Last year, we wrote about sustainability linked loans ("SLLs") and their position in the Irish loan market. Recently, the Loan Market Association (the "LMA") together the Loan Syndications & Trading Association and the Asia Pacific Loan Market Association published updated versions of the sustainability linked loan principles (the "SLLP") and associated guidance. Below, we highlight the changes made to the SLLP and guidance and provide an update on recent developments in relation to SLLs in the Irish loan market.
What's new? Updates to the SLLP
The SLLP are a voluntary framework which aim to promote the development and safeguard the integrity of the SLL market, while ensuring flexibility and consistency. They are based around the following updated core components:
1. Selection of key performance indicators ("KPIs")
The updated SLLP highlight that KPIs must be relevant, core and material to the borrower's overall business, have strategic significance to its business strategy and address relevant ESG challenges of the borrower's industry sector. By selecting KPIs that are not material and core to the business of the borrower, such borrower is left exposed to greenwashing claims. The guidance notes that best practice is for a borrower to seek to benchmark its KPIs by undertaking a materiality assessment of itself and its industry.
2. Calibration of sustainability performance targets ("SPTs")
SPTs must be set in good faith and remain relevant (so long as they apply) and ambitious throughout the life of the loan. A key update is the recommendation that an annual SPT be set per KPI for each year of the loan term. Exceptions to the annual frequency of SPTs can be agreed between borrowers and lenders where "strong rationale" is provided as to why it is not appropriate to set annual SPTs.
The updated SLLP also state that SPTs must not only be set beyond a "business as usual" trajectory, but also beyond "regulatory required targets" i.e. that they must not be set lower than the performance historically achieved by the borrower or what is required by law. The guidance notes that comparisons can be made against any publicly available peer targets and also states that both KPIs and SPTs should be selected with local context taken into consideration.
Arguably, of greater interest than the above updates to KPIs and SPTs, are the clarifications in the updated SLLP guidance that for a loan to be considered or referred to as a SLL, the KPIs and SPTs (and all other core components of the SLLPs) must be documented at origination. In some exceptional circumstances, the parties may agree to set KPIs and SPTs post-origination but that this should take place no later than 12 months post-origination. In such cases, the guidance includes a recommendation that unanimous lender consent be required to agree those SPTs and KPIs other than where the size of the syndicate makes this impractical. These clarifications are important and welcomed to ensure the integrity of SLLs.
3. Loan characteristics
A key characteristic of a SLL is that an economic outcome is linked to whether the selected SPTs are met – for example, a reduction of the margin where the SPTs are achieved and vice versa. The updated SLLP notes that in some cases, where a "strong rationale" is provided, the ratchet may include a neutral bracket in which no margin adjustment applies. The LMA is currently in the process of drafting SLL provisions and we will update you on these developments.
4. Reporting and verification
Regarding reporting, the updated SLLP now state that borrowers should provide the lenders with a sustainability confirmation statement annually with a verification report attached, outlining the performance against the SPTs for the relevant year and the related impact, and timing of such impact, on the margin.
The guidance states the verification report should describe, amongst other things, the following:
- the level and type of verification, e.g. whether a limited or reasonable assurance, or other, engagement has been conducted and the standards applied;
- a description of the procedures conducted by the practitioner and any inherent limitations;
- a description of the subject matter of verification and the criteria, such as sustainability standards used to assess conformance; and
- confirmation of the practitioners' independence and conformance with quality management systems.
The updated SLLP clarifies that independent third party verification is a necessary element of the SLLP and that the verification of the performance against the SPTs must be shared with the lenders in a timely manner.
Distinction between SLLs and sustainable economic activity
The updated SLLP guidance notes that the SLL label should not be confused with definitions in taxonomies, which are designed to define what constitutes a sustainable economic activity. SLLs are designed to support borrowers in their journey to improve their sustainability performance and will not necessarily count as sustainable economic activities in regulatory terms.
When do the SLLP take effect?
Any loans originated, extended or refinanced after 9 March 2023 must align fully with the updated SLLP in order to be classified as SLLs. All transactions completed before 9 March 2023 are exempt from following the updated SLLP and should instead be reviewed in conjunction with the version of the SLLP in force at the time of origination, extension or refinancing of the loan as applicable.
Recent developments in the Irish ESG loan market
There have been some developments in the Irish market in the last year relating to SLLs which we have outlined below:
- There is a greater level of scrutiny by lenders over the selection of the KPIs and SPTs themselves.
- While there has been a number of SLL enabled loans, there is a push to agree KPIs and SPTs at origination.
- Self-certification of compliance with SPTs is a thing of the past with almost every documented SLL requiring independent third party verification from a party acceptable to the lenders.
- Where a loan is SLL enabled, lenders typically include an undertaking that the loan cannot be called an SLL until the relevant KPIs and SPTs are agreed. What has developed is that lenders are including a breach of this undertaking as an event of default.
As you can see, most of the developments in the Irish market from the last year are already aligned with the updated SLLP.
We have seen little change in relation to margin adjustments. Whereas it is common now to have upward as well as downward margin adjustments the amount of such adjustments, from our experience, remain pretty modest. It is also very common for there to be a neutral bracket in the margin ratchet.
It will be interesting to see what new trends emerge in the near future, especially once the LMA completes and publishes the drafting project it is currently undertaking in relation the SLL provisions.