General Background
In recent years, we have seen an ever increasing number of lending transactions focused on promoting ESG in Latin America, such as green loans, social loans, sustainability loans and Sustainability-Linked Loans (“SLLs”). This article focuses on the SLLs in Latin America.
What are SLLs, and why are ESG-related products becoming popular in Latin America?
Unlike plain-vanilla sustainability loans, which focus on the underlying proceeds of the loans (e.g., the financing of any ESG-related matter), SLLs are loan instruments first used in 2017 as a means to incentivize a borrower to comply with certain sustainability performance targets (“SPTs”) that are both predetermined and measured by predefined key performance indicators (“KPIs”).1 Contrary to green (or plain-vanilla sustainable) loans, SLLs are not only concerned with specific uses of the loan proceeds. Instead, SLLs take a more holistic approach to the borrower’s business, incentivizing the borrower’s sustainability profile and measuring performance against the relevant predetermined SPTs.2
This approach widens the market for SLLs, giving borrowers who typically operate outside the green loan space the opportunity to participate in sustainable financing (without having to be confined to specific “green” projects) and to commit to sustainability in a manner applicable to its business model. Such specifically defined and bespoke ESG goals for a borrower (and its business) in turn leads to elaborately drafted credit agreement formulas, which adjust both interest rates and fee provisions based on such borrower’s performance with its selected KPIs.3
The implementation of SLLs and ESG principles in Latin America has paled in comparison to the United States, European and Asian markets. However, in recent years sustainable finance has gained traction in Latin America, driven largely by (i) disruption caused by the COVID-19 pandemic and (ii) an increased interest of many corporates to stand out from one another and attract investors and lenders in light of fewer deals in the market as a result of an increase of exchange rates and domestic inflation, which have caused investors and lenders to be more selective.4
In line with the above, many Latin American governments have used ESG as a way to promote investment and address social and environmental issues prevalent in the region, such as, but not limited to, social inequality (gender violence and poverty) and the reduction of carbon emissions.5
Initial regulatory efforts to promote ESG principles in Latin America on the right path
The application of ESG has started to become a priority in many Latin American countries; however, Chile, Colombia, Mexico and Brazil have been the leading force in the Latin American sustainable finance market. Below are illustrations of different regulatory actions taken by these countries:6
- In July 2020, the United States-Mexico-Canada Trade Agreement (USMCA) became effective. The signatories agreed to include certain environmental provisions and sustainability safeguards. In September 2020, Mexico became the first country to issue a sovereign bond—linked to the UN’s Sustainability Development Goals—by issuing a seven-year bond for $890 million.7 In April 2022, the Comisión Nacional Bancaria y de Valores (CNBV), an independent agency of the Secretariat of Finance and Public Credit with technical autonomy and executive powers over the Mexican financial system, created a tool for self-diagnosis of ESG-related risks by financial institutions, providing the CNBV a general understanding of the state of such financial institutions.8
- In April 2021, Colombia’s Financial Superintendency adopted Circular 007, requiring all Colombian institutional investors to include in their periodic disclosures any ESG related factors applied in the preceding reporting period.9 Additionally, in April 2022, Colombia became the first country to adopt a national green taxonomy, through which lenders and borrowers can identify economic activities that contribute to specific environmental targets.10
- In April 2021, the Brazilian Central Bank implemented regulatory initiatives to increase the number of ESG disclosures of financial institutions, promoting transparency in the region.11
- In November 2021, the Chilean Commission for the Financial Market (CMF) published General Rule No. 461, amending the structure and substance included within annual reporting for entities that issue securities registered with the CMF. The rule adds to the disclosure requirements for issuers as it mandates reporting on ESG factors at all levels of such issuer’s annual report rather than in one isolated section specifically geared for ESG.12 In March 2022, the Republic of Chile issued a US$2 billion sovereign sustainability link bond—the first country to do so—focusing on decarbonisation efforts.13
What we have seen in the Latin American market
Initially, in most ESG loans to Latin American corporations the borrower agreed covenanted to use proceeds for ESG purposes, without any real monitoring or effort on the side of the borrower. As a result, like what happened around the globe, sustainable financing was met with scepticism in Latin America due to the prominence of greenwashing.14
In an effort to address greenwashing, different forms of ESG loans with commercial financial institutions have developed, all relating back to one common nexus: monitoring and compliance of the SLLs. The biggest question facing the ESG market in Latin America (and by consequence the SLL market) is compliance: what authority determines whether a loan is compliant with the SLLs? The short answer is that there is no single authority that sets forth a standard for compliance, mainly due to the following factors: (i) the sector which the financial product is in, (ii) the country in which the company operates (regulatory frameworks differ from jurisdiction to jurisdiction), and (iii) the unique goals of the company endeavouring in sustainable finance. Though there are organizations, such as the Loan Market Association, the Asia Pacific Loan Market Association, the International Capital Market Association, and the Loans Syndications and Trading Association, that publish Sustainability-Linked Loan Principles and Sustainability-Linked Bond Principles15—frameworks to promote and define the fundamental characteristics of SLLs—such monitoring of SLLs tends to fall to the parties to the transaction.16
As a result of this developments, we have seen more structured frameworks on two separate levels. At one of the spectrum—the more common but less stringent—borrowers covenant to use proceeds for ESG purposes, and such proceeds are deposited in a segregated account for such purpose. This is complemented with the borrower periodically providing a compliance certificate demonstrating ESG compliance.
At the other end of the spectrum—the less common but more stringent—we have seen borrowers agreeing to hire external parties, such as sustainability consultants, to review the performance of the SLL against predetermined KPIs and SPTs. This external review may also be accompanied by periodic reporting and second-party opinions, all in an effort to increase transparency and market appetite for ESG products.17
The combination of new SLL products and standards have been met with an additional interest by consumers, investors, and governments who have begun to proactively maintain a close watch of greenwashing by borrowers in recent years, challenging such practices through lawsuits and regulatory complaints and setting up governmental agencies. For example, the United States Securities and Exchange Commission (“SEC”) launched the Climate and ESG Task Force within the Division of Enforcement to “develop initiatives to proactively identify ESG-related misconduct consistent with increased investor reliance on climate and ESG-related disclosure and investment.”18 A Brazilian meat producer was accused in a complaint to the SEC of misleading investors by issuing green bonds without disclosing the entire scope of the company’s environmental impact. The investigation arose from a whistleblower accusation that the company has engaged in greenwashing, and while the investigation is still ongoing, that company could potentially become the first issuer to sanctioned by the SEC for greenwashing. Although this level of enforcement has not yet been seen in Latin America, we anticipate that local regulators and investors will begin to hold borrowers accountable on ESG-related matters, further developing the sustainable finance framework in the region.
Going Forward
Even though recent global volatility and the demise of certain financial institutions have dampened some interest in sustainable finance activity (and financings in general), ESG and sustainable financing remains a key financial product and is here to stay. Needless to say, for sustainable finance to thrive in Latin America, there needs to be further development in the areas of compliance. Latin American countries should endeavour to establish a more unified framework that guides companies in ESG and sustainable financing by providing comprehensive data and analytic disclosures.
In addition to the improvement of monitoring to avoid greenwashing, ESG financings should implement meaningful consequences for the borrower’s failed performance against the agreed-upon KPIs and SPTs, such as two-way pricing adjustments, stricter covenants or additional pre-agreed-upon fees . Two-way pricing adjustments – where the borrower’s interest rate can go either up or down in response to meeting (or failing to meet) agreed-upon KPIs and SPTs – should become more prevalent rather than just margin adjustments downward for when the borrower meets relevant sustainability targets. To avoid any issues from lenders benefiting increased interest rates or additional fees, pre-agreed-upon actions can be taken with respect to increased payments to be made by the borrower, such as donations to charity or application of such funds to the borrower’s other ESG-related projects.
The end goal is to ultimately increase transparency in Latin America’s sustainable finance market as good practices create goodwill, which will in turn attract strong market participants and lenders.
Additional Author Daniel E. Albarran Garcia
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1 Raquel de la Orden and Ignacio de Calonje, Sustainability-Linked Finance – Mobilizing Capital For Sustainability In Emerging Markets, INTERNATIONAL FINANCE CORPORATION, FRESH IDEAS ABOUT BUSINESS IN EMERGING MARKETS, NOTE 110 (Jan. 2022), https://www.ifc.org/wps/wcm/connect/306c321d-ea77-448d-85c6-7ce3899136a5/EMCompass_Note+110_Sustainability-Linked+Finance_web.pdf?MOD=AJPERES&CVID=nVKABZX.; Erica Arcudi, Sustainability Linked Loans: A Foot In The Door And An Eye On The Exit Plan, MAYER BROWN, EYE ON EMERGING MARKETS | Q1 2022, https://view.ceros.com/mayer-brown/1/p/2 (last visited Apr. 18, 2023).
3 Benjamin Stango, et al., ESG In The Credit Agreement: A Closer Look At Sustainability-Linked Loan Mechanics, REUTERS (June 10, 2022), https://www.reuters.com/legal/legalindustry/esg-credit-agreement-closer-look-sustainability-linked-loan-mechanics-2022-06-14/; Ruti Smithline, et al., supra note 1.
4 Ruti Smithline, et al., supra note 1 ; Sustainable Finance Is Accelerating In Latin America, SCOTIABANK GLOBAL BANKING AND MARKETS (Oct. 3, 2022), https://www.gbm.scotiabank.com/en/market-insights/article.sustainable-finance.sustainable-finance-is-accelerating-in-latin-america.html.
5 Randy Bullard, et al., Environmental, Social And Governance In Latin America – Will The M&A Market Continue To Expand?, LATIN LAWYER (Dec. 02, 2022), https://latinlawyer.com/guide/the-guide-mergers-acquisitions/third-edition/article/environmental-social-and-governance-in-latin-america-will-the-ma-market-continue-expand.
6 Sustainable Finance Is Accelerating In Latin America, supra note 4.
7 Mexico Issues Sovereign SDG Bond For Most Vulnerable Municipalities, IISD (Sept. 22, 2020), https://sdg.iisd.org/news/mexico-issues-sovereign-sdg-bond-for-most-vulnerable-municipalities/.; The 17 Goals, UNITED NATIONS, https://sdgs.un.org/goals (last visited Apr. 18, 2023).
8 LatAm Regulatory Developments Advance ESG Investment Initiatives, FITCHRATINGS (Sept. 20, 2022), https://www.fitchratings.com/research/fund-asset-managers/latam-regulatory-developments-advance-esg-investment-initiatives-20-09-2022.
9 Randy Bullard, et al., supra note 5.
10 Ministerio de Hacienda y Crédito Público, Taxonomía Verde de Colombia - Fase I, GOV.CO, https://www.minhacienda.gov.co/webcenter/portal/TaxonomiaVerdeColombia/pages_taxonomiavercolombia (last visited Apr. 18, 2023).; Colombia: Leading The Path To Sustainability In Latin America, THE WORLD BANK (Sept. 7, 2022), https://www.worldbank.org/en/news/feature/2022/08/31/colombia-leading-the-path-to-sustainability-in-latin-america.
11 Luiz Gustavo Bezerra, et al., Brazil’s Central Bank Continues To Advance On Its ESG Agenda, MAYER BROWN, EYE ON ESG (Apr. 30, 2021), https://www.eyeonesg.com/2021/04/brazils-central-bank-continues-to-advance-on-its-esg-agenda/.
12 Antonia Stopler, et al., Status And Pitsfalls Of Environmental, Social And Governance Standards, LATIN LAYWER (Dec. 16, 2022), https://latinlawyer.com/guide/the-guide-environmental-social-and-corporate-governance/first-edition/article/status-and-pitfalls-of-environmental-social-and-governance-standards.
13 Chile’s Bold ESG Ambitions Powered By Sustainable Finance, SCOTIABANK GLOBAL BANKING AND MARKETS (Feb. 8, 2023), https://www.gbm.scotiabank.com/en/market-insights/article.sustainable-finance.chiles-bold-esg-ambitions-powered-by-sustainable-finance.html.
14 The term “greenwashing” refers to the dishonest practices wherein businesses represent themselves as more sustainable than they actually are by providing misleading or false information with regard to the sustainability of their products or services.
15Sustainability Linked Loan Principles (SLLP), LSTA, https://www.lsta.org/content/sustainability-linked-loan-principles-sllp/ (last visited Apr. 18, 2023).; Sustainability-Linked Bond Principles, INTERNATIONAL CAPITAL MARKET ASSOCIATION, https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/sustainability-linked-bond-principles-slbp/ (last visited Apr. 18, 2023).
16 Randy Bullard, et al., supra note 6.
17 Sustainability Linked Loan Principles (SLLP), LSTA, https://www.lsta.org/content/sustainability-linked-loan-principles-sllp/ (last visited Apr. 18, 2023).
18 Enforcement Task Force Focused on Climate and ESG Issues, U.S. SECURITIES AND EXCHANGE COMMISSION (Apr. 11, 2023), https://www.sec.gov/securities-topics/enforcement-task-force-focused-climate-esg-issues#:~:text=The SEC launched the Climate,ESG%2Drelated disclosure and investment.
