Sustainability Linked Lending – Who cares wins

• United Kingdom

• Banking and finance
• Financial services and markets regulation - ESG
• Energy and infrastructure - Clean energy

28-01-2021

Contents

- Embracing Sustainability

- Borrowing sustainably

- Environmental Sustainability

- Social Sustainability

- Governance Sustainability

- What about the future?

- How Eversheds Sutherland can help

Embracing Sustainability

In both his 2020 and 2021 letter to CEOs, Larry Fink, Chairman and CEO of Blackrock, the world’s biggest fund manager, with over US$8tr of assets under management, speaks of a fundamental reshaping of finance and a reallocation of capital away from businesses who are not making sufficient progress on sustainability related disclosures and the business practices and plans underlying them. Put simply, he said that climate risk is investment risk.

His message that every government, company and shareholder must confront the issues of sustainability appears to be resonating. Emerging evidence shows that some ESG (Environmental, Social and Governance) equity indices are outperforming non ESG peers suggesting that businesses which embrace sustainability will be the winners with value moving in their direction. We are increasingly seeing our corporate clients embrace sustainability and financial institutions putting more emphasis on ESG strategies when scrutinising potential opportunities.

So whilst we are clearly seeing a transition towards sustainability, we are also continually reminded that there is much more to do. Whilst the Covid-19 pandemic has had a number of negative consequences, it is likely to have resulted in global carbon emissions falling in the region of c5% during 2020. Although, to put that in context, evidence shows that we need a sustained reduction of 7.6% annually to negate the effects of climate change.

Sustainability is about businesses making more conscious choices about manufacturing, sourcing, social and technological factors and looking at how businesses can better serve and thrive in their communities on an enduring basis.

Borrowing sustainably

Adding to the many external push and pull factors, most banks and other financial institutions now have their own sustainability commitments and are being pushed hard by their various stakeholders to fulfil them. As such, we are seeing an exponential increase in lending linked to specific sustainability targets. This market doubled in 2019 and a similar trend is expected in 2020 and beyond, as lenders are increasingly motivated to drive growth in this direction. Whilst the pandemic unsurprisingly led to a surge in emergency liquidity lending in 2020, the level of sustainability lending has continued to grow; a great indicator that despite external pressures, sustainability remains high on the agenda for lenders and borrowers alike.

Furthermore, many credit committees and rating agencies are now embedding sustainability as a method of selecting assets and opining on credit risk, in a similar way as to how they assess other factors such as management, sector risk or the quality of financials.

Having evolved from green loans, where use of proceeds had to be specifically for green or clean projects, the Sustainability Linked Loan (SLL) product emerged in 2017 and is now available widely, where the proceeds can be for general corporate purposes.  

There are many benefits to borrowers of linking their finance to sustainability targets. In particular, it signals a clear commitment to all stakeholders, which can lead to better long term client and supplier relationships, an enhanced ability to attract and retain staff, and ultimately have a positive effect on reputation and shareholder value. It also aligns with obligations for public companies and large asset holders to disclose in line with TCFD (Task Force on Climate related Financial Disclosures) recommendations by 2022. It is worth noting here that the UK Government, as part of its post-Brexit positioning, has announced that it will ensure the UK becomes the first country to make TCFD aligned disclosures mandatory across the whole of its economy by 2025. 

An added incentive for borrowers is the ability to achieve reductions in the cost of finance if ambitious pre-agreed targets are subsequently achieved. The reductions are relatively modest, starting around 5 basis points for investment grade borrowers and up to c5% of the overall interest margin for borrowers with a higher cost of capital. Whilst a failure to meet a sustainability target may not constitute an event of default, a margin premium is likely to result. In general, many borrowers chose to enhance their credentials further by committing to reinvest any financial benefits received into their ESG projects or donate to a chosen charity.

One warning here about ‘sustainability or green washing’, which are terms to describe situations where claims on sustainable credentials are misleading, inaccurate or inflated and may occur when targets are not challenging or meaningful enough or are not disclosed or monitored correctly. The LMA (Loan Market Association) has produced helpful guidance for Borrowers on the 4 key principles for SLL’s to help ensure they do not fall into these traps.

What is often less understood, when discussing SLL’s, is the wide range of areas that performance measures can be linked to. As the market has evolved, Social and Governance factors should now be considered equally important in the area of sustainability as Environmental factors.

Environmental Sustainability

There are many compelling environmental reasons for sustainability linked lending and most businesses can play their part in some way as they think about their real estate, consumption, production or processes.

All companies, but particularly those in sectors such as oil & gas, mining, transport and some areas within heavy industry, manufacturing, chemicals and utilities may include specific targets to help these economically crucial industries transition away from fossil fuels, reduce waste or water, recycle products, source sustainably or improve energy efficiency. Such “transition” financing, which is often targeted at helping so-called “brown” companies move to greener activities are of increasing interest as they open up the markets for sustainability linked lending to a wider audience of target issuers. Shell for example recently launched a $10bn SLL RCF with specific decarbonisation targets.

The bond markets have also been at the forefront of “transition” financing with the gamut of issuers steadily widening. At the time of writing, Tesco, as well as launching a £2.5bn SLL RCF last year linked to emissions, renewable energy and food waste targets, had very recently issued one of the UK’s first Sustainability Linked Bonds. The €750m bond, which was more than 6x oversubscribed by investors, has pricing incentives linked to achieving a reduction in CO2 emissions.

Social Sustainability

Social sustainability is described as identifying, measuring and managing impacts on people, which in turn gives businesses the ability to continue to operate profitably and productively. This includes people they directly employ, in supply chains and also their end customers. It is important to note the differences between legal minimum standards which focus on policy and procedures and social sustainability which is focused on delivering ambitious, long term lasting performance.

Examples of social sustainability could involve inclusion initiatives, which can lead to reduced staff turnover and retention of talent, or supply chain innovation, where cooperation with suppliers can lead to a sharing of opportunities. Other examples may include improving working conditions such as a reduction in health and safety issues or accident reporting.

We have seen a number of recent examples of RCFs in the social housing sector, with targets being linked to the number of residents being placed into work or work based training programmes. Another example is educational services provider, Pearson, who launched a $1.19bn SLL linked to the number of children studying and hitting educational targets.

The effects of the Covid-19 pandemic on social interaction have undoubtedly heightened the importance of this area, with many businesses likely to permanently adapt business practice, through use of technology, to operate more sustainably in the future.

Governance Sustainability

Good governance is not only important for companies, it is important for society. It improves faith and confidence in leadership, it protects from known threats and keeps problems from occurring or reoccurring. The principles of corporate governance are based on transparency, accountability, responsibility and fairness.

Sustainable governance examples may include clear corporate policies in areas such as corruption and bribery, diversity and inclusion (such as gender or race targets) and remuneration. Targets may include reduction in penalties or fines, increase in BAME employees, a reduction in products and services in unethical sectors or an increase in charitable donations.

SMBC Bank recently signed a £75m SLL with Bromford Housing Group with targets relating to governance, including specific KPI’s around the gender pay gap. Furthermore, Bromford have committed to reinvest any savings in interest margin into local community projects.

In addition, the recent loan backing of TowerBrook’s acquisition of Talan SAS offers the IT consultancy business the chance to reduce interest costs tied to targets that include a minimum proportion of women in the senior management team, a target that rises each year. This transaction provides evidence that private credit lenders in the leveraged space are now beginning to adopt ESG principles as their investors become more discerning.

What about the future?

It is currently estimated that total Green and Sustainability linked lending represents c6% of global loans with rapid growth expected to continue. Many commentators observe that whilst the pandemic has been a shock to the global economy, in the long run, it may become a catalyst rather than a dampener to future growth.

So, what factors could influence future direction?

Availability criteria -  to date, sustainability-linked borrowings have been demanded most by large public entities who are keen to demonstrate ESG commitments across their business. That said, increasingly, we are seeing banks and funds develop products that broaden and lower the entry criteria (with availability below £10m in some cases) to cater for smaller businesses, many of whom are keen to play their part in the trickle-down effect.

Capital relief - Adding an ESG wrapper will definitely improve a loan’s attraction to lenders and investors, where they can treat margin reductions as an implicit financial contribution to their own sustainability agenda. That said, generally this is predicated on the credit and returns already stacking up to ensure the commercial risk and reward makes sense. If there was an advancement of discussions amongst governments, regulators and lenders on the subject of capital relief or risk mitigation for lenders and/or investors, this could be a game changer to the rate of deployment, particularly if additional financial incentives were passed through to borrowers.

Reporting – Borrowers who link their lending to sustainability targets are encouraged to provide regular information to lenders on the progress being made. Whilst self-certification is still widely used, sometimes with an obligation for referencing in audited accounts,  increased scrutiny has seen some businesses choose external verification by an independent third party such as specialist firms like Sustainalytics or Carbon Trust, or many of the large audit firms, which now have sustainability audit services. Whilst there is currently no uniform accepted methodology, we expect to see stakeholders become more demanding of businesses generally in terms of their external reporting.

Worthy of note is that ESG related reporting guidance for leveraged finance transactions has recently been issued by the LMA and European Leveraged Finance Association, as a way of providing more consistency in this particular area. Whilst linking loan terms to ESG goals is relatively established in investment-grade corporate debt, it has been comparatively rare in leveraged finance to date, albeit, investor demand for social responsibility is now pushing its way into the European private credit markets with Tikehau, CVC and Barings recently announcing ESG Unitranches with margin reductions in return for reaching ESG goals.

With the UK set to host the 26^th UN Climate Change Conference in Glasgow in November this year (COP26) and the UK government promising to ‘build back better’ post the pandemic, we expect to see sustainable lending to remain firmly on the agenda for lenders and borrowers in 2021 and beyond, and for more and more businesses to align their borrowing to their ESG targets.

How Eversheds Sutherland can help

The legal landscape on green and sustainable investment is constantly evolving, which means considered legal advice is vital. Nowhere is this more evident than the name – there is, in fact, no established market term for green or sustainable finance. These are broad definitions that cover different financial products created to support investment in projects that will benefit the environment, in the same way as responsible investment, environmental, social and governance (ESG) finance, sustainable finance and climate finance.

Whatever the terminology, the underlying principles are the same in an area in which we have vast experience. Traditionally, green finance is related to the clean energy sector, where are our team has been working for years on projects such as renewable energy finance.

With lawyers adept at securing value and protecting your interests across every stage of the value chain, we can help you successfully negotiate every aspect of this evolving area of law. With years of experience helping corporates with their environmental, social and governance performance, our ESG lawyers can help enable you to deliver your own sustainability strategies with significant positive outcomes.