While relatively new to the sustainable finance arena, sustainability linked loans (SLLs) are increasingly garnering the attention of businesses seeking to bolster their environmental, social and governance (ESG) profile.
SLLs offer flexibility and the potential for real economic benefits and positive ESG change, and we are seeing an uptick in SLL financings both domestically and internationally. But with opportunity comes responsibility, and there are many things borrowers and treasurers need to consider to ensure SLLs can be arranged, executed and managed successfully.
With a general move to social responsibility becoming the focus of investors, shareholders and financiers, and in particular the net-zero emission target year of 2050 on the horizon, we are witnessing a significant growth in sustainable finance globally. Momentum in the sustainable finance sector is growing as investors and lenders look to shift their capital allocation to ensure a more ESG-focused portfolio.
As the focus shifts towards ESG responsibility, sustainability is now seen less as a risk management issue and more as an economic imperative. Many institutional investors have mandates to take ESG considerations into account when making investment decisions and having a clear ESG strategy enables corporates to respond to investor interest in this area and access financing opportunities.
What are sustainability linked loans?
SLLs are loan facilities where the borrower is incentivised through the loan pricing to achieve pre-agreed sustainability performance targets (SPTs). Where SPTs are achieved, the borrower is rewarded with a decrease in the applicable interest rate (and conversely, a failure to meet SPTs may result in an increased interest premium).
Unlike green bonds and loans, or social loans, proceeds from SLLs are not required to be applied to specific purposes. They offer a higher degree of flexibility, and can be used for general corporate purposes. SLLs also have broader coverage and application across industry sectors as the SPTs may aim to achieve ESG goals beyond decarbonisation and cleaner energy, such as biodiversity, equality and diversity in the workplace, social and charitable investment and supply chain conditions.
The Sustainability Linked Loan Principles published by the Asia Pacific Loan Market Association, Loan Market Association and Loan Syndications and Trading Association set out a useful framework for agreeing SLLs, including that SPTs ought to be ambitious and meaningful based on recent performance levels of the borrower, and that a carefully considered mechanism to independently verify the borrowers' ESG performance is required. These aspects are critical for transacting parties to ensure rigour and integrity in SLLs, but also provide scope for borrower's to tailor their SPTs to matters that are important to their business and where they see an ability to improve performance.
Opportunity for borrowers and treasurers
The recent increased focus on ESG and net-zero emissions target provides a ripe opportunity for businesses to look at their business models, and either implementing or ramping up sustainability strategies with a view to building these into funding strategies. SLLs provide opportunities for a range of large, SME and smaller entities to access a sustainability-linked finance product, whether through a large syndicated financing or more simple bilateral arrangement.
For borrowers to fully capitalise on the increasing market for SLLs, they need a coherent, meaningful and verifiable sustainability strategy. In working with their financiers to structure SLL loans, borrowers will need to communicate their sustainability strategies, policies and objectives and assess what SPTs are appropriate and meaningful to underpin the SLL that can stretch the borrower to improve their ESG performance.
Company CEOs, in seeking to keep pace with the demands placed on them to meet ESG targets, can now also turn to their treasurers and CFOs to play leading roles to assist with developing a clear ESG agenda, and are more likely to reap the benefits. With a focus on the business' risk and funding requirements, treasurers and CFOs can not only play a key part in procuring SLLs, but in integrating and embedding ESG goals into broader corporate strategies to align the company's financial interests with ESG. Treasurers and CFOs, together with the CEO, are well placed within an organisation to be leaders and drivers of change in advancing sustainability goals. By embedding best practices in governance frameworks and strategy developments, they will be able to establish a strong foundation for conversations about SLL with financiers.
The cultivation of meaningful banking relationships will also be critical. Many of the major banks now have ESG teams to assist borrower clients with assessing whether SLL can be a funding option. The need for disclosure of, reporting on and testing of SPT goals in addition to financial performance also means that SLLs will require a greater level of engagement with financiers. By demonstrating sound knowledge of the company's ESG objectives and strategy and building strong connections with financiers focused on assisting with SLL products, treasurers and CFOs can place themselves in a position to effectively lead discussions for pursuing SLLs.
Challenges and risks
Once a borrower has entered into an SLL, they will need to be mindful of their ability to achieve the SPTs. Consequences of breaching an SPT will generally result in a pricing impact under the loan which would also need to also be considered in relation to its interplay with financial covenant compliance. Corporate treasurers and CFOs are therefore incentivised to play a key part in achieving SPTs, and working with the CEO to ensure a business-wide operational shift to integrate sustainability into business practices. In so doing, they must ensure understanding and engagement from key stakeholders. Identifying what specific changes are required, involving the right personnel and implementing well-considered messaging and incentives will be essential to reshaping the corporate approach to ESG and driving forward the business' sustainability agendas such that it may benefit from a lower interest rate margin.
A key challenge with respect to proceeding with SLLs is the higher transaction costs associated with negotiating an appropriate SPT framework and the ongoing monitoring and reporting requirements. Financiers and regulators are responding to these issues with some financiers developing their own frameworks internally to assist borrower clients with a baseline position. Regulators are also developing frameworks to reduce costs and barriers to entry for borrowers to these products. For example, the Monetary Authority of Singapore recently launched a Green and Sustainability-Linked Loans Grant Scheme, under which certain transaction costs of both financiers and borrowers are defrayed for eligible green and sustainable financing, thereby increasing the accessibility of such funding, particularly for small and medium-sized enterprises.
Another challenge is that standard market practices have not fully developed for SLLs, and there is a need to build industry knowledge and understanding of SLLs. With an increase in SLL expected, an expansion in the SLL knowledge base will provide for greater ease of transacting.
While there are many aspects to consider to ensure SLLs can be arranged, executed and managed successfully against SPTs, they present a real opportunity for borrowers with sustainability strategies to access capital at a lower financing cost, making them an attractive source of financing for businesses that are ready to commit to making a difference.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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