Sustainability Linked Loans in Emerging Markets: challenges and unfulfilled potential

However, when you consider that more than USD 84 billion in SLLs and green loans were arranged globally in the first quarter of 2022 alone, we expect to see an increase in such deals in emerging markets. In our view, rather than slowing down this growth, recent volatility in commodity and energy prices, the war in Ukraine and increasing inflationary pressures make it even more likely that the appetite for SLLs in emerging markets will continue to grow.

SLLs are attractive partly due to the fact that, rather than limiting the use of proceeds to sustainable projects (in the way that green loans do), SLLs contain no such limitations. Rather, they price to specific performance targets ("SPTs"), measured by predetermined KPIs, both of which can be selected in a flexible manner to suit particular businesses and countries and their current position on the ESG spectrum.

Here we see how sovereign and state-owned borrowers, the heterogeneity of lending syndicates and measurement and verification create both challenges and opportunities for the use of SLLs in emerging markets.

Sovereign and State-Owned Enterprises (SOEs)

The types of borrowers in emerging market deals are diverse. A sovereign or a state-owned company will likely have different ESG considerations compared to a private company. Businesses operating in multiple sectors or geographies may have more difficulty in agreeing KPIs or SPTs. Clearly it is necessary to pay particular attention to the challenges faced by the borrower in question when structuring SLLs in emerging markets.

Whilst we have represented the lenders on several green loans to sovereigns, not many sovereigns or SOEs have borrowed SLLs. Measuring the KPIs of a sovereign or an SOE, and its performance against predetermined SPTs, is a delicate matter. Unlike private companies, sovereigns and SOEs have to take into account political considerations as well as ESG-related and economic considerations.

Although sovereigns in emerging markets have issued green bonds and borrowed green loans, Chile recently issued the world's first sovereign sustainability linked bond. The USD 2 billion bond was issued on 2 March 2022. The bond adheres to the Paris Agreement on climate change, including that the country emit no more than 95 metric tons of carbon dioxide and equivalent by 2030 and that 60% of electricity production be derived from renewable energy by 2032. It was heavily oversubscribed, showing that there is real investor demand for sustainability linked financings in emerging markets.

One way of assessing a sovereign's ESG position and considering possible SPTs could be to consider its existing reporting. For example, SPTs could be set by looking at the countries' nationally determined contributions (NDCs) to the Paris Agreement.

Finance parties

Central banks and regulators have focused on climate change and the green economy more and more in recent years. Driven in part by commitments made in or around the 2015 Paris Agreement and the 2021 Glasgow Climate Pact and in conjunction with the framework provided by the United Nations Sustainable Development Goals, commercial banks have grown their sustainable financing capabilities in recent years. To date this has largely been deployed in developed markets, initially in the investment grade space and more recently in areas such as structure trade and commodity finance. However, in order for banks to lend the large amounts of sustainable finance that most have committed to in the next few years, deploying more SLLs in emerging markets is almost inevitable.

Multinational development banks ("MDBs") and private financial institutions alike have committed to moving their portfolios towards sustainable financial products. And whilst most export credit agencies ("ECAs") have traditionally underwritten a lot more oil and gas projects than renewable projects, many of them (including UK Export Finance) have now committed to no longer support fossil fuel projects overseas. SLLs can be one of several products to help to assist such market participants in these aims.

Emerging markets funds have also been more and more active in this space. For example, a fund managed by Actis recently signed a USD 1.2 billion SLL which included a discount on the margin linked to the use of proceeds of the facility. The fund aims to invest in sustainable infrastructure projects which contribute to SDG 7 (affordable and clean energy). It is not solely a renewables fund and can, for example, invest in gas projects if the impact is deemed beneficial to the environment overall. If the facility is used for investment in an energy sector that mitigates climate change or in a country where energy access is limiting economic growth, or for an investment creating a new positive impact, then the interest rate will be lower.

Measurement and verification

If a borrower group is spread across different jurisdictions, the measurement and reporting process becomes more complicated, and specific aspects might need to be introduced in the calculation methodology to account for different verification standards across jurisdictions.

Furthermore, it is recommended that KPIs (and a borrower's performance in connection with them) are publicly available and externally reviewed. Depending on the borrower and its industry, third party ESG linked ratings may not be readily available, and companies may be unwilling to undertake the potential associated cost of employing an external reviewer, if they do not have sufficient incentives to do so. Consequently, the measurement and verification process in emerging markets may initially need to rely on the borrower's internal reporting, which is never desirable from an audit perspective.

Conclusion

The appetite for sustainable financial products in emerging markets is clear.

When structuring SLLs in emerging markets, an early dialogue between the lending and the borrowing entities over the potential issues and challenges will be important. This is particularly the case with respect to identifying appropriate KPIs and SPTs and the margin step-ups and/or step-downs. There are ways to provide for unexpected events in the underlying documents, and to allow for enough flexibility while simultaneously guarding against greenwashing. We expect that SLLs will be increasingly used in emerging markets in the coming years, and we look forward to deploying our experience of working on SLLs in the investment grade and structured trade and commodity finance markets there.