Written by Karen Dawson, Chris Porter and Simon Grant
Sustainability-linked loans are loan products designed to reward a borrower with improved pricing for achieving predefined sustainability performance targets related to environmental, social and/or governance-related sustainability considerations. Now a global go-to asset class, sustainability-linked loan issuances reportedly reached US$350-billion in the global loans markets in the first half of 2021 according to research conducted by Bank of America, up from $197-billion for the year 2020.
Introduced in the Canadian loans market in late 2019, sustainability-linked loans have proven an attractive debt financing option for predominately investment grade Canadian borrowers incentivized to reduce cost of capital while conveying carefully planned environmental, social and governance (ESG) initiatives to investors. Deployment in Canada has spanned a diverse range of industries from consumer food to power generation, construction to oil and gas. In accessing sustainability-linked loans (not only from institutional lenders but also from alternative lenders), borrowers and lenders have been looking to the Sustainability Linked Loan Principles for guidance, which have, through a few different iterations of the principles, standardized the key tenets of sustainability-linked loans in global markets, including in Canada.
The Sustainability Linked Loan Principles
Given global interest in sustainability-linked debt products generally, the Asia Pacific Loan Market Association, the Loan Market Association and the Loan Syndication and Trading Association collaborated to provide a voluntary framework for the establishment of sustainability-linked loans. Originally published in March 2019, the Sustainability Linked Loan Principles were revised in May 2021 to better clarify the five core components of a sustainability-linked loan:
- selection of key performance indicators (KPIs);
- calibration of sustainability performance targets (SPTs);
- loan characteristics;
- reporting; and
The Tenets of a Sustainability-Linked Loan
KPIs, SPTs and Other Loan Characteristics
When entering into a sustainability-linked loan, borrowers (usually in consultation with the lender(s) in the syndicate acting as sustainability coordinator(s) or a sustainability structuring agent) select appropriate KPIs relevant to the challenges of the borrower's industry and business model. The borrower then calibrates ambitious and meaningful SPTs with respect to each KPI; each SPT should represent a material improvement in the respective KPI. Those material improvements may be gauged over the term of the loan via external assessment, in the form of the maintenance of, or improvement in, a rating or score allocated by an external sustainability rating agency, or by internally driven and internally or externally assessed KPIs related to the ESG specific targets. The Sustainability Linked Loan Principles' publication contains examples of environmental, social and governance KPIs, as an appendix to the materials. Those examples include targeted improvement in environmental matters like energy efficiency, waste disposal and greenhouse gas emissions, in social matters like affordable housing and employee engagement, diversity and inclusion, and in governance matters like business ethics and transparency. These SPTs may translate more concretely into targets involving, for example, a specific percentage reduction in GHG emissions, increased representation of women on the borrower's board of directors or in senior management positions and/or a specific percentage reduction in water consumption by the borrower.
Borrowers that achieve the stipulated SPTs are generally rewarded with pricing decreases or a downward "ratchet" of the cost of funds (as it is sometimes referred to) of between 5 and 7.5 basis points in applicable loan margins, as determined by the loan characteristics set forth in the credit agreement (or like documentation). Likewise, while failure of the borrower to achieve a given SPT does not result in an event of default under the credit agreement (or like documentation), a pricing increase or upward ratchet in applicable loan margins is likely to result.
A "dual ESG ratchet" in the form of including an ESG agency rating metric as well as sustainability KPIs in the loan documents (rather than one or the other) have recently been observed in European loans markets, providing the borrower with flexibility in meeting targets (and an increased opportunity to potentially benefit from decreased pricing). A "toggle option" is also sometimes available in that market, with the borrower in a position of choosing one approach over the other at certain points over the term of the loan. It is perhaps only a matter of time before similar provisions are incorporated in Canadian sustainability-linked loan documentation.
Reporting and Verification
Annual reporting and annual external verification of the borrower's performance provide lenders with the information required to determine whether the KPIs and SPTs have been achieved. While earlier iterations of the Sustainability Linked Loan Principles suggested external verification of borrower performance in meeting SPTs was a point of negotiation among the borrower and the lenders, the current Sustainability Linked Loan Principles suggest that independent and external verification should be an enshrined loan characteristic. Borrowers should nevertheless establish and maintain internal processes as well to evaluate satisfaction of their sustainability-linked loan SPTs.
While green loans have also become an arrow in the quiver of borrowers seeking sustainable debt finance in Canada, the loan proceeds must be used solely for green projects. The ability to deploy loan proceeds for general corporate purposes in connection with sustainability-linked loans offers flexibility to borrowers. That flexibility, along with the potential for pricing relaxation, make sustainability-linked loans an attractive debt finance product for borrowers that are already actively pursuing ambitious ESG targets, looking to build more sustainability into their supply chains and looking to strengthen their overall sustainability profile.
If you have questions about sustainability-linked loans or other kinds of responsible debt finance, contact the authors noted above; we would be pleased to discuss these financial products with you in greater detail.