Introduction
In recent years, borrowers and lenders increasingly have recognized the benefits of sustainability linked loan products. Sustainability linked loans align the cost of borrowing with a borrower's performance measured against prescribed sustainability performance targets. Unlike with so-called green loans — which are also intended to promote sound environmental practices — the borrower is not restricted in its use of loan proceeds to only green projects with clear environmental benefits. But the borrower must conduct its business so as to achieve ambitious, yet attainable, sustainability performance targets. If a borrower meets these sustainability targets, there is a discount — or, if the borrower fails to meet the target, a premium — in the borrower's cost of borrowing.
Sustainability financing can be attractive to commercial and investment banks that want to be perceived by the public, their shareholders and other constituencies as having a commitment to good corporate citizenship. For borrowers willing to wager on improvements to their sustainability performance, this type of loan offers an additional avenue of financing that may prove more economical than conventional alternatives.
Sustainability Linked Loan Principles
The cornerstone of a sustainability linked loan product is the formulation and policing of relevant sustainability targets. For this purpose, sustainability linked loan principles were published in March 2019, followed by guidance published in May 2020, by the Loan Syndications and Trading Association in collaboration with the Loan Market Association and the Asia Pacific Loan Market Association. These principles establish a voluntary, high-level framework for sustainability linked loans, based on four main components, and afford market participants the flexibility to tailor the principles to the particular circumstances of the borrower and its industry.
The first component addresses the relationship of the sustainability targets to a borrower's overall corporate social responsibility strategy. A borrower's sustainability objectives should be clearly communicated to its lenders and should align with its proposed targets. Borrowers should also disclose any third-party sustainability standards or certifications they are looking to adopt for their corporate social responsibility strategy.
The second component is directed to establishing the sustainability performance targets. The targets are typically formulated through negotiation between the borrower and its lenders on a case-by-case basis. Oftentimes, a "sustainability coordinator" or "sustainability structuring agent" is appointed to assist in the negotiation process. The targets should be (1) ambitious yet meaningful to a borrower's business, (2) tied to a predetermined benchmark(s) and (3) based on recent performance levels. The targets may be either internal — based on the borrower's internal corporate social responsibility strategy — or external, based on metrics established by organizations that rate this type of corporate conduct.
For example, sustainability linked loans may be linked to an environmental, social and governance (ESG) rating. Penalties may come with a decline in ESG rating, while a higher ESG rating can lead to lower cost for capital. Sustainalytics evaluates a wide range of ESG categories that can be fashioned into targets, such as the environmental and social impact of products or services, human rights, data privacy and security, business ethics, bribery and corruption, access to basic services, community relations, emissions, effluents and waste, carbon operations, human capital, land use and biodiversity, occupational health and safety, ESG integration, product quality and/or safety, resilience, and resource use. Depending on the nature of a borrower's business activity, some subset of these metrics can be incorporated into the sustainability performance targets of its loan facility.
The third component is directed to reporting. Information regarding a borrower's sustainability performance must be reported to the lenders periodically, at least on an annual basis. The borrower is required to demonstrate its compliance with the sustainability performance targets in reasonable detail that includes a discussion of the methodology used to gauge compliance and underlying assumptions. Borrowers are often required to publicly report this information, which can be found in a borrower's annual financial reports or in a dedicated sustainability report.
The fourth component is review. Sustainability linked loans often provide for external review of compliance. Whether a loan will require external review is a matter of negotiation between a borrower and its lenders, but the sustainability linked loan principles strongly recommend external review where information concerning the borrower's compliance with its targets is not publicly available. Irrespective of whether external review is required, a borrower should have internal controls in place to verify the calculation of its sustainability performance.
An Example: NRG Energy
In June 2016, NRG Energy Inc., the leading integrated power company in the United States, signed a $1.9 billion term loan and revolving credit facility. Sustainability performance targets for the facility relate to the reduction of carbon dioxide, methane and nitrous oxide emissions (referred to as greenhouse gas or GHG emissions) from fuel combustion in boilers, turbines and engines used for the production of wholesale electric power at facilities owned or controlled by the borrower and its subsidiaries. In its 2019 Sustainability Report, released in May 2020, NRG Energy reported committing to GHG emission reduction goals and targeted a 50% reduction by 2025 and net-zero emissions by 2050, based on a 2014 baseline. NRG reported that its 2019 GHG emissions decreased by 41% since 2014.
Under the terms of the NRG facility, the applicable margin for term and revolving loans is adjusted based on the performance of so-called KPI Metrics relative to a Baseline Sustainability Amount, as indicated in the borrower's annual baseline sustainability report and audited by nationally recognized independent public accountants. The KPI Metrics measure (i) total annual GHG emissions in millions of metric tons (mTCO2e) and (ii) Revenue Carbon Intensity, a quantity equal to the amount of GHG emissions divided by the total operating revenue of the borrower and its subsidiaries. The Baseline Sustainability Amount is 46 million mTCO2e and 4,628 mTCO2e/$M, respectively. For example, if both KPI Metrics are greater than 110% or less than 90% of the applicable Baseline Sustainability Amount, the applicable margin will be adjusted up or down by 30 basis points, respectively.
Conclusion
Sustainability linked loans have become increasingly popular in recent years. Refinitiv, a global provider of information on the syndicated loan and high-yield bond markets, reported that a combined $167 billion in green loans and sustainability linked loans came to the global loan market in 2019, an increase of 150% over the prior year. In the past year, COVID-19 has disrupted the financial markets and dampened the growth of sustainability linked loans, but indications are that enthusiasm for sustainability linked loans remains high. With the evolving prominence of ESG and similar investment programs in the financial markets, institutional lenders can be expected to become increasingly open to extending sustainability linked loans. Borrowers may increasingly seek out these loans as well, as they not only burnish an image of social responsibility but also offer the prospect of lowering a performing borrower's cost of capital.
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