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.
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:
Taking a closer look at these findings may help companies find the right KPIs, targets and margin ratchets to best take advantage of SLLs.
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.
Environmental KPIs account for six out of the top ten KPIs
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.
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.