Corporates and lenders are increasingly considering the possibility of “green” or “sustainability-linked” bonds, loans and derivatives, in the face of scrutiny from activist investors and lenders and allegations of greenwashing.
In the last year or so there has been a huge increase in talk about ESG generally, including in relation to finance and financial products, and our finance practice from Australia through Europe and Africa down to California has had no shortage of exposure to green bonds, sustainability-linked loans and derivatives in one way or another. It seems reasonable to say that this looks like the hot topic to replace LIBOR transition in 2021 and beyond. However, there lurks an uncomfortable dichotomy that has undoubtedly given rise to more than a few suggestions of “greenwashing” – a cosmetic confection which does not survive close scrutiny. When a borrower and lender (for convenience, in this article we refer to a loan, but largely the same issues would arise with a sustainability-linked derivative or bond) decide to do an ESG-related financing, the borrower is likely to take the lead in identifying the targets in discussions with the lead lender when issuing the loan mandate. A borrower’s desire to be a virtuous corporate citizen can be matched with ESG-dedicated credit funds looking for the right assets, which could be worth a cost of funds deduction of a few basis points to the borrower and enable it to widen its pool of investors if it can find and then meet some ESG-related targets. Given the width of what targets are encompassed by the phrase “sustainability-linked,” most borrowers should be able to come up with some performance indicators that can be referenced. For convenience, in this article we use the phrase “sustainability-linked” as an umbrella term which includes linkage to societal and governance factors, since similar considerations apply to devising a framework for the incentivisation of, say, more women in management as to a reduction in C02 emissions, and since the only relevant LMA guidelines relate to “sustainability-linked” loans.
Some observers may challenge this as potentially being too cosy and convenient, but when all is said and done, the credit margin has to reflect the risk to the lender, and the lender would not benefit financially if the ESG targets are met: quite the opposite; and so in theory, this could lead to fraught negotiations, with the lender battling to make the targets very difficult to hit to preserve the full margin. In practice, however, this is unlikely, given the nature of healthy competition between finance parties to win a debt mandate, and the probable impossibility of a lender being able to judge whether a borrower is capable of achieving a certain target or not, and so a more likely outcome – unless funded by a lender whose own return to its investors is outcomes linked – is a range of targets which the lender has to assume will be met, and so it has to price the loan on the assumption that they will be. Once that is done, the tension which could conceivably have surrounded the negotiation of the targets is relaxed, which allows the borrower to choose targets and attainment levels that it can conclude with a high degree of confidence have at least a good chance of being met, the lender being largely indifferent. There is a school of thought that this dichotomy underpins a fundamental contradiction in an ESG-linked loan: cynics may claim that while the parties’ motivation may appear to be to incentivise good ESG behaviour, the real motivation is to appear to incentivise good ESG behaviour so as to allow all concerned to be able to proclaim their concern for the environment etc to shareholders, contracting parties and others. There is, of course, in reality very often an underlying pro-ESG outcome or behaviour that the borrower has identified as a goal to which its organisation is working, and the loan terms will reflect this outcome or behaviour, and although the loan terms are unlikely to be the sole driver of that outcome or behaviour, nevertheless, those terms can be a very useful concrete external statement of a borrower’s commitment to that goal with the result that it is more likely to achieve it than it would have been had it not entered into the loan on those terms. Both parties should therefore work to ensure that the chosen ESG targets, and the measurement of the borrower’s attainment of those targets, are real “stretch targets”. Doing so will also avoid any claims of greenwashing: some done deals have attracted criticism for being more holey than holy, and this is not where any well-advised borrower or lender wants to be.
So, when it comes to target selection, a borrower may well have some kind of existing ESG framework and certain targets which it is already monitoring, and on which it may already be reporting in its audited financial statements. If so, choosing these targets simplifies defining the targets and the ongoing measuring and reporting of them, and does not require active monitoring by the lender or anyone else. To the extent a third party is involved, it may well already be verifying the data used for the purposes of the annual report, so that there is little incremental cost if it also provides some certification to the credit parties.
The range of performance targets in publicised deals around the world in the last two years stretches from the most obvious such as reducing CO2 emissions or increasing the use of renewable sources of energy, through to those which focus on societal impact, such as the number of women or minorities in management, and the percentage of a workforce which has taken part in training on inclusion, diversity, anti-harassment and other similar causes. The measurement of the targets is non-standardised: “management” may mean board-level, or it may be all levels of management. Greenhouse gas emissions could be measured widely (scopes 1-3) or narrowly, and so on. Deal-watchers have questioned whether many of the targets are really quite as difficult as they are proclaimed to be, especially where the chosen base measurement is set several years before the signing date, and in at least one case a critical examination showed that a particular pollution-related target could be met by a borrower achieving economies of scale through increased production, even though that would in turn entail increased pollution by reference to other (non-targeted) measures which had not been selected as targets.
The recent focus has been in the development of common taxonomies to bring about some standardisation, and there are some signs, and hope, that the recommendations made by the Taskforce on Climate-related Financial Disclosures (an FSB-sponsored body) and the UK or EU taxonomies will gain traction in coming years. The EU’s Taxonomy Regulation1European Union (Withdrawal) Act 2018, and HM Treasury is consulting about the necessary technical standards that will be required. As the UK was closely involved in developing the EU taxonomy, the UK’s standards are unlikely to deviate much from the EU’s.
This is an ambitious undertaking by the EU and not without difficulty: as Yves Mersch of the European Central Bank said in November 2020, “I see the risk of informational market failures if information on the sustainability of businesses and financial products is inconsistent, largely not comparable and at times unreliable or even completely unavailable. Definitions of what constitutes a sustainable investment are often subjective and inconsistent. The EU taxonomy is a promising initiative, albeit incomplete. Its practical usability remains a challenge. Plans are also under way for widely applicable industry standards.”
The LMA, APLMA, LSTA and ICMA have all issued principles and guidelines which parties may choose to follow, although inevitably they tend to be rather high level, and for the most part the measurement of the level of attainment of a particular target is to some degree qualitative rather than quantitative. There is no shortage of third-party agencies offering verification and certification services, but these too necessarily involve qualitative judgments being made, or else measure an enterprise’s exposure to ESG risks rather than its virtuousness; for example, a coal producer might rate poorly, not because coal is per se a bad thing, but because, as things stand, the financial outlook for a coal-seller is not rosy. One rating agency has gone further and attempted, as objectively as it can, to measure and score an entity’s ESG goodness, which is an interesting attempt at replicating the familiar credit ratings, but so far just over a dozen entities have been given a public rating, so this is probably little more than essentially conceptual at present.
On 10 February 2021, the European Commission published its “Summary Report of the Stakeholder Consultation on the Renewed Sustainable Finance Strategy,” and its conclusions included that the quality, reliability and comparability of ESG data and ratings was currently poor, and that the growing level of concentration in the market for ESG ratings and data providers, and potential conflicts of interest suggested a need for some kind of regulation of the sector. This indicated the direction of travel for the EU (which has been ahead of most of the world on ESG), and the UK chancellor’s November 2020 announcement regarding introducing ESG disclosure standards for corporates and financial institutions by 2025 which would be aligned with the TCFD recommendations, and comments from the Bank of England that there needs to be an orderly market transition to a low-carbon economy, indicate a similar direction for the UK.
Returning to the dichotomy mentioned earlier, one obvious solution would be to provide some form of subsidy to lenders for any ESG-related margin discount, and possibly the obvious way of doing this – so far as regulated lenders are concerned, at any rate – would be to allow an offsetting incentive by way of a reduced regulatory capital charge. This is not the case at present, and even in the medium term it seems an unlikely outcome, as it runs counter to the central tenet of prudential financial institution regulation, which is principally concerned with the liquidity and creditworthiness of a regulated institution; and in any event would face major practical impediments given the lack of a consistent definition of what might be given favourable capital treatment, and lack of data to be used to decide what the risk differential might be.