Sustainable lending and energy transition: a smart solution?
Climate change concerns, environmental issues, a push for carbon neutrality driven by governments across Europe and, now, OGUK's statement of intent to half greenhouse gas emissions in the UK oil and gas industry in the next decade and become net zero by 2050: the pressure on traditional energy companies to demonstrate a commitment to sustainability continues to ramp up.
Combine this with the recent oil price drop, the reduced demand for oil as a result of COVID-19 and the fact that the UK has just seen its longest ever period of coal-free energy use, and the case for energy transition becomes ever more important but at a time when finances are increasingly stretched.
Could sustainable lending be the answer; and how might Sustainability Linked Loans (SLLs) be used to help the energy industry prepare for energy transition?
Green bonds and green loans have been part of the debt instrument arsenal for some time but these facilities are subject to strict requirements that the funds are used for a specific "green" purpose. In terms of a "transition" facility, green loans have limited scope and traditional funding options may be increasingly difficult to come by. SLLs potentially provide a solution.
The Loan Market Association (LMA) published its Sustainability Linked Loan Principles (SLLP) in 2019 and these define SLLs as being "any types of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) which incentivise the borrower's achievement of ambitious, predetermined sustainability performance objectives. The borrower's sustainability performance is measured using sustainability performance targets (SPTs), as set against key performance indicators, external ratings and/or equivalent metrics and which measure improvements in the borrower's sustainability profile".
In other words, rather than looking at what the proceeds will be used for, the key consideration for issuing SLLs is a borrower's behaviour and its efforts to improve its sustainability profile.
In terms of the energy industry, this opens up funding options. Loans can continue to be used for general corporate purposes but are linked to the borrower's sustainability strategy. This allows a company to borrow and apply funds to usual day-to-day operations, provided that the company commits focus and energy to achieving certain SPTs. The SLLP set out common categories of improvements that borrowers and lenders might look to measure in the context of SLLs, (non-exhaustive) examples of which are noted below:
But why opt for a SLL rather than relying on standard funding options that have previously been available to energy companies? The potential benefits are many but the most basic is economic: there is a financial reward if a company complies with the sustainability targets set out in the loan documentation, most commonly a reduction in margin.
The other benefits are perhaps less tangible but, nevertheless, important. In light of the Paris Agreement and the UN's Sustainable Development Goals, there is increasing pressure on energy companies operating in the oil and gas or traditional heavy mining industries to develop green, sustainable strategies and develop "clean" processes. By linking these strategies to sustainable financing, companies can clearly evidence their sustainability credentials. This has a clear reputational benefit and is good for business, whether in terms of customers and business partners and even, in the context of staffing, where green credentials are increasingly seen as a positive in terms of both recruitment and staff retention.
Lenders too are facing pressures to increase their lending in this space. For example, ING had 15% of its portfolio committed to "responsible finance" at the start of 2019. ING want to double that by the end of 2022. BNP Paribas have commented that interest rates linked to sustainability are going to be key to their agenda and have commented that this is the "future of banking". To the extent this continues, we will see lenders actively directing capital towards borrowers who are committed to implementing robust sustainable strategies, meaning that more funding options will likely be available to those who seek out SLLs. This is all without even mentioning the benefits to the environment of companies meeting their sustainability goals.
For any companies considering a SLL, the four core components of a SLL are as follows:
In determining SPTs, the guidance suggests that a number of methodologies can be used including: "(a) ESG metrics and targets set out in the borrower's sustainability strategies and policies; (b) external analysis to establish sector-specific ESG criteria and best-practice performance; and/or (c) verified industry metrics reported against frameworks with verification or evaluation by civil society organisations or external reviewers who will determine if SPTs are ambitious for the borrower and that borrower's industry, and/or align the SPTs to existing regulatory targets (such as those set out in the Paris Agreement)".
Materiality assessments as against the borrower's business or that of the wider energy industry will be important in determining whether the proposed SPTs are core to that borrower's business. So too are the likes of industry initiatives and standards, e.g. the Transition Pathway Initiative for a lower carbon economy. Ultimately, both borrowers and lenders must agree that SPTs are sufficiently ambitious and not simply reflective of "business-as-usual" improvements.
It is worth noting that whilst the LMA has produced guidance in connection with the SLLP there is, as yet, no template drafting available. This means that the borrower and the lender group will need to work together with their respective advisers to set an appropriate methodology and ensure that any finance documents are drafted to clearly identify SPTs. Borrowers and lenders should be clear as to how to deal with amendments to SPTs over the life of a facility. In a fast changing environment, sustainability targets are likely to evolve and the loan documentation should be clear as to how any required amendments will be dealt with.
In terms of the final two components, there is again no specific template drafting available. Careful consideration will need to be given to both the information undertakings contained in the loan documentation in connection with the "Reporting" requirement and the mechanic for measuring improvement as against SPTs in connection with the "Review" element.
There is already commentary that the success of SLLs as a loan product will depend on transparency (the feeling that green loans have suffered from "greenwashing" and a lack of accountability will surely increase focus). Accordingly, visibility as to reporting is likely to be particularly important to lenders and their stakeholders. As such, borrowers will likely be encouraged (where possible) to make their reporting public and at the very least, any company entering into a SLL should expect to have to make available detailed information as to their underlying methodology for reporting on SPTs and report on an annual basis as a minimum. The applicable standard of reporting also needs to be considered.
Whilst the SLLP does not dictate that any one reporting methodology should be used, particular mention is made of the Global Reporting Initiative's Sustainability Reporting Standards, which would provide a useful and widely accepted reporting framework.
In terms of review, the documentation will need to set out the mechanism for measuring improvement against the SPTs: will measurements be made on an absolute value basis or as a percentage of change? Will an internal compliance certificate suffice or will reports need to be independently verified?
The need for any external review is likely to be a key topic for negotiation between borrowers and lenders. Borrowing power may be one element in deciding this but, equally, if a company can show that it has sufficient internal expertise to determine whether SPTs have been met, an external review may be avoided. Where a company has a dedicated sustainability team, a clear sustainability strategy and has historic data available in respect of the relevant metrics, internal expertise may be sufficient.
Equally, where an industry regulator requires SPT reporting, lenders may be willing to rely on that reporting. Sustainalytics, one of the leading firms in ESG and corporate finance research and ratings, notes that an external review process is particularly important where the reporting element discussed above is not made public. By measuring SPTs against a third party ESG rating, both borrower and lender can be confident in the assessment of the company's progress as against their SPTs and draw clearer conclusions as to whether SPTs have been met.
Finally, the commercial approach of what happens if SPTs are not met will need to be agreed and documented. As mentioned earlier, the incentive to meet SPTs tends to be a financial reward in the form of margin reduction but parties should consider whether there will any repercussion for failure to meet such targets. Generally, this should not trigger an event of default but might the lender, for example, impose a financial penalty in the form of a margin increase? Approaches for failing to meet SPTs will vary on a case-by-case basis.
The introduction of the SLLPs is a welcome development. In SLLs, we find a debt product that provides clear benefits for companies looking to push forward with a sustainability programme and agenda over a period of time whilst still running its usual day-to-day operations.
In the context of energy transition and the political push to a net-zero industry, there could be significant advantages for companies in entering into these types of facilities.
Combine this with the recent oil price drop, the reduced demand for oil as a result of COVID-19 and the fact that the UK has just seen its longest ever period of coal-free energy use, and the case for energy transition becomes ever more important but at a time when finances are increasingly stretched.
Could sustainable lending be the answer; and how might Sustainability Linked Loans (SLLs) be used to help the energy industry prepare for energy transition?
Green bonds and green loans have been part of the debt instrument arsenal for some time but these facilities are subject to strict requirements that the funds are used for a specific "green" purpose. In terms of a "transition" facility, green loans have limited scope and traditional funding options may be increasingly difficult to come by. SLLs potentially provide a solution.
The Loan Market Association (LMA) published its Sustainability Linked Loan Principles (SLLP) in 2019 and these define SLLs as being "any types of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) which incentivise the borrower's achievement of ambitious, predetermined sustainability performance objectives. The borrower's sustainability performance is measured using sustainability performance targets (SPTs), as set against key performance indicators, external ratings and/or equivalent metrics and which measure improvements in the borrower's sustainability profile".
In other words, rather than looking at what the proceeds will be used for, the key consideration for issuing SLLs is a borrower's behaviour and its efforts to improve its sustainability profile.
In terms of the energy industry, this opens up funding options. Loans can continue to be used for general corporate purposes but are linked to the borrower's sustainability strategy. This allows a company to borrow and apply funds to usual day-to-day operations, provided that the company commits focus and energy to achieving certain SPTs. The SLLP set out common categories of improvements that borrowers and lenders might look to measure in the context of SLLs, (non-exhaustive) examples of which are noted below:
- Energy efficiency: e.g.. improvements in the energy efficiency rating of buildings and/or machinery owned or leased by the borrower.
- Greenhouse gas emissions: e.g.. reductions in greenhouse gas emissions in relation to products manufactured or sold by the borrower or to the production or manufacturing cycle.
- Renewable energy: increases in the amount of renewable energy generated or used by the borrower.
- Sustainable sourcing: increases in the use of verified sustainable raw materials or supplies.
- Circular economy: increases in recycling rates or use of recycled raw materials / supplies.
- Biodiversity: improvements in conservation and protection of biodiversity.
- Global ESG assessment: improvements in the borrower's ESG rating and/or achievement of a recognised ESG certification.
But why opt for a SLL rather than relying on standard funding options that have previously been available to energy companies? The potential benefits are many but the most basic is economic: there is a financial reward if a company complies with the sustainability targets set out in the loan documentation, most commonly a reduction in margin.
The other benefits are perhaps less tangible but, nevertheless, important. In light of the Paris Agreement and the UN's Sustainable Development Goals, there is increasing pressure on energy companies operating in the oil and gas or traditional heavy mining industries to develop green, sustainable strategies and develop "clean" processes. By linking these strategies to sustainable financing, companies can clearly evidence their sustainability credentials. This has a clear reputational benefit and is good for business, whether in terms of customers and business partners and even, in the context of staffing, where green credentials are increasingly seen as a positive in terms of both recruitment and staff retention.
Lenders too are facing pressures to increase their lending in this space. For example, ING had 15% of its portfolio committed to "responsible finance" at the start of 2019. ING want to double that by the end of 2022. BNP Paribas have commented that interest rates linked to sustainability are going to be key to their agenda and have commented that this is the "future of banking". To the extent this continues, we will see lenders actively directing capital towards borrowers who are committed to implementing robust sustainable strategies, meaning that more funding options will likely be available to those who seek out SLLs. This is all without even mentioning the benefits to the environment of companies meeting their sustainability goals.
The key components: considerations for negotiation
For any companies considering a SLL, the four core components of a SLL are as follows:
- Relationship to borrower's overall sustainability strategy: i.e., identifying how the loan is linked to the borrower's overall sustainability strategy.
- Target setting – measuring the sustainability of the borrower: i.e. how progress as against the sustainability strategy is measured.
- Reporting: i.e., availability of information to show progress as against SPTs.
- Review: i.e. determining and evaluating performance.
In determining SPTs, the guidance suggests that a number of methodologies can be used including: "(a) ESG metrics and targets set out in the borrower's sustainability strategies and policies; (b) external analysis to establish sector-specific ESG criteria and best-practice performance; and/or (c) verified industry metrics reported against frameworks with verification or evaluation by civil society organisations or external reviewers who will determine if SPTs are ambitious for the borrower and that borrower's industry, and/or align the SPTs to existing regulatory targets (such as those set out in the Paris Agreement)".
Materiality assessments as against the borrower's business or that of the wider energy industry will be important in determining whether the proposed SPTs are core to that borrower's business. So too are the likes of industry initiatives and standards, e.g. the Transition Pathway Initiative for a lower carbon economy. Ultimately, both borrowers and lenders must agree that SPTs are sufficiently ambitious and not simply reflective of "business-as-usual" improvements.
It is worth noting that whilst the LMA has produced guidance in connection with the SLLP there is, as yet, no template drafting available. This means that the borrower and the lender group will need to work together with their respective advisers to set an appropriate methodology and ensure that any finance documents are drafted to clearly identify SPTs. Borrowers and lenders should be clear as to how to deal with amendments to SPTs over the life of a facility. In a fast changing environment, sustainability targets are likely to evolve and the loan documentation should be clear as to how any required amendments will be dealt with.
In terms of the final two components, there is again no specific template drafting available. Careful consideration will need to be given to both the information undertakings contained in the loan documentation in connection with the "Reporting" requirement and the mechanic for measuring improvement as against SPTs in connection with the "Review" element.
There is already commentary that the success of SLLs as a loan product will depend on transparency (the feeling that green loans have suffered from "greenwashing" and a lack of accountability will surely increase focus). Accordingly, visibility as to reporting is likely to be particularly important to lenders and their stakeholders. As such, borrowers will likely be encouraged (where possible) to make their reporting public and at the very least, any company entering into a SLL should expect to have to make available detailed information as to their underlying methodology for reporting on SPTs and report on an annual basis as a minimum. The applicable standard of reporting also needs to be considered.
Whilst the SLLP does not dictate that any one reporting methodology should be used, particular mention is made of the Global Reporting Initiative's Sustainability Reporting Standards, which would provide a useful and widely accepted reporting framework.
In terms of review, the documentation will need to set out the mechanism for measuring improvement against the SPTs: will measurements be made on an absolute value basis or as a percentage of change? Will an internal compliance certificate suffice or will reports need to be independently verified?
The need for any external review is likely to be a key topic for negotiation between borrowers and lenders. Borrowing power may be one element in deciding this but, equally, if a company can show that it has sufficient internal expertise to determine whether SPTs have been met, an external review may be avoided. Where a company has a dedicated sustainability team, a clear sustainability strategy and has historic data available in respect of the relevant metrics, internal expertise may be sufficient.
Equally, where an industry regulator requires SPT reporting, lenders may be willing to rely on that reporting. Sustainalytics, one of the leading firms in ESG and corporate finance research and ratings, notes that an external review process is particularly important where the reporting element discussed above is not made public. By measuring SPTs against a third party ESG rating, both borrower and lender can be confident in the assessment of the company's progress as against their SPTs and draw clearer conclusions as to whether SPTs have been met.
Finally, the commercial approach of what happens if SPTs are not met will need to be agreed and documented. As mentioned earlier, the incentive to meet SPTs tends to be a financial reward in the form of margin reduction but parties should consider whether there will any repercussion for failure to meet such targets. Generally, this should not trigger an event of default but might the lender, for example, impose a financial penalty in the form of a margin increase? Approaches for failing to meet SPTs will vary on a case-by-case basis.
Conclusion
The introduction of the SLLPs is a welcome development. In SLLs, we find a debt product that provides clear benefits for companies looking to push forward with a sustainability programme and agenda over a period of time whilst still running its usual day-to-day operations.In the context of energy transition and the political push to a net-zero industry, there could be significant advantages for companies in entering into these types of facilities.