Financing sustainable growth: An emerging opportunity

Sarah Strang Director, Debt & Capital Advisory, PwC United Kingdom

As corporates look to align their financing strategy with their sustainability ambitions, the sustainable finance market has grown to reach $1.6 trillion globally in 20211. Around c.$600bn of that was driven by the sustainability-linked loan (SLL)2  market, and that only looks set to grow.

Flexible and offering a way for a wider audience to tap into the ESG-related finance available, SLLs are attracting increasing interest from companies and lenders alike. But to make the most of this market requires first understanding how they work alongside your ESG KPIs as well as wider emerging best practice and trends.

What are Sustainability Linked Loans and why consider them?

SLLs typically include a pricing mechanism that links the cost of a loan with a borrower’s performance on certain ESG related targets. Those able to demonstrate progress benefit from more competitive rates. As lenders’ own ESG and Net Zero commitments influence their lending decisions, companies willing to sign up to action can take advantage of the increasing liquidity available.

Proceeds can be used for general corporate purposes and the loan can be tailored to a borrower’s specific needs. With the market developing at pace, best practice is still evolving. The Loan Market Association guidelines on SLLs act as a useful framework for corporates and lenders alike, but there is still a lack of standardisation when it comes to key characteristics of these loans. In particular the selection of ESG KPIs and the ESG margin ratchet (e.g. pricing) mechanics.

In response to the conversations we’ve been having around KPIs, setting the right sustainability targets and understanding the potential cost benefit, we decided to analyse the market more closely. We used our ESG Debt Dashboard to examine 870 European SLLs across the investment grade, leveraged loan and private debt markets equating to over EUR250 billion of debt. Our findings reveal that:

  • 41% of SLLs examined did not provide specific info on ESG KPIs agreed
  • Around 62% of SLLs included just one or two KPIs
  • Environmental KPIs (particularly around carbon emissions reduction) accounted for six of the ten most commonly occuring KPIs

Taking a closer look at these findings may help companies find the right KPIs, targets and margin ratchets to best take advantage of SLLs.

ESG KPIs - Striking a balance between quality and quantity

In order for ESG KPIs to be meaningful they need to be tailored to the borrower's individual situation and this flexibility is a key benefit of SLLs. However this also means that borrowers often have an extensive list of potential KPI areas to choose from and may have difficulty narrowing their focus. Looking at the ESG KPI areas most prevalent in existing SLLs allows us to pinpoint key themes and understand common parameters that are currently measured.

Our analysis shows that the level of disclosure and details on specific KPIs which are included in SLLs varies significantly. The majority opted for one or two KPIs, with a number of companies selecting an ESG rating as their single KPI. These typically incorporate a range of criteria across the environmental, social and governance spaces.

We think there’s room for improvement in this area. The Loan Market Association’s guidance on SLLs states that KPIs and the related sustainability performance targets should be ‘suitably ambitious’ in order to be viewed credibly and avoid accusations of greenwashing. So both borrowers and lenders should consider incorporating a range of ESG KPIs. Most importantly, selected KPIs must touch upon areas material to the business alongside related sustainability performance targets that are stretching.

Top SLLs KPIs (where disclosed)

Environmental KPIs account for six out of the top ten KPIs

Environmental KPI areas

Two of the most common Environmental KPIs relate to carbon emissions/greenhouse gas (GHG) reduction. This is unsurprising given the trend towards standardisation in terms of measurement and reporting. Other popular KPIs include targets around energy efficiency (e.g. % of renewable energy used) and metrics focused on resource use (e.g. water reduction; zero waste to landfill; no single use plastic). The final areas which appear relatively frequently are KPIs which aim to make borrowers’ product offerings, services or assets more green or sustainable. As business models adapt to take advantage of new market opportunities and manage their existing ESG operational risks, we expect this to continue as a focus.

Scope 3 emissions KPIs (e.g. inclusion of areas of the supply chain) are beginning to appear in SLLs. Although the level of disclosure and standardisation currently varies, these should become more concrete as more companies publicly commit to Net Zero targets and sign up to science-based targets.

Social KPI areas

SLLs increasingly include KPIs in social areas. Gender diversity metrics such as gender pay gap is the most common measure. This is due to a large proportion of companies having existing policies, tracking and disclosing publicly.

Key stakeholders metrics are also common, such as customer satisfaction or employee wellbeing and inclusion. Depending on the sector and business model some borrowers have included KPIs which cover its supply chain (e.g. workers rights and empowerment; responsible wages). But given the nature of these areas it may take time to track performance and show significant improvements.

The third most common KPI area is supporting local communities which can include things such as employability schemes and community training. Included within the ‘Other’ category are things such as KPIs mapped to UN Sustainable Development Goals and KPIs around charitable giving.

Governance KPI areas

The number of governance-related KPIs is more limited, although this can be due to overlap in areas such as sustainable or responsible supply chains. Governance is also picked up in ESG ratings. However, the most popular governance-related KPI addresses reducing accidents at work - which as a metric may be more ‘material’ for some businesses than others (e.g. those with manufacturing sites). The remaining KPIs are a mix of externally focused metrics including supply chain traceability or responsible sourcing and internal measures such as good governance and investment policies.

We expect this area to evolve to include more stretching targets, for example linkage to board remuneration or external verification and publication of material ESG areas for the business as companies set up their internal frameworks around ESG governance.

Pricing - ESG margin ratchets

As with KPIs, there is still a lack of standardisation and transparency on how the ESG margin ratchets included in SLLs work in practice. Many SLLs mention that pricing is in some way linked to ESG performance. However only around one in eight loans examined disclosed the margin adjustment (i.e. the number of basis points) and mechanics such as the increase / decrease in pricing or how it linked to the loan’s KPIs.

Of those SLLs where margin ratchets were disclosed, only c.5% had margin ratchets of greater than 15 bps. As the SLLs examined are a mixture of investment grade and non investment grade loans, it is not possible to derive the exact impact (i.e. greenium) of the ESG margin on the overall cost of debt. However, there does appear to be room for improvement in terms of the magnitude and materiality of the ESG margin adjustments so that borrowers and lenders both have ‘skin in the game’. Greater disclosure of margin ratchet mechanics and inclusion of pricing that is material to the overall cost of funding can only lead to a better alignment of financial and ESG performance.

An emerging opportunity

While it’s encouraging to see the increase in the number of companies using SLLs, for both lenders and borrowers, there remains a significant opportunity to use this financing option to better prioritise investment, accelerate change and deliver truly sustainable value.

Striking the right balance on setting targets that are stretching but achievable will be critical, both in terms of motivating companies to move further and faster on their ESG ambitions and providing lenders with some comfort that their capital is being used as intended. Ensuring margin ratchets are material to pricing will also be key to incentivising action and stimulating further uptake in the market.

Importantly, more comprehensive disclosures (akin to those in the public markets) open the opportunity for external scrutiny and accountability that may provide the tailwinds for this product to fully reach its full potential.

For more information or to discuss the points raised in this article, please reach out to a member of the team below.

[1] Source: Refinitiv data January 2022
[2] Source: Refinitiv data January 2022

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Sarah Strang

Sarah Strang

Director, Debt & Capital Advisory, PwC United Kingdom

Tel: +44 (0)7808 105576

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