Introduction to Sustainability-Linked Loans

With increasing regulatory, political and investor focus on climate change and sustainability, it comes as no surprise that the sustainability-linked loan (SLL) has been readily gaining recognition in the world of financing since the first green bond bloomed in 2007. But what exactly is an SLL and will it really make a difference to global sustainability efforts? We break down the main mechanics behind SLLs in this article, which is the first of our three-part series on SLLs.

What is an SLL?

An SLL is a type of loan where the interest rate and/or any fees charged by the lender are linked to the borrower’s sustainability performance. In practice, this means that the interest payable on the loan will reduce if the borrower meets certain ESG targets which have been determined for that specific borrower. This is known as a “margin ratchet” where the interest payable on a loan can ratchet up or down.

It might be surprising to learn that there is no requirement that the actual money being lent to the borrower via an SLL be used on anything sustainable or any ESG project – the money can be used for anything the borrower requires (unlike green loans and social loans where use of proceeds is the key determinant). The key “link” to sustainability with an SLL is that the debt becomes cheaper if the borrower meets certain predefined sustainability performance targets (SPTs) and key performance indicators (KPIs).

Selecting KPIs and SPTs

Thanks to the sustainability linked loan principles (SLLP) issued by the Loan Syndications and Trading Association (LSTA) for the U.S. loan market and the Loan Market Association (LMA) for the Europe, Middle East, and Africa (EMEA) market, there is some guidance as to the selection of KPIs and SPTs.

According to the SLLP, KPIs must be “material” to the borrower’s core sustainability and business strategy, as well as capable of addressing the relevant Environmental, social, and governance (ESG) challenges in its industry sector. SPTs must be set in good faith, whilst also remaining “relevant” and “ambitious” throughout the lifespan of the loan. What counts as “ambitious” will clearly be determined on a case-by-case basis for each borrower.

The SLLP also contain guidance relating to reporting to ensure that lenders have up-to-date information to allow them to monitor the performance of SPTs. Additionally, the borrower must obtain independent and external verification of their performance against each SPT for each KPI for the relevant period. There is a lot of great work for third-party service providers able to audit and verify carbon emissions.

Most of the targets that we have seen relate to the environment, but SLLs are increasingly including at least one social or governance related target (e.g., the roll out of diversity and inclusion training, targets to increase minority and female representation, local community initiatives).

Margin ratchet

As mentioned above, the margin ratchet is a mechanism by which the initial margin may be reduced or increased, depending on the achievement of SPTs. The current market trend is a step down/step up of 5 to 15 basis points. By way of example, if a borrower achieved all five of their SPTs on the test date, the change in margin would be 5.75%, whereas if they achieved only four out of five SPTs, the margin would change to 5.90%. The margin is typically added to a floating interest rate, such as SONIA or EURIBOR (RIP LIBOR), which together provides the total interest rate charged per annum.

What happens if a borrower fails to hit SPTs?

Failure to hit SPTs or specified ESG targets will mean that the interest payable on the loan will not be reduced. Borrowers will be relieved to know that it is not typical in the SLL market for failing to meet SPTs or ESG targets alone to constitute a default or an event of default under the facility agreement. However, lenders weary of green-washing allegations may move to incorporate this punishment in the future. As a potential compromise, lenders may consider inaccurate or false reporting on ESG performance to constitute a breach of the facility agreement (in the same vein as inaccurate or false reporting on financial performance, covenants or performance of the business plan).