Sustainability linked loans (“SLLs”) are any type of instrument designed to incentivise the borrower to achieve ambitious, predetermined sustainability performance objectives. They aim to facilitate and bolster environmentally and socially sustainable economic activity and growth.
SLLs have become a feature of the loan market over the last few years as environmental, social and governance (“ESG”) concerns are becoming progressively significant for both borrowers and lenders. The lenders and borrowers commonly have become increasingly aware of the potential for long term success provided sustainability is placed high on the agenda. The main drivers behind this are regulatory and political factors but also the ever changing demands of various stakeholders such as investors, consumers and employees.
In recent years, the Loan Market Association (the “LMA”) have published guidelines in relation to SLLs and we are seeing an increase in these types of loans in the Irish market. The Irish government and the Central Bank of Ireland have also shown commitment to sustainable finance.
What does the LMA provide for?
The Sustainability Linked Loan Principles (the “SLLP”) were created by the LMA to promote the development and preserve the integrity of the SLL product by providing guidelines capturing the fundamental characteristics of these loans.
The LMA have recognised that there are some challenges in applying the SLLP in the REF and real estate development finance contexts as the type of lending is typically asset-based and the borrower will often be a special purpose vehicle (“SPV”). As a result, the borrower may not have an existing ESG strategy or access to historical ESG data in relation to the relevant property / properties or developments being financed. Because of this, the selection of key performance indicators (“KPIs”) and calibration of sustainability performance targets (“SPTs”) can prove more challenging.
The use of proceeds in relation to SLLs is not a determinant in its categorisation. Rather, the SLL must comply with five core components, which are set out below.
The five core components are:
(1) Selection of KPIs
The KPIs should be (i) relevant and material to the borrower’s core sustainability and business strategy, (ii) measurable or quantifiable on a consistent methodology basis and (iii) able to be benchmarked. The LMA advises that KPIs be included in the term sheet stage.
In the REF and development finance contexts where the borrower is an SPV with no trading history or assets other than the property / land being financed, the LMA suggests that the KPIs should be linked to the assets being financed. The LMA also advise that in these types of financings, at least one KPI will usually refer to energy efficiency, carbon or greenhouse gas emissions.
(2) Calibration of SPTs
The SPTs should (i) represent a material improvement in the respective KPIs, (ii) be compared to a benchmark or external reference (where possible), (iii) be consistent with the ESG strategy of the borrower and (iv) be determined on a predefined timeline.
(3) Loan characteristics
A key characteristic of a SLL is that an economic outcome is linked to whether the SPT is met, e.g. reduction of the margin.
Borrowers should provide the lenders participating in the loan with up-to-date information sufficient to allow them to monitor the performance of the SPTs and to determine that the SPTs remain ambitious.
Borrowers must obtain independent and external verification of the borrower’s performance level against each SPT for each KPI, at least once a year.
What we are seeing in the Irish Loan Market
What we have mainly seen in the market at the moment is “agree to agree” language whereby the parties to a facility agreement agree that the KPIs will be negotiated and agreed at a later date.
Where KPIs are agreed, some examples of what we are seeing include reduction of greenhouse gas emissions, reduction of food waste, direct renewable energy use, onsite energy generation, net zero carbon manufacturing and harvesting of certain amounts of rainwater.
KPIs and the applicable SPTs for each are typically being set out in a separate sustainability indicators and targets document which we are seeing being included as schedules to the facility agreement. Where KPIs are being agreed at a later date, we are seeing provisions in facility agreements providing that the loan cannot be called an SLL until the relevant KPIs are agreed.
The incentive for meeting SPTs in relation to the KPIs is a reduction in the margin for a certain period, often a period of one year. The amount of the decrease in margin will depend on how many SPTs are achieved, up to an agreed maximum amount. On the other hand, a failure to meet the SPTs can result in an increase in the margin for the relevant period (again, up to an agreed amount). Thus far, any increase or decrease has been of the more modest end of the spectrum.
We are also seeing the inclusion of information undertakings whereby the borrower covenants to supply the agent with a sustainability compliance certificate demonstrating the values achieved by the borrower in respect of each KPI for that financial year. From our experience, the penalty for failure to provide the certificate is, again, in limited circumstances, a modest increase in the margin but does not result in a breach of the facility agreement.
It will be interesting to see where this develops in the Irish market in relation to:
- Downward only margin adjustments.
- The level of margin decreases / possible increases.
- The requirement for third party verification and whether this becomes mandatory.
- Overall level of reporting and lender oversight.