The Loan Market Association ("LMA"), Loan Syndication and Trading Association ("LSTA") and Asia Pacific Loan Market Association ("APLMA") have published new guidance1 on the key aspects of the Green Loan Principles ("GLP")2 and the Sustainability-Linked Loan Principles ("SLLP")3. In this second of a two part series4, we discuss the GLP and the SLLP and which aspects of sustainable finance favour each structure.
Sustainable loans, with over US$163 billion5 of green and sustainability-linked loans extended last year alone, have now gone mainstream and are an essential tool to help corporates align with the EU Taxonomy, especially for emerging markets borrowers looking to transition their business to operate on a more sustainable basis.
A recap of green loans and sustainability-linked loans
Green loans ("GLs"), based on the GLPs, are generally structured in the same way as standard loans except that the loan proceeds are tracked and allocated to eligible green projects. The GLPs contain a non-exhaustive list of indicative categories. GLs also require: transparency about how the sustainable projects are selected and how the funds are allocated.
Sustainability-linked loans ("SLLs"), based on the SLLPs, deviate from the GL "use of proceeds" model. Unlike GLs, SLLs involve setting "sustainability performance targets" ("SPTs") for the borrower (e.g. if "internal", reduction in greenhouse gas emissions; improvements in energy efficiency; or if "external", attaining a certain sustainability rating from an external reviewer) and if these targets are met, the borrower is rewarded with a ratcheting down of the loan's interest rate. Further, SLL proceeds do not need to be allocated exclusively (or indeed at all) to green projects.
Sustainability-linked loan or green loan?
Where prospective borrowers have a choice, they may ask "what type of sustainable loan structure should I use: a GL or a SLL?" Three key considerations may help determine which structure is more appropriate:
1. Will the loan monies be allocated and tracked to specific green projects?
If the fundamental purpose of the loan is financing clearly identifiable green projects into which the loan monies can easily be tracked, a GL may be the most suitable option. If the use of proceeds of the loan is likely to be more diverse or cannot all be allocated to qualifying green purposes, a SLL may be the better option.
As a general rule of thumb, larger corporates in certain sectors (obvious examples include energy, transportation) with a variety of sources of finance and the capacity to allocate sizeable chunks of capital to large-scale eligible projects will be best placed to borrow under the GL structure. An advantage of the SLLPs is that they open the sustainable loan market to companies in a wider variety of sectors (which may not naturally provide those projects as a funding requirement) and to smaller companies that have not been able to overcome barriers to entry to participating in a GL or issuing a green bond. SMEs are less likely to be able to commit the entire proceeds of a loan to specific green projects, so the flexibility of the SLL structure, alongside the incentive to improve the borrower's sustainability profile, mean the product may be more inclusive and widely accessible than its GL cousin.
2. Is the company looking to borrow under a term loan or revolving credit facility structure?
In general, term loans are best suited to the GL structure and revolving credit facilities ("RCFs") to the SLL structure. This is due to the relative difficulty of segregating and tracking RCF monies, which is a requirement of GLs but not SLLs. By their nature, RCFs are periodically drawn upon and repaid as and when needed: a characteristic which means they are best suited to flexible use for general corporate purposes that are not necessarily known when the loan is initially agreed. That said, we have also seen the use of SLLs in a term loan context and the application, by reference to the company's performance against the SPTs, of the margin increase or decrease against a drawn term loan (as opposed to a RCF that might be an undrawn backstop) which results in the borrower more genuinely having "skin in the game".
3. Is the company looking to improve the company's overall sustainability profile?
If the borrower is looking to improve its overall sustainability profile, a SLL may be the most appropriate option. If the company hits its sustainability targets, it would also receive a direct financial benefit through a reduced cost of borrowing; the potentially greater liquidity for an ESG linked product may in itself drive enhanced pricing. However, since the de facto reward of margin reduction is relatively limited, arguably the more powerful driver for a SLL is the alignment of the financing in supporting the company's commitment to its sustainability objectives and as evidence of the adoption of those objectives across the organisation as a whole. Companies investing in their own sustainability are aligning themselves with the global drive towards mandating climate-related disclosure by companies. There is also a growing belief that an entity's ESG credentials have a direct correlation to their ability to repay their debt and a SLL engages a borrower's ESG performance in lenders' credit processes.
Conversely, if the desired use of proceeds of the loan, though environmentally beneficial, will not improve the overall sustainability profile of the borrower, a GL may be most appropriate.
Key considerations when structuring sustainable loans
|Lender considerations||Borrower considerations|
|Impact on pricing||Sustainability framework assessment and alignment
(for SLLs) Internal v external SPTs
Cost of compliance vs benefits
|Term loan or revolving credit facility||Pricing benefits|
|Consequence of breach of "sustainable" terms||Risk and consequences of breach|
|Reputational risk||Additional documentary terms or controls|
|Compliance with GLP / SLLP — ongoing monitoring||Ability to self-monitor and report|
|Future-proofing — impact of mandatory rules on taxonomy and disclosure requirements||Reporting and disclosures (esp. any public disclosures re SLLs)|
Alignment with the EU Taxonomy
Given the propensity of SLLs to incentivise and support improvements in a borrower's sustainability profile, these instruments will be invaluable ahead of the coming into force of the EU's Taxonomy Regulation this summer.
The Taxonomy Regulation together with the Non-Financial Reporting Directive will require large companies, issuers of securities and financial market participants to perform an analysis of their economic activities and quantitatively report on the extent to which they are 'sustainable', as defined by the EU Taxonomy. These reports will have to be made public (e.g. in the company's annual report), so in-scope companies will be effectively required to publicly 'name and shame' themselves to the extent they are failing to operate on a sustainable basis.
If, however, a relevant company is investing in transitioning a particular economic activity towards compliance with the sustainability criteria in the Taxonomy, e.g. through the proceeds of green or sustainability-linked loans, the company can report that the transitioning aspects of its business are sustainable, improving the company's overall public sustainability profile. Thus, by borrowing a SLL and meeting the SPTs thereunder, a company could benefit from both a lower interest rate on its loan and the positive publicity associated with being more closely aligned with the EU Taxonomy.
Wider applicability to transition finance
Looking beyond the loan market, much of the guidance on SLLs is equally applicable to sustainable capital markets products aimed at transitioning the issuer away from a highly carbon-intensive business model – sustainability-linked bonds ("SLBs") and transition bonds.
SLBs are conceptually similar to SLLs, but unlike lenders, bond investors are generally not willing to accept a lower interest return if the borrower meets their sustainability targets. SLBs issued to date address this by offering a step up-only mechanism ("one way" pricing) to the interest rate – i.e. if the issuer fails to meet its targets, the coupon increases, but there is no corresponding step-down mechanism if the issuer does reach its targets. As with pricing dynamics for SLLs, issuing in the sustainability-linked format can increase demand for the notes, which may also drive down the initial coupon.
Similarly, the guidance could help potential issuers of transition bonds. Essentially, the procedural requirements for transition bonds are the same as for green bonds, except that the use of proceeds can effectively fall short of something that could be described as traditionally green, as long as is part of a strategy to transition towards a lower-carbon economy. As with SLL borrowers, transition bond issuers may be expected to set SPTs as a way of measuring the positive impact the transition bond is having.
Transition bonds recognise that companies from less green sectors of the economy who enter the sustainability market are often those that can make the most difference in combatting climate change by transitioning their business model to become more sustainable, though the route to sustainability may be less direct.
Both structures have already proven to be useful tools in the area of sustainable finance and each is becoming a mainstream financing tool in its own right. The sustainability-linked structure in particular not only aligns companies to investor sustainability expectations but allows access to a wider range of companies who might not have a specific green projects pipeline or funding needs to seek funding through GLs. The concept is also spreading into the bond market in the form of SLBs and transition bonds. These in turn appeal to segments of financial markets which were previously untapped from a sustainability perspective, such as large emerging market corporates, providing an incentive as the global regulatory environment continues to push for companies' sustainability profiles (or lack thereof) to be made increasingly public.
1 The GLP guidance is available here: https://www.lma.eu.com/application/files/7215/8866/8713/GLP_Guidance_V06.pdf The SLLP guidance is available here: lma.eu.com/application/files/3815/8866/9028/SSLP_Guidance_V04.pdf
4 See part One here: https://www.whitecase.com/publications/alert/new-industry-guidance-clarifies-sustainable-loan-market
5 According to Refinitiv
Alexander Buchanan (White & Case, Professional Support Legal Assistant, London) contributed to the development of this publication.
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