Sustainability-Linked Loans and SMEs

Introduction

It is some time since we looked at Sustainability-Linked Loans (SLLs).  For an introduction, see our previous article here.  In this latest article we will remind you of the key aspects of SLLs and then look at the challenges faced by small and medium-sized enterprises (SMEs) and their lenders in this market.  A word of warning – there are a lot of acronyms in this article!

The Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA) have published what are known as the Sustainability-Linked Loan Principles together with guidance notes.  They have recently published a Practice Note on the Application of Sustainability-Linked Loan Principles to SMEs, all of which, along with other materials, can be found at: LMA: Sustainable Lending Microsite.

These are excellent resources, on which this article has been based, and should be your next port of call if you are interested in this area.

What is an SLL?

Whilst Green Loans and Social Loans are used to finance eligible Green Projects and Social Projects respectively, an SLL is a slightly different kettle of fish.  SLLs do not need to be linked to a project. They can be used for general borrowing as long as they facilitate and support environmentally and socially sustainable economic activity and growth.  An SLL is designed to incentivise a borrower to meet its sustainability commitments and reduce its environmental impact, usually by means of a pricing adjustment based on the borrower’s sustainability performance.  This is measured using predefined sustainability performance targets as measured by predefined key performance indicators.  SLLs should adhere to the Sustainability-Linked Loan Principles.

What are the Sustainability-Linked Loan Principles (SLLPs)?

The LMA has suggested five key components to enable all market participants to clearly understand the characteristics of an SLL:

• Selection of key performance indicators (KPIs) – SLLs look to improve the borrower’s sustainability profile over the term of the loan by aligning loan terms (see third bullet below) to the borrower’s performance. Performance is measured using one or more sustainability KPIs and sustainability performance targets (SPTs).  These must be clearly defined, credible and material to the borrower’s business.
• Calibration of SPTs – the purpose of SLLs is to encourage ambitious, positive change in the KPIs through incentives, and this should form the basis of target setting.
• Loan Characteristics – a key characteristic of an SLL is that there is a financial incentive linked to whether the SPT(s) are met. For example, the interest margin under the relevant loan agreement may be reduced where the borrower achieves an SPT as measured by the KPIs or possibly increased where an SPT is not met.
• Reporting – a borrower should provide the lender(s) with up-to-date information sufficient to allow the Lender(s) to monitor the performance of the SPTs and to determine that the SPTs remain ambitious and relevant to the borrower’s business.
• Verification – the borrower must obtain independent and external verification (for example by a qualified external reviewer with relevant expertise, such as an auditor, environmental consultant and/or independent ratings agency) of the borrower’s performance level against each SPT for each KPI, at least once a year.

Challenges for SMEs

What may be relatively straightforward for a larger corporation can be much more difficult for an SME.  Challenges include a lack of a developed sustainability strategy, limited data on its environmental impact, social responsibility and corporate governance (ESG) and therefore no baseline metrics for setting KPIs and SPTs, limited ESG capacity and expertise, high proportional costs when set against the financial benefits (i.e. lower interest cost) of the loan, limited ESG reporting systems, capacity and resource constraints and disproportionate verification costs.

The LMA practice note referred to above makes a number of useful suggestions.  These include:

• The “stackable” KPI approach – in their words “phased progression from foundational sustainability measures towards more outcome-oriented indicators as the borrower’s data maturity develops”. Not the easiest language to understand but they illustrate it with a helpful example for environmental footprint improvements.

1. In year 1, the borrower must calculate a CO2e baseline using recognised standards;
2. In year 2, it must establish CO2e reduction targets, covering at least operational emissions; and
3. In year 3, it must reduce operational emissions in line with the targets established in year 2, while continuing to map additional emissions categories, such as value chain emissions.

• Using practical, operationally meaningful measures rather than derived sustainability metrics. They give as an example, where an SME’s greenhouse gas emissions are driven primarily by purchased electricity or fuel consumption, measuring reductions in electricity (kWh) or fuel use. This provides a more practical and readily verifiable basis for setting ambitious SPTs rather than requiring actual emissions calculations.
• Reporting arrangements for SMEs should be proportionate, practical and aligned with the borrower’s internal capabilities. Where possible, reporting arrangements should be aligned with the borrower’s existing reporting processes, data cycles and internal systems and any existing regulatory or voluntary disclosure frameworks applicable to SMEs may be accepted to reduce duplication.
• KPI data sourced directly from independent and reliable third-party providers (e.g. utility bills, certification bodies, external agencies or professional advisors) may support satisfaction of the verification requirement. They give the example of a waste management provider producing for the borrower a detailed customer-specific report covering metrics such as waste volumes, waste fractions, recycling rates, sorting ratios and diversion from landfill, which a lender may consider to be sufficient to support the verification process for the relevant KPI.

There is plenty more in the practice note suggesting pragmatic ways of supporting SMEs whilst adhering to the SLLPs.

Dirty Washing

There is a strong emphasis in the LMA publications on maintaining the integrity of the products at all times by adhering properly to the SLLPs and not allowing “greenwashing” (the practice of a borrower holding out itself or its project as having green credentials but where this is misleading, inaccurate or inflated) or the equivalent “social washing” and “sustainability washing”.  In other words, for lenders and borrowers participating in this market, it is important to be transparent and take their duties seriously.  Trying to pull the wool over people’s eyes in these areas is not doing the planet or society any favours.

We are here to help

Our Banking and Finance team has extensive experience of drafting and negotiating domestic and cross-border finance documentation. In recent years, we have developed extensive expertise in impact investment loans with strong environmental, social and governance criteria and we are therefore ideally placed to assist you in the developing sustainability-linked loan market.  Whether you are external lawyers or in-house lawyers, acting for borrowers or lenders, we can assist you with all your needs. With a substantial regional presence, you can benefit from a competitive fee arrangement but with the same level of expertise as a big city firm.