-chain) emissions.

Streamlining the adjustments process

The setting of key performance indicators (KPIs) has been relatively haphazard to date but that is all about to change.

The major underlying trend in the SLL market will be a streamlining of the adjustments process across industries to include the most material SPTs and KPIs, and a tightening of deliverables and expectations.

As a rhythm is established, many contracts are expected to be standardised, saving on loan administration and legal costs.

Companies that are in-step with the process will be best positioned to secure funds and should save on administration costs. 

As the above examples illustrate, recent SLLs have generally been linked to two, three, or even four KPIs.

The main KPI focus in the near-term is on including at least one decarbonisation metric. 

Other must-have metrics will soon join the fray, such as circularity and biodiversity (circularity and biodiversity are already being included in KPIs but decarbonisation dominates).

All three speak to the E (environment) in ESG. 

These environmental metrics tend to be expensive, requiring massive capital to fund operational transformation, the challenges of which extend through the entire supply chain.

For now, however, many corporations have been focusing on the relatively low- hanging fruit S (social) and G (governance). 

Metrics such as workplace injuries and women and minorities in leadership are easy metrics to report on, are relatively inexpensive to implement and are common to all companies, not just those with high environmental exposures.

Social metrics to get more expensive

Social metrics are likely to become more demanding as the fourth industrial revolution, to be built on green and circular technology, gains pace.

This will be the point at which the S metric in particular, becomes more costly to corporations. 

Onshoring labour may be expensive, but it will by partly offset by lower environmental savings in a user-pays environment. A smaller geographical footprint is likely to equate to a smaller carbon footprint.

The Organisation for Economic Development and Co-operation (OECD) says a shift to circularity also augurs greater independence and supply chain control for corporations; and a shift from a linear value chain to a circular value chain.

The OECD expects a company’s transition to circularity will reduce absolute material useage, save for the most scarce or toxic materials. But it will be an expensive road to reach that point.

An easy row to hoe for now

Most of world’s major corporations have been preparing for ESG and the green transition for at least 5-10 years so are fairly well equipped to deal with the vagaries of the SLL penalty mechanisms.

For the next few years at least, SPTs are likely to be extremely realistic. Even now, many corporations are setting targets that have already been met, or let’s say have been “prepared” for to ensure they are met.

While investors decry this activity as a form of greenwashing that could prove expensive for investors, it also means that the early days of SLLs are likely to prove smooth sailing. 

And for investors, given most of the loans are roughly for only five-year terms, many of the repercussions from today’s funding decisions are likely to be less than would a poor decision for a longer dated instrument.

In the meantime, the carefully examined performance of companies in the SLL market will offer investors strong cues on future performance.

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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