Sustainability Linked Loans - Leverage your ESG Rating
While investors are increasingly focused on how their investment decisions impact the environment and key stakeholders, forward-looking lenders also have sustainability at the core of their allocation strategies. As a result, the demand for sustainable finance products has increased in recent years.
Until recently, green bonds were the primary sustainable finance instrument, but a relatively new and fast-growing product is the Sustainability Linked Loan. A key feature of this product is a mechanism linking discounts or premiums applied to interest rates to a borrower’s ESG (environmental, social and governance) rating or other sustainability metrics. These loans are being issued under various labels including ESG Linked Loans and Positive Incentive Loans.
Benefits to borrowers
Incentive and commitment to improve sustainability – Sustainability Linked Loan (or ESG-linked loan) provide one of the most direct ways of incentivizing borrowers to improve their sustainability performance and demonstrate that commitment to stakeholders. Typically, the loan margin is tied to a borrower’s ESG ratings from a credible third party like Sustainalytics but it can also be linked to a company’s internal sustainability performance indicators or targets.
Lower cost of capital with preferential interest rates – Loan terms tied to ESG ratings or metrics impact borrowers’ overall cost of capital; if the company’s ESG rating improves, the interest rate on the loan goes down and vice versa. According to ING, discounts and penalties vary between 5 to 10% on the interest rate margin depending on the cost of capital.
Benefits to lenders
Enhanced value proposition – Sustainability Linked Loan (or ESG Linked Loan) help lenders strengthen their positioning as sustainable finance leaders to their customer base and provide them with competitive differentiation.
Lower risk – Securing a Sustainability Linked Loan (or ESG Linked Loan) requires a meaningful, long-term commitment to sustainability improvement. Forward-looking lenders recognize that companies focused on improving their ESG rating are better positioned to manage their material sustainability risks and opportunities.
Key difference between use of Sustainability-linked loans and Sustainability Bonds
For Sustainability Linked Loans (SLLs), the use of funds generated can be tailored to a range of corporate needs - While both SLLs and sustainability bonds tie capital to sustainability criteria, these SLLs don’t require a borrower to target specific use of proceeds as is the case for sustainability bonds. SLLs fall under the broad lending category of ‘general corporate purposes’ and hence provide more flexibility to borrowers in terms of utilizing the funds obtained.
The first Sustainability-linked loan (or ESG-linked loan) - Phillips
The first SLL was led by ING and Philips, the Dutch health technology company, in April 2017, when a consortium of 16 banks agreed on a $1.2 billion syndicated loan. Sustainalytics played a critical role in this first deal as the revolving credit facility’s (RCF) interest rates were tied to its ESG rating by Sustainalytics. As per the loan terms, if Philips’ sustainability performance improves annually then its interest rates go down or vice versa. Since the pricing was dependent on the company’s overall ESG rating as opposed to a defined use of proceeds, Philips got maximum flexibility in utilizing the funds.
Another significant loan in Europe involved French food company Danone, which introduced ESG criteria to its syndicated €2billion credit facility in February 2018. This deal too utilized the ESG rating from Sustainalytics as one of three key inputs for measuring and annually tracking Danone’s ESG performance for any discount or premium on the loan margin.
A milestone deal was Asia’s first sustainability-linked club loan announced by agribusiness Olam International in March 2018. The $500 million credit facility with 16 banks is based on the company’s ESG rating assessed annually by Sustainalytics.
In the US, CMS Energy became the first company to receive a SLL, in June 2018, by committing to internal targets related to renewable energy generation. The $1.4 billion RCF allows CMS to lower its interest rates by increasing the share of renewable electricity to 40%, reducing carbon emissions by 80% and phasing out all power plants by 2040.
Most recently, Xylem, a global water technology company headquartered in the US, announced an $800 million RCF with a syndicate of lenders. The interest rate is linked to Xylem’s overall sustainability performance as rated by Sustainalytics and the facility will be used for general corporate purposes.
Positioned for growth
As the market for SLLs is still in its early days, there were no clear standards or definitions governing such loans until early this year. In March 2019, three global loan trade bodies, Europe’s Loan Market Association (LMA), the US Loan Syndications and Trading Association, and Asia Pacific Loan Market Association (APLMA), launched a set of voluntary global guidelines called the Sustainability Linked Loan Principles. These principles provide a high level framework focused on improving transparency and disclosure related to criteria for loans linked to sustainability performance.
Overall, since the first such loan was issued in April 2017, the market grew to $36.4 billion in 2018, gaining the most traction in Europe and notable momentum in the Asia Pacific region. As a key player in this market, Sustainalytics supports corporations and lenders in leveraging their ESG ratings for capital raising activity. Based on increased market demand and dedicated pools of capital to finance sustainable development, the SLL market is well-positioned for global traction.
The Role of Sustainability-Linked Financial Instruments in Heavy Industry Decarbonization
With the effects of climate change looming, governments and organizations of all stripes need to work with carbon-intensive industries and invite them to participate in global decarbonization efforts. This can, in part, be achieved through sustainability-linked instruments.