Incentivising sustainability-linked loans

Sustainability performance measure at first glance can appear complicated, but with banks seeking to drive their own sustainability initiatives, it may be the case that delivering on your sustainability promises as an organisation can give you access to lower interest loans — saving you money at a time of heightened inflation. This brings the topic firmly into the mainstream for chief financial officers.

Green and social bonds is where organisations can raise debt to specifically fund projects with a specified environmental or social purpose. This typically involves significant due diligence and can be linked to achieving certain externally recognised ESG ratings, from agencies such as, Sustainalytics. However, sustainability linked loans (SLL) are gaining significant attention.  They are more flexible than green bonds because they can be used for general corporate funding that is not linked to specific projects. These instruments have their bond coupon rate or loan term tied to meeting several pre-determined ESG-related targets.

Guidelines exist whereby the International Capital Market Association’s (ICMA) Sustainability-Linked Bond Principles (SLBP), or the Loan Syndications and Trading Association’s (LSTA) Sustainability-Linked Loan Principles (SLLP), determine how key performance indicators (KPIs) are agreed, which need over time to reach pre-agreed sustainable performance targets (SPT). The loan provider, typically a bank, is using these types of mechanisms to bolster their own sustainability credentials, by being able to point to actively incentivising corporate borrowers to improve their performance over time. The SPTs typically step up gradually during the period of loan to ensure steady progress is maintained. The challenge is in agreeing to targets that are related to material ESG aspects and are considered ambitious but achievable by other sides. The expectation is that these KPIs go beyond regulatory requirements and might typically look at the delivery of carbon emission transition plans (as measured by Science Based Target commitments) or diversity and inclusion (D&I) performance measures, such as board and senior management female and ethnic minority representation.

Whereas sustainability goals are often the focus of the board and heads of strategy, or chief sustainability officers, the growing popularity of SLL type bond-structures, brings the topic into the sphere of chief financial officers and their treasury teams. This is happening at a time of increased scrutiny over climate and wider sustainability disclosures. On both sides of the Atlantic proposals for standards over non-financial disclosures are tightening. The Taskforce for Climate-Related Financial Disclosure (TCFD) framework is being superseded by the new International Sustainability Standards Board (ISSB) requirements, which the U.S. Securities and Exchange Commission is consulting over climate disclosures that would be subject to external audit. Finally the European Union is finalising its Corporate Sustainability Reporting Directive requirements. The resulting additional scrutiny is forcing organisations to establish stronger internal controls over these non-financial disclosures and increasingly drawing in finance professionals into their review and sign-off.

Hence, chief financial officers and their teams having increasing oversight of both the external disclosure of sustainability performance and assurance of this information, which may have a meaningful role to play in capital and debt management. The element that may be of most interest to finance teams is that typically an SLL agreement would work on a two-way basis, so achieving the target will result in interest reduction but failure to comply with an agreed target can result in an increase in the margin.

Generally, a compliance certificate needs to be issued on each anniversary of the SLL agreement. This would as a minimum include a management attestation but is increasingly requiring certification by an external independent provider. The trend is for limited assurance to be required from audit firms and one can envisage this trend increasing once the new International Standard on Sustainability Assurance (ISSA) 5000 is finalised.

Our experience of conducting these types of engagements suggests that corporates wishing to enter these types of agreements need to recognise some precursors of success, namely:

• sustainability action plan: there needs to be a clear plan of action signed off by senior management and/or the board to drive performance over the medium term to address the typical performance ratchet included in these types of loan structures. Should executive remuneration be tied to similar metrics, there would then be a clear alignment of interest and focus on achievement.
• key performance metrics: need to be clearly defined and agreed. The meaning of measures needs to be unequivocal, such as the definition of ethnic minorities and how to deal with those who prefer not to self-identify. When and how the test is applied also needs to be agreed, in terms of whether it is a point-in-time test once per year, or an annual average metric. This is important when considering what is a realistic improvement that can be achieved in any 12-month period.
• documented procedures: the process for capturing, analysing, and calculating the key performance indicators needs to be clearly documented. The procedure needs to be followed in practice and the organisation needs to be able to demonstrate it has appropriate internal controls over the information flows from source through to disclosure. Much can be learned from the existing processes and controls in place over mainstream financial reporting.

However, where the organisation has already made a commitment to driving significant sustainability improvements, these types of loan structures help to strengthen the business case for change and ensure alignment of interest between the organisation and its long-term lenders.

Putting in place a sustainability strategy and establishing key performance indicators is central to driving improvement in performance for many organisations, but it is a relatively recent development that could influence banks to offer preferential interest rates on corporate debt facilities. This can be an attractive option given the rate of inflation and heightened interest rates.

Organisations need to understand that this involvement is a long-term commitment, and you need to be able to demonstrate performance improvement to a third-party assurance provider.

Please contact Alex Hindson or your usual Crowe contact for more information.