The LMA model provisions for Sustainability Linked Loans and their applicability in emerging markets

The LMA SLL Model Provisions provide the market with standardised sustainability linked loans. They also largely reflect practices across Europe and the United States, where SLLs have become fully established in recent years. In this article we look at the applicability of the LMA SLL Model Provisions for loans involving borrowers in emerging markets.

As we have previously discussed here, SLLs are an attractive option in emerging markets, as they offer a reduction in interest rates if certain specific performance targets ("SPTs"), measured by predetermined KPIs, are met. SPTs and KPIs can be selected in a flexible manner. Understanding the potential challenges of applying the LMA SLL Model Provisions in emerging markets is therefore particularly important.

1. KPIs, ESG Standards, and Calculation Methodology

Briefly, ESG Standards (a defined term used in the LMA SLL Model Provisions) are external, industry standards that provide detailed and repeatable requirements for what should be reported for each KPI (e.g., the International Sustainability Standards Board's ("ISSB") general requirements for disclosure of sustainability-related financial information (the "IFRS S1") (for further information on the ISSB sustainability disclosure standards, read our blog here)).

A Calculation Methodology (a defined term used in the LMA SLL Model Provisions) is the method used to assess the borrower's, parent's, and/or group's performance against each KPI. The Calculation Methodologies should be the same as used to benchmark a KPI against the relevant ESG Standards selected.

One of the challenges with applying the LMA SLL Model Provisions in emerging markets is that, whilst borrowers may monitor ESG data internally, they may not do so in accordance with specific ESG Standards or apply specific Calculation Methodologies, and even if they do, they may not have done so for a sufficiently long period of time to allow for the requisite level of benchmarking.

Furthermore, at the time of writing, several standards bodies are consolidating their frameworks, making the selection of a standard a moving target. IFRS S1 was published with the intention of functioning as a baseline, but its complexity has been the subject of much debate.

The LMA SLL Model Provisions are a useful reference point, but will need to be adapted to allow for some flexibility so that emerging market borrowers and their lenders can agree on the ESG Standards and the relevant Calculation Methodologies that can be applied by the borrower without incurring excessive initial and ongoing costs.

2. Monitoring

The LMA SLL Model Provisions define "External Reviewer" as "an independent [internationally recognised] professional services firm, environmental consultancy firm or ratings agency which is regularly engaged in the application and monitoring of ESG standards and ESG calculation methodologies", and in any event not the borrower, the parent, or one of their affiliates.

The External Reviewer either verifies the borrower's self-reporting, or carries out a new, independent sustainability report.

The LMA SLL Model Provisions also set out information undertakings from the parent (or the borrower, as applicable) with regard to the different reports to be delivered.

It will be more complicated and costly for companies whose business is spread across different jurisdictions in emerging markets to engage external reviewers for the purposes of this auditing. Borrowers may be unwilling to incur the potential associated cost. Therefore, the potential costs of external reporting should also be part of the commercial discussion on whether a SLL is appropriate from the outset.

3. The margin adjustment

The LMA SLL Model Provisions contain a margin ratchet, with rates set at different percentages per annum, depending on how many SPTs are met.

This can be amended and adapted, by offering a "blended" margin ratchet where different SPT thresholds correspond to different margins, or by weighting the SPTs for importance, so that certain SPTs translate into greater margin changes.

Overall, the use of a margin ratchet can offer greater flexibility to borrowers in emerging markets jurisdictions, who might decide to set up ratchets for different SPTs, conscious that these may be adapted from time to time with the needs of the business.

Facility agents should pay close attention to the operational mechanics behind margin adjustments, to make sure that they are operationally feasible within the prescribed time.

Whether or not the potential margin adjustments are sufficient to warrant a borrower incurring the associated cost of entering into a SLL is a topic of regular debate, but we would encourage borrowers to also consider the potential liquidity that a SLL may involve, in addition to savings on interest.

4. Sustainability Amendments and Declassification Events

The concept of "Sustainability Amendment Event" in the LMA SLL Model Provisions refers to events that change a borrower's circumstances to such an extent that SPTs become too easily achievable (e.g., due to external changes in the "Calculation Methodology" or "Applicable ESG Standard").

Failure to agree on revised SPTs results in a "Declassification Event", upon which the loan will no longer be considered "sustainability-linked". Other examples of Declassification Events include (but are not limited to) consistent failure to miss SPTs over time or breaches of sustainability provisions. Notably, as a reflection of the recent market tendency towards cautiousness in labelling financing arrangements as "green", the LMA provides for such Declassification Events to be irreversible.

Parties should tailor such events to the industry and corporate structure of the borrower. These provisions are helpful in emerging markets financing, where the adoption of SLLs has been slower. They offer lenders and borrowers a certain level of comfort that, should circumstances materially change, they can (with respect to Sustainability Amendment Events) renegotiate the sustainability aspect of their loan, and (with respect to Declassification Events) give some comfort to market participants in relation to their greenwashing concerns.

Conclusion

With the LMA SLL Model Provisions, the LMA sought to propose a form of drafting for sustainability-linked loan provisions that reflected market practice at the time of publication, can be adapted for use with other LMA recommended forms, and can be subject to deal-specific customisation. Adapting these provisions to the market and industry in a way that provides the correct incentives to borrowers will be part of early, ad hoc negotiations, especially in emerging markets. We look forward to being part of that discussion.