At A Glance
There are various "sustainable" financial products available, including sustainability-linked loans ("SLLs") . Before we consider issues specific to emerging markets, below is a summary of the main characteristics of SLLs generally:
What?
SLLs are loan instruments that incentivise the borrower's achievement of an ambitious predetermined sustainability performance objective. These objectives (also called sustainability performance targets ("SPTs")), are predetermined and measured by predefined key performance indicators ("KPIs").
Importantly, and contrary to green loans, SLLs do not determine the uses of proceeds, but rather take a more holistic approach to the borrower's business, seeking to incentivise and measure its improvement against the relevant, predetermined ESG targets. Meeting the predetermined SPTs results in a financial "reward" for the borrower, often by a reduction in the loan margin. Depending on the characteristics of the loan in question, a margin "penalty" may also be assigned for falling below a predetermined minimum SPT, whereby any previously achieved incentive is lost.
How?
Currently, there is no universal methodology surrounding the selection and measurement of KPIs.
The Loan Markets Association ("LMA") published guidance on the topic, to provide clarity in particular, on the selection of KPIs, and calibration of their respective SPTs.
KPIs
The selection of KPIs needs to be performed bearing in mind the feasibility and availability of a verification process. KPIs can be bespoke to the borrower's business, referencing science, and/or externally determined against the industry's ESG standards. In all of these cases, KPIs need to be clearly defined in their scope and objective. Attention is drawn to the wider borrower and group's strategy, as well as to the specific calculation methodology used to measure them.
KPIs can differ widely across industries, and when selecting KPIs borrowers should look at their existing reporting requirements, particularly if they are already employing external reviewers to measure them. For example, a mining company that is already obtaining an ESG rating from an independent provider, may seek to link its SLL to KPIs that it is already monitoring to improve its rating.
Calibration of SPTs
When discussing sustainable finance, it is important to address the elephant in the room: "greenwashing". The term is used to refer to unsubstantiated or misleading claims about the positive impact of a product, in this case SLLs. For this reason, it is important to set SPTs that are achievable, yet aspirational.
This means that achieving the predetermined SPT should be part of the wider borrower's ESG plan, but also represent a material improvement from its current daily business operation. SPTs should be benchmarked, where possible, against industry standards or objectives clearly set out in international agreements (such as the Paris Agreement or the United Nations Sustainable Development Goals (SDGs)).
Severe controversy events and exit provisions
KPIs and the associated SPTs cannot be taken in isolation from the borrower's wider ESG strategy and performance. For this reason, lenders are often keen to include provisions to address this, ensuring that the borrower will not be rewarded for reaching a predetermined SPT in circumstances where its overall ESG performance has been poor.
So-called "severe controversy event" provisions allow lenders to suspend the SLL element of the transaction until maturity, if there is a significant event affecting the borrower, which has an adverse ESG impact (but is unrelated to the selected KPI). The margin will therefore no longer be adjusted by reference to the SPTs. Such concepts can sometimes work both ways, whereby borrowers can use them in the event of an acquisition, or other similar significant corporate event, to the extent that this results in the borrower's KPIs performance falling below the predetermined minimum SPTs.
Conclusion
When looking into sustainable financing, it is important to bear in mind the characteristics of the borrower in question. Different industries will have different KPIs, SPTs are dependent on the current position of the borrower, and measurements and reporting requirements need to take into account both existing processes and potential issues.
Ultimately, when entering into SLLs, parties need to consider the overall business strategy of the borrower, its challenges, and unfulfilled potentials. We address some of these in an emerging markets context in the following article.
