Is the “S” in ESG Poised for a Breakout Yr in 2022 for Sustainability-Linked Loans? | Bracewell LLP

If final yr was any indication, 2022 could also be one other record-setting yr for the sustainable syndicated mortgage market. Based on monetary information supplier Refinitiv, new issuances of sustainability-linked loans (“SLLs”) climbed to $717 billion in 2021, a rise of greater than 300 % year-over-year from 2020. As urge for food for sustainability-linked credit score amenities grows, lenders must also be ready to deal with the evolving necessities of debtors on this market. Historically, SLLs have been aligned extra towards the environmental element of a borrower’s Environmental, Social, and Governance (ESG) technique; nonetheless, as debtors carve out extra space for non-environmental objectives of their ESG methods, SLLs at the moment are more and more incorporating social objectives as nicely, both on a stand-alone foundation, or along with environmental (and/or governance) objectives.

For the uninitiated, sustainability-linked loans are a kind of mortgage instrument designed to incentivize debtors to attain sure predetermined environmentally and/or socially sustainable targets. A distinguishing characteristic of an SLL is {that a} explicit financial end result, often a discount (or improve) within the mortgage’s pricing, is made contingent upon the borrower’s satisfaction of (or failure to fulfill) sustainability efficiency targets (SPTs) that correspond to sure predetermined key efficiency indicators (KPIs). Not like inexperienced loans, SLLs don’t require the mortgage proceeds for use for a inexperienced or sustainability-related mission, and could also be used to fund any normal company goal.

The rising curiosity amongst debtors within the social points of ESG comes as variety and inclusion (D&I) initiatives have gained wider acceptance and staff are more and more returning to the workplace, making worker well being and security a renewed company precedence. As a partial reflection of this development, in April 2021, non-public fairness agency Blackrock amended its $4.4 billion revolving credit score facility, introducing a sustainability-linked pricing mechanism that references three separate KPIs, two of which (Black, African American, Hispanic and Latino Employment Fee and Feminine Management Fee) are socially-oriented. Within the ensuing months, now we have additionally seen increasingly more debtors, together with the next, incorporate a number of social KPIs into their SLLs:

• The Southern Firm (Various Provider Spend);
• American Campus Communities Working Partnership LP (Range Employment Fee, Range Director Fee);
• HP Inc. (Proportion of Black and African Individuals amongst US-based Executives);
• Autodesk, Inc. (Ladies in Technical Roles); and
• Enerplus (Common 3-year Misplaced Time Damage Frequency charge).

Selecting KPIs
When incorporating social-oriented KPIs into an SLL, lenders and debtors will usually set up KPIs which can be bespoke to the borrower. This strategy supplies lenders and debtors with added flexibility to make sure the mortgage’s sustainability provisions intently conform to the Sustainability Linked Mortgage Ideas (SLLP).¹ KPIs that adhere closest to the SLLP will probably be each core to the borrower’s enterprise, related to the sustainability challenges confronting the borrower’s business, and able to being benchmarked.

Importantly, the mortgage’s KPIs must also be linked in some trend to the ESG technique of the borrower or its guardian. A evaluate of a corporation’s ESG materiality evaluation can present a foundation for lenders to judge which sustainability matters (whether or not environmental, social, or governance oriented) are most vital to a borrower’s enterprise and its stakeholders. Lenders needs to be cautious of building KPIs that haven’t been beforehand documented by the borrower or in any other case established as an inside firm precedence. An SLL containing KPIs missing demonstrable connection to a borrower’s enterprise or insurance policies can increase questions of so-called “sustainability-washing,” which poses a reputational threat to all events of the mortgage.

Alternatively, lenders and debtors may select to undertake a KPI that references a sustainability score issued by an impartial ESG score company, akin to MSCI, Sustainalytics, or V.E (previously often known as Vigeo Eiris). Utilizing their very own inside methodologies, ESG score businesses will calculate a borrower’s sustainability efficiency relative to that of the borrower’s business friends. The usage of such a score company also can take pleasure in lending an extra aura of credibility to a agency’s ESG reporting, as ESG score businesses will normalize scores inside a given sector, offering extra context to buyers.

Calibrating SPTs
In accordance with the SLLP, debtors ought to have important enter in growing the SPTs, which should stay bold all through the mortgage’s time period. SPTs, together with for social KPIs, could also be based mostly on a number of benchmarking approaches, together with an evaluation of the borrower’s personal efficiency over a time frame, a comparability of a borrower’s efficiency relative to that of its friends, or by reference to different systematic, science-based proxies, together with targets that will already be set on the nationwide, regional, or worldwide degree. SPTs shouldn’t be set at decrease ranges, or on a slower trajectory, than another associated targets that will have already been set by the borrower in inside methods or elsewhere.

Usually, SPTs will probably be structured to focus on an enchancment of a borrower’s personal efficiency underneath the related metrics. To make sure that these SPTs stay bold, lenders and debtors can elect to include a shifting baseline. Utilizing this system, annually, the borrower’s efficiency from the prior yr is included into the SPT and would require a set diploma of enchancment over that baseline from the prior yr to fulfill the SPT.

Verification
Pursuant to the Might 2021 launch of the SLLP, lenders and debtors at the moment are required to acquire verification from an impartial and exterior reviewer as to a borrower’s efficiency towards all SPTs. This evaluate should happen at the least yearly and is incessantly carried out by the borrower’s monetary auditor, however any certified exterior reviewer with the requisite expertise, akin to an exterior guide or ESG rankings company, can carry out the evaluate. The reviewer’s verification is often issued within the type of an impartial audit or assurance assertion that’s supplied the place the borrower reviews its efficiency, typically in its monetary statements or ESG reporting paperwork.

Outlook
Because the SLL market continues to mature, it’s seemingly extra adjustments to market requirements await debtors and lenders. As debtors proceed to refine their ESG methods to include extra social and governance points, it’s seemingly they may search to harness the reputational advantages of doing so by together with extra KPIs associated to these points of their SLL packages. Moreover, with the rising variety of SLL issuances, “sustainability washing” will stay an ongoing concern available in the market. The Might 2021 revisions to the SLLP established the verification requirement, partially, to go off “sustainability washing” and protect the integrity of the SLL product. In gentle of those dangers, lenders and debtors can be nicely suggested to include extra flexibility into their mortgage paperwork, notably with respect to the rights to change and alter sustainability targets in addition to necessities associated to reporting and verification.