How ESG-linked lending helps hold companies accountable



Virtue can bring rewards, as more and more businesses are discovering when applying for a loan. Some banks offer rebates to borrowers if they meet targets for reducing pollution, reducing food waste, or even helping job seekers. To give the incentives some teeth, there are penalties for missed goals. Global issuance of loans linked to borrowers’ environmental, social and governance performance jumped to nearly $500 billion in 2021, from $4.9 billion in 2017 when the first such agreement was created, the companies looking for options to present themselves as socially responsible.

1. How do loans work?

The agreements are set up like normal loans or revolving credit facilities, often with a group of banks providing funds to the borrower. Traditional loans are priced against a benchmark rate used in interbank lending, such as Euribor or the Secured Overnight Funding Rate (SOFR), and borrowers pay a premium, or spread, in plus the reference rate, depending on factors such as credit ratings and the transaction. length. A sustainability-linked loan has an additional twist, discount or spread penalty that depends on the borrower achieving specific ESG goals. For example, the interest rate of a loan can be 100 basis points above Euribor and can be adjusted according to the ESG performance of the borrower.

A loan can be tied to an overall ESG score or to specific sustainability goals called key performance indicators. KPIs can be quite varied, as long as both parties agree on the goals. Turkish lender Akbank TAS secured a $660 million loan in April 2022 with pricing tied to the amount of energy from renewable resources and progress in renewing expiring plastic credit cards with recycled cards. An infrastructure loan for Rubis Terminal Infra SAS which was in syndication in August included as objectives the reduction of its carbon intensity, waste and work accidents. Telefonica SA modified its main facility in January 2022 to commit to reducing carbon emissions and increasing the number of women in management positions. If a borrower is looking to link their performance to an overall ESG rating, they can obtain scores or ratings from a company that independently assesses ESG standards.

3. Is the idea making headway?

Since their inception in 2017, sustainability-linked lending, or SLL, has become the second-largest and fastest-growing segment of ESG debt instruments, and the idea has spread to other parties. of the credit market, in particular bonds and the Schuldschein. The sustainability-linked structure has been widely adopted by the bond and Schuldschein market, posting record sales in 2021.

4. How important are ESG incentives?

It’s hard to know for sure because the market is still developing and borrowers don’t always reveal the details of their loans. It is still possible to get an idea. Turkey’s Yapi ve Kredi Bankasi AS can potentially cut a 240 basis point spread for dollar borrowing by up to 3 basis points, while pulp and paper producer Asia Pacific Resources International Ltd. negotiated a discount of up to 5 basis points on a spread of 200 basis points. interest rate in basis points.

5. What other forms can they take?

In the United States, where most corporate revolving facilities are undrawn, borrowers like HP Inc. have agreed to impose the sustainability price adjustment on commitment fees paid on undrawn amounts. In recent years, there have been instances where borrowers waive discounts and will only be penalized if targets are not met. And some borrowers have pledged to use any savings from rebates for ESG projects. Similarly, some lenders have also contributed ESG pricing adjustment profits to sustainable causes.

6. What about lenders?

The main benefit for banks could be customer retention and a clearer view of companies’ extra-financial performance, such as diversity and workplace safety. Many ESG-indexed loans were traded as replacements for older maturing facilities, meaning borrowers could have sought a deal elsewhere. Loans can also help reduce banks’ risk exposures, as companies with strong ESG policies tend to have a good track record of profitability and debt repayment.

7. What about regulations?

Regulators and policymakers are pushing banks to pay more attention to the environmental and social impact of transactions. This has led more than 270 banks representing more than 45% of banking assets worldwide to adopt responsible banking principles developed with the United Nations. Europe has led the way in this area, helping to make it by far the largest region for ESG-related lending.

8. What challenges does the market face?

As with other efforts to link environmental and social objectives to financing, such as green bonds, a big challenge for ESG-linked lending is to ensure that transactions actually have a positive impact, and to prove it. In an attempt to prevent the sector from becoming a mere marketing tool for lenders and borrowers, the three major global lending associations have developed a framework for the agreements. The main criteria are that borrowers are transparent in their corporate social responsibility strategy; set more ambitious goals than they have already achieved; and that their actions are evaluated by independent evaluators. Even then, there is a lack of agreement on how to objectively assess corporate social responsibility. The European Commission adopted in April 2022 technical standards to be used by financial market participants when disclosing sustainability information.

9. How do loans fit into the wider ESG financial market?

There is a plethora of green and socially responsible financing options, and the variety is constantly growing. Green bonds make up the largest portion of the sustainable finance market at over $600 billion for all of 2021, according to BloombergNEF. ESG-related lending has been the fastest growing part of the entire ESG financial sector, albeit from a much lower starting point. The main differences between the two products include how the money can be used and the price. Green bond funds must be spent on projects designed to be environmentally friendly. Prices are also set for sale, with no potential discounts or penalties. Sustainability-linked loans offer much more flexibility as there is no need to use the funds only for investments directly related to achieving the ESG objective. Any pricing incentive is purely based on whether the borrower hits or misses the target.

10. What are the latest developments?

The SLL market is still evolving, with innovations such as “dormant” transactions where ESG objectives or metrics are only disclosed at a later date during a loan agreement. This “dormant” SLL has raised questions about eligibility to be classified as an ESG debt. Meanwhile, the German Schuldschein market has developed a so-called ESG gateway giving companies time to build their ESG reporting, which can potentially be included in financing agreements. Borrowers will be penalized if ESG reporting deadlines are not met, and the instrument is designed for companies that want to commit to a sustainability framework but are not yet ready to have debt-related targets.

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