In our May edition of REF News & Views, we have provided an introduction to Sustainability Linked Lending (“SLL”). As a reminder, SLLs have emerged alongside green lending as a result of the movement towards greater awareness and improved environmental and social beneficial outcomes in the way businesses and lenders make their loans, investments and other business decisions. While green loans and SLLs are similar in their macro mission to environmental and social sustainability, there are important differences in their approach.
In this next article in our series on sustainability-linked lending, we explore this growing field further by introducing and describing the principles of sustainability-linked lending (“SLLP”) and the basic components of SLLP.
Principles of sustainability-related lending
As a joint initiative of the Loan Market Association (“LMA”), the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association, the SLLPs were published to provide a framework of principles to help market players to understand and identify the key elements of establishing sustainability-related lending. The SLLP was first published in March 2019 and is periodically reviewed and updated, with the latest version being published on March 31, 2022.
By providing a set of guiding principles, its ambition is to help facilitate and support environmentally and socially sustainable economic activity and growth, and to promote sustainable development more generally. It achieves this by seeking to solve the following problems:
- the advantages of concluding an SLL;
- who can participate in an SLL;
- the differences between an SLL and a green loan; and
- documentation issues for SLLs.
As mentioned above, in March 2020 (then updated in August 2021), the LMA also published a glossary of terms applicable to SLLs, providing an alphabetical list of terms and concepts relevant to SLLs. It is advisable to read it in conjunction with SLLPs, as several key terms and concepts applicable to sustainable lending are explained in more detail here.
SLLP – Fundamentals
The fundamental principles of the SLLP are to encourage the borrower of an SLL to:
- clearly communicate to its lenders its logic for selecting its key performance indicators (“KPIs”) (that’s to sayrelevance and materiality) and motivation for Sustainable Development Performance Goals (“SPTs”) (that’s to saylevel of ambition, consistency with overall sustainability objectives as set out in its sustainability strategy, benchmarking approach and how the borrower intends to achieve these SPTs);
- position this information in the context of their main sustainability objectives, strategy, policy and/or processes; and
- disclose to lenders any sustainability standards or certifications they seek to comply with.
SLLP – Core Components
The SLLP has also established a framework allowing all market participants to fully understand the characteristics of an SLL. The framework is based on five main components:
- Selection of KPIs
The KPIs selected by the borrower should be clearly defined and relevant, essential and material to the borrower’s business, and of high strategic importance to its future operations. Each KPI should be measurable or quantifiable on a consistent methodological basis and be able to be compared to an industry standard when possible.
The appendix to the SLLPs contains a list of some common categories of KPIs, along with an example of the improvements that category might seek to measure.
- SPT Calibration
The process of calibrating the SPTs by KPI is essential to the structuring of the SLLs. SPTs are an expression of the level of ambition to which the borrower is willing to commit (that’s to say, representing a significant improvement in the relevant KPI and going beyond a status quo trajectory). SPTs must be established in good faith and remain relevant (as long as they apply) throughout the term of the loan.
- Characteristics of the loan
A key feature of an SLL is that an economic outcome is tied to whether or not the selected predefined SPTs are met. A common example is that the margin under the relevant loan agreement may be reduced when the borrower meets a predetermined SPT as measured by the predetermined KPIs.
- Reporting progress against SPTs
Borrowers should report at least annually with sufficient up-to-date information to allow lenders to monitor progress and confirm that goals remain ambitious and relevant to the borrower’s business.
Since transparency is particularly valuable in this SLLP market, where prospective borrowers should be encouraged to report the underlying calculations and methodologies publicly (such as in a borrower’s annual integrated report or sustainability report).
Borrowers should obtain independent external verification of their level of performance for each SPT at least once a year (for example, by auditors, environmental consultants or independent rating agencies).
It should be noted, however, that although SLLPs are recommended guidelines, they are currently still voluntary and should be applied on a case-by-case basis depending on the underlying characteristics of the transaction.
In the next article in this series of sustainability-related loans, we’ll dive deeper into the five main components.