The Situation: Given the negative impact that sustainability-related risks can have on investment returns, investors, banks, and borrowers alike are increasingly focusing on environmental, social, and governance ("ESG") issues. Banks and borrowers have collaborated to create new financial instruments, such as sustainability-linked loans ("SLLs") and sustainability-linked bonds ("SLBs"), designed to provide greater flexibility while incentivizing companies to meet and exceed their long-term energy transition and other ESG objectives.
The Opportunity: Since the launch of the first SLL in 2017, the number of SLLs has increased exponentially. The global market for SLLs grew from $5 billion in 2017 to $40 billion in 2018. SLLs have already evolved into other financial products, including sustainability-linked bonds. As of December 16, 2020, companies have raised approximately $275 billion in SLLs and $488 billion in SLBs.
Looking Ahead: The market for sustainability-linked instruments in the United States and Latin America is expected to grow significantly. The change in administration in the United States and the recent spike in activity on the regulatory side in Latin America are expected to result in increased demand for sustainability-linked financing and transition finance for companies in, and outside of, "green" sectors. As ESG measurement criteria and regulation become more standardized, investments in SLLs and SLBs by capital sources focusing on ESG and transition energy will continue to grow.
What Are Sustainability-Linked Financial Instruments?
SLLs were created in 2017 to fill a gap in green and social financing and to incentivize borrowers to be more ambitious in implementing their ESG targets by lowering their funding costs based on pre-established "sustainability performance targets" ("SPTs").
Prior to SLLs, green loans and bonds were the most common sustainable financing instruments in the market. Most companies, however, could not take advantage of them because the use of proceeds for green loans and green and social bonds was limited to specific, eligible environmental and/or social projects and tracked throughout the term of the borrowing. As a result, the market for green loans and bonds was limited to companies with large pools of green assets, such as renewable energy companies, or companies in sectors with established methods to identify and quantify sustainability metrics, such as real estate or agriculture.
The market for social bonds was also limited. Prior to 2018, only governments and governmental entities issued social bonds given the requirement that the bond proceeds be used to address a specific social need. The first corporate social bond was issued in 2018 by multinational agribusiness company Danone to finance and refinance projects on food research with a positive social impact.
In 2017, Philips, a Dutch health technology company, was the first company to borrow through an SLL, whose interest on the $1.2 billion revolving credit facility was tied to Philips' ESG rating by a third-party provider. Unlike green loans and green and social bonds, proceeds from SLLs can be used for general corporate purposes and need not be directed for use in a traditional green or social project. SLLs are like any other loan product with one notable distinction-a sustainability-linked pricing incentive. Borrowers are incentivized to meet the SPTs to reduce their cost of funding, while improving their sustainability profile. These pricing adjustments may include a reduction in interest margins if SPTs are met, or an increase or premium, if they are missed. To measure and track SPTs, SLLs typically require regular reporting and third-party verification of results by an independent ESG assurance provider. For companies that publish a sustainability report, often a self-certification from the borrower can suffice. In SLLs, a failure to meet an SPT does not result in an event of default under the loan agreement. In some cases, if a borrower fails to meet its SPT or reporting requirement, it may be required to deposit the premium into an account that must be used for ESG purposes or donated to a charitable ESG organization.
Similarly, the voluntary sustainability-linked principles ("SLBPs") define SLBs as "any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/ESG objectives." As in SLLs, the typical structure pays higher interest to the bondholders if the SPTs are not met and the use of proceeds is not limited to a specific project. This allows issuers that cannot allocate proceeds to specific capital expenditure projects to participate in the sustainability finance markets. Unlike SLLs, where borrowers can rely on third-party ratings or self-reporting, the SLBPs discourage the use of ratings and recommend independent third-party verification of the performance of the issuer against each specified SPT, preferably at least annually. The SLBPs also emphasize the importance of developing SPTs that are measureable and under the control of the issuer and that reflect the material sustainability risks specific to the issuer.
SPTs are often highly negotiated. They can take the form of key performance indicators ("KPIs") or other metrics, such as third-party ESG ratings. SPTs can relate to environmental and decarbonization initiatives, as well as measures to improve working and social conditions. They may also be tied to the 2015 U.N. Sustainable Development Goals. Because there are no standardized required SPT metrics, borrowers and issuers can craft their company-specific SPTs. This gives them the flexibility to tailor their pricing incentives to fit their specific sustainability and business strategy.
The popularity of sustainability-linked financial instruments, first seen in Europe, is increasing in the United States and Latin America. The first SLL extended in the United States was for CMS Energy in June 2018, worth $1.5 billion, closely followed by a syndicated loan of $2.5 billion extended to another energy company that same year. Since then, U.S. borrowers from other industries have entered the market, including a real estate investment trust with a $2.5 billion revolving credit facility, a water technology company with an $800 million financing, and a major airline with a $550 million refinancing.
A year after CMS Energy, the first SLL was structured in Latin America, when Fibrauno signed the first-ever SLL in the region, worth approximately $1.1 billion. Other SLL deals in the region include a Mexican construction materials producer's $3.2 billion refinancing, leading telecommunications provider Millicom's $600 million revolving credit facility, and a Chilean paper company's $100 million revolving credit facility. Of these, Millicom's SLL is novel in that it includes governance and social-related targets in addition to environmental targets, which are more commonplace. Millicom's SPTs include reducing its environmental footprint in its Latin American operations through equipment recovery, training suppliers on corporate responsibility, empowering women, and reducing the gender gap by training women and teachers on digital literacy and entrepreneurship.
The first SLB issuer was Italian energy company Enel with its $1.5 billion global issuance of SLBs in September 2019. Brazilian paper producer Suzano was next with its $750 million SLB issuance in September 2020. During January 2021, an Argentine e-commerce company and another Brazilian paper producer issued $400 million and $500 million of SLBs, respectively. The first SLB issuance by a North American company took place in December 2020, when NRG Energy issued $900 million in SLBs.
Given that sustainability-linked financial instruments appear to be a win-win for borrowers, issuers, investors, and society at large alike, what are the challenges facing the market in the United States and Latin America?
Standardization in reporting and measurement criteria could be one challenge to the growth of SLLs and SLBs in the United States and Latin America. There is currently no formal regulatory framework in the United States or Latin America to govern sustainability-linked financial instruments. Standards are voluntary, and the principles underlying SLLs and SLBs are fairly new. In 2018, sustainability-linked loan principles ("SLLPs") were published by recognized industry associations and were followed in 2020 by SLBPs. These principles consist of recommended guidelines to be applied on a case-by-case basis, which results in nuances from deal to deal.
Regulatory frameworks also differ from jurisdiction to jurisdiction. Unlike the European Union, which has an established framework that guides companies in supporting sustainability claims with comprehensive data and analytic disclosures, the regulatory frameworks in the United States and Latin America have not been fully developed. Borrowers, even those with access to traditional green financing, may be unfamiliar with the increased disclosure and external review that may be required by sustainability-linked products. Some companies may also lack the internal protocols required to measure and self-report their sustainability performance.
Finally, sustainability performance rating calculation methodologies are evolving. External rating agencies or auditors may come to different ESG scores or assessments than the companies they are evaluating. Standardized reporting and evaluation criteria will make sustainability-linked products more attractive to borrowers, issuers, and financing sources.
Why should borrowers and issuers look to sustainability-linked financial instruments?
Increased deal and regulatory activity can be expected in this area in the United States and Latin America in the near future. ESG issues such as climate change, social justice, transparency, and human welfare are key concerns for stakeholders. Credit rating agencies are increasingly focusing on ESG risks to determine creditworthiness. Governments are also focusing more on ESG, including to address social issues raised during the pandemic, and some are implementing policies to incentivize private companies to advance ESG issues. Based on the success of the European Union's framework and the recent surge in private sustainability-linked transactions, the G20 has asked the Financial Stability Board to prepare a framework for global disclosure standards. The World Economic Forum's International Business Council is also recommending the adoption of, and reporting on, a set of common ESG metrics as a means for companies to objectively meet their commitments to stakeholders to align their corporate values and strategies with the 2015 U.N. Sustainable Development Goals.
Investors are also encouraging companies to expand ESG initiatives, advance ESG targets, and raise their sustainability profiles (with some publicly stating that they will divest investments that do not comply with certain sustainability criteria). Other stakeholders such as customers, suppliers, and employees have social and environmental issues that matter to them and are increasingly making their views known. A positive sustainability profile could encourage consumers to buy a product or service, a company to use a specific supplier, or a job candidate to choose an employer. Companies are increasingly engaging with their key stakeholders, as they realize that finding out what matters to them can improve the company's decision-making and help optimize their sustainability strategy.
Finally, banks and other financing sources are eager to coordinate and participate in sustainability-linked structures, which can be tailored to each individual borrower, their sector, and goals. While the additional transaction costs that these structures present can be lower for companies that have a developed sustainability strategy with identified goals to further such strategy, it is also expected that these instruments will be increasingly available to other companies (including those in high carbon-emitting sectors) that are eager to access liquidity in the sustainable finance market to improve their ESG performance and, in some cases, transition toward decarbonization.
Increased stakeholder focus and regulatory activity, along with the growing number of SLLs and SLBs coming to market, will lead to standardization, which will in turn help make these products more broadly and readily available and less costly to implement for market participants, even those that may not have robust internal ESG functions.
Four Key Takeaways
- SLLs and SLBs are gaining popularity in the United States and Latin America, as more companies seek to incorporate sustainability goals and initiatives into their financing strategy in a manner that does not limit the use of proceeds to a specific green or social project like green loans and green and social bonds.
- SLLs and SLBs offer borrowers and issuers the flexibility to tailor their pricing incentives to fit their specific sustainability and business strategy. Financing sources also benefit by enhancing their own sustainability profile by facilitating the growth of sustainability-linked financings.
- One challenge facing SLLs and SLBs in the United States and Latin America may be the evolving standards for ESG disclosure by companies. Standardization in measurement and reporting will result in reduced costs for companies. Further, standardized evaluation metrics will make these sustainability-linked products more attractive to borrowers, issuers, and financing sources alike.
- Given this climate, companies and investors should understand the various sustainable financing options available to them and get comfortable with the sustainability-linked products available in the market. Companies considering sustainability-linked products should consult their legal and financial advisors to determine how best to take advantage of these products in line with their sustainability goals.
Originally published February 2021.
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