Sustainability Linked Lending (“SLL”) refers to any type of instrument designed to incentivize the borrower to achieve ambitious and pre-determined sustainability performance targets. They aim to facilitate and support environmentally and socially sustainable economic activity and growth.
SLLs have become a feature of the lending market in recent years as an environmental, social and governance (“ESG”) concerns are gradually becoming important for both borrowers and lenders. Lenders and borrowers have generally become increasingly aware of the potential for long-term success provided sustainability is placed at the top of the agenda. The main drivers of this development are regulatory and political factors, but also the ever-changing demands of various stakeholders such as investors, consumers and employees.
In recent years, the Loan Market Association (the “AML”) have issued guidelines for SLLs and we are seeing an increase in these types of loans in the Irish market. The Irish government and the Central Bank of Ireland have also demonstrated a commitment to sustainable finance.
What does the LMA provide?
The principles of sustainability-linked lending (theSLLP”) were created by the LMA to promote the development and preserve the integrity of the SLL product by providing guidelines capturing the fundamental characteristics of these loans.
The LMA has recognized that the application of the SLLP in the contexts of REF and real estate development financing presents certain challenges, as the type of loan is generally asset-based and the borrower will often be a special purpose vehicle ( “VSP”). Therefore, the borrower may not have an existing ESG strategy or access to historical ESG data in relation to the relevant property/properties or developments being financed. Therefore, the selection of key performance indicators (“KPIs”) and the calibration of performance objectives in terms of sustainable development (“SPT”) may be more difficult.
The use of the products in relation to the SLL is not decisive in its categorization. Instead, the SLL must conform to five basic components, which are set out below.
The five main components are:
(1) Selection of KPIs
KPIs should be (i) relevant and meaningful to the borrower’s sustainability and core business strategy, (ii) measurable or quantifiable on a consistent methodological basis, and (iii) capable of being compared. The LMA recommends that KPIs be included in the term sheet stage.
In REF and development finance contexts where the borrower is an SPV with no business history or assets other than financed property/land, the LMA suggests that KPIs be tied to the financed assets. The LMA also indicates that in these types of financings, at least one KPI will generally refer to energy efficiency, carbon or greenhouse gas emissions.
(2) Calibration of SPTs
SPTs should (i) represent a significant improvement of the respective KPIs, (ii) be benchmarked against a benchmark or external benchmark (if possible), (iii) be consistent with the borrower’s ESG strategy, and (iv) ) be determined on a predefined timeline.
(3) Characteristics of the loan
A key feature of an SLL is that an economic outcome is linked to whether or not the SPT is met, for example a reduction in the margin.
Borrowers should provide lenders participating in the loan with sufficient up-to-date information to enable them to monitor the performance of the SPTs and to determine whether the SPTs remain ambitious.
Borrowers should obtain independent and external verification of the Borrower’s level of performance against each SPT for each KPI, at least annually.
What we see in the Irish loan market
What we’ve mostly seen in the market right now is “agree to agree” language whereby parties to a facility agreement agree that KPIs will be negotiated and agreed upon at a later date.
Where KPIs are agreed, some examples of what we see include reducing greenhouse gas emissions, reducing food waste, direct use of renewable energy, on-site energy generation, manufacturing to net zero carbon and the harvesting of certain amounts of rainwater.
The applicable KPIs and SPTs for each are typically set out in a separate Sustainability Indicators and Goals document which we see being included as annexes to the facility agreement. Where KPIs are agreed at a later date, we see provisions in facility agreements that the loan cannot be called SLL until the relevant KPIs are agreed.
The incentive to meet SPTs versus KPIs is a reduction in margin for a certain period, often a one-year period. The amount of margin reduction will depend on the number of SPTs achieved, up to an agreed maximum amount. On the other hand, non-compliance with SPTs may result in an increase in margin for the relevant period (again, up to an agreed amount). So far, any increase or decrease has been the most modest of the spectrum.
We also note the inclusion of disclosure commitments whereby the borrower agrees to provide the officer with a sustainability compliance certificate demonstrating the values achieved by the borrower against each KPI for that exercise. In our experience, the penalty for failing to provide the certificate is, again, in limited circumstances, a modest increase in margin but does not result in a breach of the facility agreement.
It will be interesting to see where this develops in the Irish market compared to:
- On the downside only margin adjustments.
- Margin level decreases/increases eventually.
- The third party verification requirement and if it becomes mandatory.
- Overall level of reporting and monitoring of lenders.