As environmental, social, and governance (“ESG”) initiatives are increasingly implemented by borrowers and lenders, sustainability linked loans provide opportunities for both.
What are Sustainability Linked Loans?
Sustainability linked loans (“SLLs”) are based on the Sustainability Linked Loan Principles developed by the LMA, APLMA and LSTA. In SLLs, a borrower, together with its lender group, determine and set certain sustainability performance targets (“SPTs”) for the borrower to achieve, to be measured by key performance indicators (“KPIs”). Independent organizations, including the Sustainability Accounting Standards Board (“SASB”), provide guidance on the ESG metrics most relevant to certain industry sectors. Once agreed between the borrower and lenders, the KPI/SPT benchmarks are then integrated into margin adjustments to the interest rate or commitment fee for the credit facility (i.e., by achieving the KPIs, the interest rate is reduced). The credit facility documentation will also include reporting requirements for independent, external verification of the borrower’s performance level with respect to each SPT for each KPI, at least annually.
Borrower Benefits
Many companies have already undertaken ESG data collection and reporting, and more will likely do so as the SEC expands its focus on ESG disclosures and as more investors demand this information. While the above noted third party verification and reporting costs are inherent to SLLs, borrowers that are already engaging in these efforts may find they can efficiently obtain an additional economic incentive through SLL financing. Additionally, SLLs can be part of a comprehensive alignment with the borrower’s ESG strategies and policies.
Lender Benefits
Lenders are undertaking ESG initiatives as well, in which SLLs may be a component. And, regulatory agencies for certain lenders are communicating their plans to provide guidance on climate-related risks, and integrate these principles into their supervisory expectations. Further, studies have shown that companies (e.g., SLL borrowers) that identify and manage their ESG risks have improved financial performance. So, financing SLLs can benefit lenders across policy, regulatory and business aspects.
Current State of the Market and Next Steps
Although SLLs are a relatively new financing concept, particularly in the U.S., the volume of SLLs globally quadrupled in issuance between 2020 and 2021. As ESG momentum continues to build in the U.S., the volume of SLLs is likewise expected to continue to grow. Currently, terms are negotiated on a transaction specific basis, and market provisions have not been added to the LSTA’s suite of documentation. But, as SLLs become more common, the market is likely to coalesce on terms. Stay tuned for more updates on SLLs and other trending sustainable finance products, including green bonds and commercial property assessed clean energy (C-PACE) financing.