Green loans
The Equator Principles were first
published in 2003 and incorporate
the International Finance Corporation
Performance Standards and the World
Bank Group’s technical industry guidelines
for projects in emerging markets. The
Equator Principles are intended to help
ensure that project finance transactions
are undertaken in a socially responsible
way and in accordance with appropriate
environmental management practices.
While widely adopted in the project
finance sector, the Equator Principles are
rarely encountered in ordinary corporate
loan transactions. The introduction of the
Green Loan Principles may have broader
reach into other parts of the loan markets,
but they are less established than the
Equator Principles.
While the Green Loan Principles do not
contemplate the pricing on the loan
being linked to green use of proceeds,
that linkage has been a feature of some
corporate financings. In one example,
a revolving credit facility for general
corporate purposes was split into two
tranches – the first tranche, which was
available for general corporate purposes
did not benefit from any discount, but the
second tranche, which was available only
for green purposes had reduced pricing.
"Two-way pricing mechanisms better incentivise
performance by providing for a pricing reduction
if sustainability criteria are met, and applying a
pricing increase where performance declines."
One-way or two-way pricing
Early financings were structured such that
if the borrower satisfied its sustainability
criteria, the margin on the loan was
reduced. The size of that reduction varied
between loans and markets, but might
typically be in the range of 0.02% to
0.04% on a general corporate financing.
In some markets the discount might be
higher – as much as 0.10% to 0.20%.
Where sustainability targets were not
met, the margin calculation mechanism
on those financings had no penalty for
poor performance. Instead the margin
reduction was simply not applied.
More recently, two-way pricing
mechanisms have been introduced on
some deals. Two-way pricing mechanisms
better incentivise performance by providing
for a pricing reduction if sustainability
criteria are met, and applying a pricing
increase where performance declines.
The underlying objective of incentivising
borrowers to make improvements to their
sustainability profile is probably more likely
to be achieved through two-way pricing
mechanisms, but it is possible that they
could be viewed in a less positive way
– after all, they result in lenders making
greater returns on loans from borrowers
who are not meeting sustainability targets.
There are examples of alternative
structures being considered, which could
mitigate that concern. One idea replaces
increases in pricing with a requirement to
make additional payments into a separate
bank account should sustainability targets
not be met. Those amounts could then be
reinvested into improving the sustainability
profile of the borrower.
"As the market becomes more
sophisticated, rating methodologies are
becoming more tailored."
Third party oversight
The Sustainability Linked Loan Principles
state that the need for external review of
the borrower’s ESG performance is to be
negotiated and agreed on a transaction
by transaction basis. Where information
relating to sustainability performance
targets is not publicly available or
otherwise accompanied by an audit or
assurance statement, the Sustainability
Linked Loan Principles recommend that
external review of those targets is sought.
Even where data is publicly disclosed,
independent external review may be
desirable. The majority of deals signed to
date require external review rather than
relying on self-reporting. This is in some
ways similar to the requirement for an
independent environmental and social
consultant under the Equator Principles.
A number of factors influence whether third party oversight is required by lenders. At a general level, the integrity of the product is promoted by credible independent review. In many cases, self-reporting is not feasible because borrowers do not have the internal expertise to perform the role themselves. Larger corporates, which may have the necessary internal expertise to self-report, are encouraged by the Sustainability Linked Loan Principles to thoroughly document that expertise and their internal processes.
One reason borrowers might prefer to self-report is to avoid incurring an increased cost burden. It is worth bearing in mind the wider trend toward companies assessing and reporting on their ESG performance for other purposes, so to the extent information is already being gathered, it may be possible to repurpose it for a lower incremental cost.
Methodology changes
A less obvious concern is the potential
for external ESG rating providers to
change their methodologies unilaterally.
There are many entities in the market
that research and rate corporate
sustainability, although reporting in the
loans market is concentrated on a smaller
group of providers.
Each of the ESG rating agencies
considers various data points to arrive
at their respective ratings. Their rating
methodologies are not only varied from
each other, but evolve over time. In part
that reflects shifts in perception towards
particular risk factors – what is considered
green or sustainable today may be less so
tomorrow. For example, the production of
electric vehicles might in some cases rely
on the transport and use of raw materials
that are extracted using polluting methods
or perhaps involving poor employment
conditions. Early ESG ratings tended not
to differentiate between sectors when
assessing the relevance of particular
risks, but as the market becomes more
sophisticated, rating methodologies are
becoming more tailored.
Evolving rating methodologies can also be
the result of consolidation in the market.
For example, Sustainalytics acquired ESG
Analytics in 2015. Vigeo Eiris was formed
in 2015 by the merger of Vigeo and Eiris,
both of which were ESG data providers.
There are also moves from credit rating
agencies into the market – Moody’s
acquired a majority stake in Vigeo Eiris in
April 2019.
Concerns have been raised about
the low correlation between different
ESG rating agencies’ assessment of
the same company, which contrasts
with the strong positive correlation
generally seen in the context of credit
ratings. This is a challenge for investors
seeking a comparative assessment
across companies with ratings provided
by different sources. It is perhaps
less of a problem in the loan markets
where a particular ESG rating agency’s
rating is being used to demonstrate an
improvement in the performance of
the borrower over time rather than to
compare different borrowers. In time, the
industry may well develop a more uniform
approach, but to get there will require
greater standardisation of the various
methodologies used currently.
Changing methodologies could create a
potential difficulty for the sustainability
linked loans market. It is agreed when the
loan is entered into that the pricing will
change by reference to whether particular
ESG performance targets are hit. If a
rating agency changes its calculation
methodology for whatever reason during
the life of the loan, and that results in
changes to a particular corporate’s rating,
the pricing on the loan may also change.
Whether or not methodology changes are
significant enough to have a substantial
impact is another question.
It is not uncommon for the facility
agreement to include a list of possible
rating providers or otherwise contemplate
that the rating provider could change over
the life of the loan.
Sustainability criteria
The suggested criteria listed in the
Sustainability Linked Loan Principles are
indicative only – the critical factor is that
the criteria chosen are ambitious and
meaningful to the borrower’s business.
Market participants are not tied to using
only the criteria listed in the Sustainability
Linked Loan Principles. Metrics such
as target
CO2
emissions are common,
but there are examples of novel criteria
relevant to the borrower’s business, such
as the proportion of electric vehicles
in an electricity company’s fleet, or
improvements in uptake of energy
consumption monitoring tools among
customers of a utility company. Criteria
can be tailored to the business – for
instance, the three-year average intensity
of
CO2
emissions in kilograms per
megawatt hour of power produced by an
electricity company.
It is common for pricing to be set by
reference to the borrower’s overall ESG
rating (which is typically expressed on
a scale of 0 to 100, although some ESG
rating agencies use a scale similar to
that of the credit rating agencies). The
borrower’s ESG rating is usually assessed
annually, and a discount (or increase)
to the applicable margin is applied if the
ESG rating has moved more than a few
points higher or lower than the initial ESG
rating at the time the loan was entered
into. The threshold for a change to the
ESG rating to impact the applicable margin
varies, but tends to be in the range of two
to five points (on a scale of 0 to 100).
The annual changes to the margin are
not usually cumulative – the discount
(or increase) is applied each year to the
originally applicable margin if the ESG
rating has moved sufficiently from the
initial ESG rating, rather than to an already
discounted (or increased) figure.
On transactions where specific ESG
criteria are used rather than an overall
rating, different discounts (or increases)
can be applied for each specific target
that is met. The alternative is an all or
nothing approach that requires all targets
to be met before the pricing changes.
"It is common for pricing to be set by reference
to the borrower’s overall ESG rating, typically
expressed on a scale of 0 to 100."