With growing international concern around limiting corporations’ environmental footprints, companies are increasingly including enforceable contractual arrangements in their business contracts, which incentivise the achievement of ambitious environmental sustainability objectives. In the context of corporate debt funding, these have become known as sustainability linked loans (SLLs).
Generally, what makes SLLs different from other similar corporate loans is that they include one or more entity-wide or asset-specific sustainability key performance indicators (KPIs) in the documentation, usually tested annually, that have financial consequences, if not achieved. Those consequences include a reduction in pricing if the KPIs are met or an increase, if they are not. At the current stage in the market, failure to achieve a KPI does not trigger the severe consequences of an event of default.
Some of the advantages that SLLs provide to lenders and borrowers include:
- the loan agreement sets out a contractual framework that outlines the KPIs, which the borrower is seeking to achieve and the lenders are supporting. This promotes keeping environmental KPIs consistent within the organisation for the term of the loan as the organisation will either have to renegotiate its KPIs with the banks or pay the higher pricing if it no longer wishes to meet the KPIs in the SLL. The financial incentive also makes the KPI a factor that managers should take into account in their decision-making throughout the business rather than merely a policy where the consequences of non-compliance are unclear;
- as one or more third parties independently verify the KPIs at the documentation stage for the loan and on an ongoing basis, it encourages KPIs that are verifiable; and
- in the current market, often organisations that can show that they are carrying out their business in an independently verifiable environmentally responsible manner trade at higher valuations than others that do not necessarily have the same ‘green’ credentials.
In light of the growing popularity of SLLs, we outline below a simple framework to use as a basis for reviewing SLL loan provisions, comparing different facility agreements and advising internal or external clients.
One way of looking at SLLs is to identify the following four key elements:
- Assurance provisions.
- Consequences of breach.
- Exit provisions.
KPIs: Making targets achievable but ambitious
As the KPIs are the triggers for whether the borrower has to pay a premium or discounted pricing, it is important to ensure that these targets represent an achievable but ambitious goal for the borrower. Depending on the nature of the loan and the borrower, KPIs could be relatively simple such as satisfying certain carbon reduction emissions targets across the whole corporate group. Alternatively, they could be quite complex and a borrower and lender may agree that certain measures are implemented so that a specific asset owned by the borrower has less of a carbon footprint.
Once a corporate group settles its sustainability KPIs, they will usually become its standard for other future financings, much in the way of financial covenants. This way, the hard work of negotiation is only done once for the first such deal, with the settled provisions simply slotted into future deals.
Assurance provisions: When KPIs are tested and externally verified
Once the KPIs are agreed, the parties will then need to consider how they will be tested and externally verified. In our experience, this can often involve detailed negotiation around:
- when the KPIs need to be tested – annually or more frequently?
- evidentiary requirements regarding compliance, such as a compliance certificate similar to a compliance certificate for financial covenants.
- the identity of the external third party certifier, and how often it will need to verify KPI compliance – often, the third party will be an accounting firm, who provides assurance similar to that provided by an auditor with respect to financial covenants, to verify compliance, although specialist boutique advisers are emerging.
A number of questions might arise from these considerations. For example, what if the external third party certifier is to change midway through the loan? If the borrower has 10 sustainability loans with 10 different lenders and the external third party certifier unexpectedly resigns or the borrower wishes to replace them, it would be unlikely that the borrower would want to individually negotiate with all 10 lenders and end up with 10 different assurance certifiers on its loans. Similarly though, given the early stage of this market, lenders will likely want some say as to who is verifying the borrower’s compliance with the SLL provisions. In our experience, we have observed that this is an area of tension between borrowers and lenders.
Consequences of breach: A breach but not a default
Once the KPIs and the regime for testing them are agreed, it is necessary to consider the consequences if a borrower fails to meet its KPI targets at a testing date or if there is otherwise a breach of the sustainability provisions. The key difference between sustainability provisions and traditional facility agreement covenants is that a breach of the sustainability provision or failure to meet a KPI generally does not, at least at this early stage of the market’s evolution, result in an event of default or review event.
In light of that, it is important to set out the consequences of a breach. These consequences typically include:
- a higher margin and/or commitment fee or other financial penalty is payable by the borrower until the KPI is next tested and satisfied.
- in some cases, a serious or persistent breach will result in an obligation on both the borrower and the lender(s) to cease describing the facility as an SLL in their accounts and marketing materials.
In contrast, if the targets are achieved, the borrower may be entitled to a lower margin and/or fees.
Another issue of interest is what happens to the premium or discount. Sometimes, rather than the lender enjoying a windfall if the borrower fails a KPI, the amount of the premium is required to be spent by the borrower on sustainability purposes or donated to an agreed sustainability fund or charity. We have even seen a facility where the borrower is obliged to apply the discount upon achieving its KPIs to sustainability purposes.
Exit provisions: Continuing without the sustainability elements
One further interesting aspect of SLLs is that the facility agreement can contain an ‘exit’ provision. Under these types of provisions, either party or just the borrower (on the basis the borrower is the person running the business) is allowed to switch off the SLL provisions if the borrower’s circumstances change or if there is a change in the SLL regulatory environment. An example of a change in the borrower’s circumstance is a major corporate event such as an acquisition or divestment that makes the KPIs no longer appropriate.
Usually, the SLL provisions would be switched off after a negotiation period if the parties are unable to agree on the amendments to the KPIs and assurance aspects of the facility agreement following the relevant circumstantial change. If this right is exercised, the sustainability clauses would then cease to apply, but the loan would otherwise remain on foot.
What does it mean in practice if the SLL provisions are switched off? Essentially, the margin and other pricing will not be adjusted by reference to the KPIs. The borrower would no longer need to provide a sustainability compliance certificate or other assurance. Parties can also no longer publically represent the loan as an SLL. Often, the pricing will default to the higher level (in other words, as if KPIs had not been met) to act as a disincentive to switching off too readily.
As SLLs become increasingly common and market practice develops, it will be interesting to see the approach that borrowers adopt if they are unable to meet the KPIs and there is still some time before the maturity date for the loan occurs. Will they use the exit mechanisms to convert their SLLs back into traditional loans? Alternatively, will they elect to continue paying the higher margin because of the importance, in terms of publicity, of complying with the terms of the SLL? Or will it become more common among borrowers to refinance the SLL with another lender with a lower KPI, just like an interest rate?
The increasing prevalence of SLLs seems to reflect an awareness in the market that loans can be used for a diverse number of reasons and are useful in facilitating the achievement of sustainability objectives. The current preferred approach of incentivising the borrower to become more ‘green’ rather than penalising it for failing to do so by way of an event of default is likely resulting in continued growth in the popularity of SLLs. However, in coming years, it will be worth watching how borrowers and lenders choose to approach a situation where the SLL still has a substantial period until its maturity date and it becomes clear the borrower will not be able to meet its KPIs for the remaining term of the loan.
If you have any questions in relation to the above, please reach out to Nuncio D’Angelo, James Morris, Robert Murphy or Natalie Ho.
Norton Rose Fulbright has been named ‘ESG Legal Advisor of the Year’ at the inaugural IJGlobal ESG Awards.