Introduction to Sustainability Linked Loans and ESG Ratings
Sustainable finance and green lending are on the rise as more borrowers and lenders recognize the potential benefits of green and sustainability-linked loan products for their businesses. According to the Loan Markets Association (LMA), sustainability linked loans are a "dynamic and innovative product that enables lenders to incentivize improvements in the borrower's sustainability profile.” Sustainability linked loans align the loan terms to the borrower's performance against pre-determined sustainability performance targets such as a company’s ESG rating. Learn more about ESG Ratings
The interest rate of these types of loans fluctuates and is linked to improvements in the borrower’s sustainability performance or ESG rating. There are penalties that come with a decline in ESG score, but a higher ESG rating can lead to lower cost for capital.
While a few organizations have mature sustainability profiles and are well known for their environmental agendas (such as Accor Hotels and Patagonia), other companies face a challenge with respect to sustainability and environmental performance due to their business model or industry. Through Sustainability Linked Loans (aka ESG Linked Loans or Positive Incentive Loans) these organizations can access capital to fund initiatives that will support their transition to a greener company. This sustainable financial instrument also gives companies access to commercial and investment banks who have made commitments to sustainable investing.
Sustainability Linked Loan Principles
To contribute towards the fast-moving field of green finance, the Loan Market Association, together with the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association, introduced the Sustainability Linked Loan Principles to provide guidance to green finance participants.
The SLLP consist of voluntary recommended guidelines providing a framework for sustainability linked loan products. A summary of the SLLP's core components is shared below.
Relationship to Borrower's Overall Corporate Social Responsibility (CSR) Strategy
The borrower of a sustainability linked loan should clearly communicate to its lenders its sustainability objectives, as set out in its CSR strategy. The Sustainability Performance Targets upon which the terms of the loan will be based, should be aligned with the borrower’s broader sustainability objectives.
Target Setting – Measuring the Sustainability of the Borrower
The borrower and lender set agreed upon Sustainability Performance Targets (SPTs) which are meaningful to the business.
As mentioned, the sustainability linked loans look to improve the borrower’s sustainability profile, thus the SPTs should also be ambitious. Many borrowers use a credible external performance indicator, such as an ESG rating from Sustainalytics, as their SPT. By linking the loan terms to the borrower’s sustainability performance, borrowers are incentivized to make improvements to their sustainability profile over the term of the loan.
Reporting and transparency are important components of the SLLPs. The guidance recommends borrowers keep SPT-related information, such as their ESG Rating, up to date and readily available. The information should also be provided to loan participants at least once per year. As transparency is valued in the market, borrowers are encouraged to publicly report this information.
The need for an external review is to be negotiated and agreed between the borrower and lenders on a transaction-by-transaction basis.
For sustainability linked loans where borrowers choose not to disclose information related to their SPTs publicly, it is strongly recommended that borrowers obtain an external review of their performance against the SPTs. In cases where the data is publicly disclosed, it is still desirable to have the borrower’s sustainability performance verified by an independent external review. Learn more about External Review.
After the reporting and external review is complete, lenders evaluate the borrowers’ performance against the SPTs based on the information provided.
ESG Rating and Sustainability Linked Loan
Typically, the bank or a lender measures the borrower’s success (or lack thereof) using a predetermined performance target benchmark, like an ESG rating from a third party. Sustainalyics’ ESG risk ratings are a preferred metric to measure and report on an organization’s sustainability performance because of their independence, credibility and comparability year over year. ESG ratings, like those provided by Sustainalytics, provide an assessment of a company’s management of material environmental, social and governance issues and are a good measure of whether a company has maintained, or improved, their overall sustainability performance.
Connect with us know more about Sustainability Linked Loans and Sustainalytics’ ESG Risk Ratings.