The debt market begins to integrate ESG factors
With increasing public pressure for companies to prioritize sustainable business practices and reduce their carbon footprint, environmental, social and governance (ESG) factors are in the public spotlight. Regulatory and corporate commitments to net zero operations or lower carbon impacts mean that environmental considerations in particular will play a significant role in future business decision making.
Given the important function that debt instruments play in most business transactions, it follows that debt instruments such as bonds and loan facilities are poised to play an important role in sustaining financial markets. lenders and borrowers to their sustainability goals. There is a tremendous opportunity for debt markets to catalyze corporate adoption of sustainability practices through different types of–impact debt products, including through sustainability linked loans (SLLs).[1]
Rising ESG pressures within stakeholder groups have increased interest in sustainable finance and ESG principles have found their way into debt instruments themselves, through a variety of sustainable finance vehicles, including project finance loans, green bonds, social loans or bond issues linked to sustainable development. in the public or private debt capital markets. All of them directly link a borrower’s or issuer’s payment obligations to its performance against specified ESG objectives.
Perhaps the most flexible debt product to have emerged in response to the ESG imperative is SLL. Given their immense flexibility, in our opinion, SLLs are poised to experience exponential growth in Canada’s debt markets over the next several years as they help lenders and borrowers align their sustainability goals. in the relationship-driven world of lending markets.
Sustainable development loans
SLLs are “any type of lending instrument and / or conditional facility (such as surety lines, lines of guarantee or letters of credit) that induce the borrower to achieve ambitious sustainability performance goals and predetermined “.[2] These incentives are always linked to the actual performance of the borrower against predetermined ESG measures agreed by the loan stakeholders.
SLLs can be project specific loans, term loans or, unlike most other durable debt instruments, revolving credit facilities used for general corporate purposes. To legitimize and standardize SLLs, many of these loans are traded under the Sustainability Lending Principles, last updated in July 2021.[3] SLLs using these principles contain four key elements:
1. The borrower’s sustainability goals
The borrower should select clearly defined, measurable and ambitious performance objectives that are relevant and meaningful for their strategic business or operating plans. Common environmental objectives are to reduce carbon emissions, improve energy efficiency, generate or consume renewable energies, conserve water, cultivate sustainably, obtain recognized ESG certification or ” improve a third-party ESG assessment. Goals should also be comparable to the borrower’s historical performance, industry peers, or global or national goals.
2. Characteristics of the loan
Product use. It is important to note that SLLs allow borrowers to use the loan proceeds for general business purposes (i.e., SLLs do not prevent borrowers from using their loan proceeds only for eligible green projects). However, a borrower will need to invest in significant sustainability improvements to meet their SLL goals.
Financial motivations. SLLs typically incorporate interest rate reductions for borrowers who meet their sustainability goals. These rates are case specific, negotiated bilaterally and vary depending on the difficulty of the sustainability goal. A borrower’s failure to meet their sustainability goals is not an event of default and does not allow lenders to speed up the loan, assert collateral, or trigger cross defaults.
3. Reports
A borrower under SLL must report at least once a year on its performance against its sustainability goals. When a borrower has public disclosure obligations or other public reporting practices, the public can access the borrower’s performance data. However, SLL borrowers only share the results of their actual performance against their sustainability goals and thus maintain a high degree of confidentiality around their commercially sensitive practices.
4. Third party review or verification
To extend the credibility of an SLL to a borrower who does not offer a public report on its sustainability performance, experts strongly recommend that it engage in annual progress reviews with independent experts (e.g. , auditors, environmental consultants or rating agencies).
Where is the market going?
Growth
Most experts predict that the debt market will see an increasing volume and proportion of structured loans in the form of SLLs and ESG-linked loans in Canada which could reach $ 20 billion by the end of 2021, from many blue chip Canadian companies pledging their large corporate debt general facilities to SLL.[4] Some experts predict that the $ 3 trillion ESG debt market could reach $ 11 trillion by 2025.[5] The crystallization of the Net-Zero Banking Alliance will further encourage banks to invest their loan capital in SLLs.
Flexibility
SLLs are available to a wide range of businesses, even those traditionally considered to be non-environmentally friendly. SLLs offer borrowers the ability to combine different ESG objectives into a single loan product. Additionally, a multi-tranche loan product obtained by a company with multiple ESG initiatives could assign different sustainability performance goals to different debt tranches offered by a common lender syndicate. While the current SLL market is primarily limited to high quality, blue chip public issuers, the SLL principles can also extend to corporate loans for small businesses or smaller sized loans (e.g. bonds green).
Increased regulation
Until now, sustainability-oriented credit markets have evolved on a self-regulating and voluntary basis. We anticipate that stricter environmental regulations will increase disclosure and standardize SLLs over time. In particular, the “additionality†factor will require that SLL’s goals become increasingly ambitious to be eligible for tariff discounts in the loan market as carbon pricing laws evolve.
Financial institutions providing these loan products may themselves be regulated or adhere to voluntary standards. In addition to the Net-Zero Banking Alliance and other voluntary sustainable cross-border lending and investing initiatives, the Office of the Superintendent of Financial Institutions, an independent federal agency responsible for overseeing certain financial institutions in Canada, has begun consulting on climate-related risks. with federally regulated financial institutions and pension funds in January 2021, which will likely guide government climate change regulation on institutions in Canada.
Conclusion
There is a strong and growing pressure on capital providers to direct their funds to borrowers in sectors that favor ambitious and credible sustainability practices and away from borrowers whose business operations and future plans are not aligned with the reduction emissions and other environmental targets. SLLs are likely to play a growing role in ESG-oriented debt products, which in turn are likely to become an increasingly attractive segment of the public and private debt markets.
