The global sustainable debt issuance set a record of surpassing $1.6 trillion in 2021 and exceeded $700 billion during the first half of 2022. Corporations are leveraging sustainability-linked finance instruments to further their Environmental, Social, and Governance (ESG) agenda, reduce the cost of borrowing, and diversify the lender base.

Sustainability-Linked Loans (“SLL”) have now emerged as one of the important types of sustainable financings. Despite a mere 4-year track record, SLLs have shown the strongest growth among various sustainable debt issuances. Starting with $49 billion in 2018, SLLs have crossed $350 billion in the first half of 2021—with 614 percent growth (Figure 1). So, it has now become imperative that all CFOs and Treasurers understand SLLs.

Figure 1: Annual Sustainable Finance Growth (USD$ billion), 2013-2021

History of SLLs

Formerly known as Positive-Incentive Loans, SLLs are loan products that incentivise borrowers to achieve pre-defined Sustainability Performance Targets (SPTs) related to environmental, social, and/or governance aspects. The targets measure improvements in a borrower’s sustainability performance and include pre-defined Key Performance Indicators (KPIs), external ratings, and/or equivalent metrics among others. If a company achieves its pre-defined SPTs, it benefits from a reduced interest rate, and a failure to do so leads to higher rates. For instance, JSW recently raised ₹400 crore from MUFG Bank India as SLL. According to the reports, JSW plans to deploy the funds as capital expenditure to achieve its annual capacity target of 25 million tonnes by FY25.

SLLs are based on Sustainability Linked Loan Principles that have been issued by the Loan Market Association, the Asia Pacific Loan Market Association, and the Loan Syndications and Trading Association.

Flexibility

Unlike Green Loans, SLLs give a lot of flexibility to borrowers. In Green Loans, the proceeds must be used for green-focused projects or investments. However, SLLs are often structured as revolving credit facilities for general corporate purposes and don’t require details of the proceeds when borrowing. The absence of any pre-defined eligible project gives a lot of flexibility to the CFOs in fundraising and fund deployment. This is one of the key reasons for the rapid growth of SLLs compared to Green Loans.

Liquidity and opportunity to diversify the lender base

In addition to flexibility, liquidity is another reason for CFOs to embrace SLLs. A senior banker, who has been working in the Indian loan market for over 25 years, attributed the rapid growth in sustainability-linked financing to a combination of factors such as better liquidity, international lenders’ commitment to Net Zero targets, and ease of the use of proceeds. For some borrowers, SLLs can also be an opportunity to onboard new lenders and diversify their lender base. Further, the abundance of liquidity in many cases has also resulted in SLLs being priced more competitively. In addition, there is also a potential to reduce the cost of borrowing as the margin on the loan is linked to achieving pre-defined KPIs. Several SLLs adopt stepped pricing, allowing borrowers multi-level pricing benefits as they achieve one target after the other. Borrowers typically need to achieve a base target and then exceed this target by certain pre-agreed levels for further improvement in pricing.

Conversely, lenders receive higher compensation in exchange for an increased (credit or operational) risk stemming from poor sustainability performance. To this end, credit rating agencies are exhibiting signs of a much more standardised integration of ESG risk assessment into the credit ratings, which would ultimately affect security and loan pricing. Irrespectively, in the backdrop of excessive liquidity, a CFO can reduce the cost of borrowing by focusing on SLLs.

So, while flexibility and liquidity are beneficial to the borrowers, there are also certain nuances about SLLs that a CFO must keep in mind. These are related to the lender’s expectations from the borrowers.

Reporting and verification requirements

Whilst SLL gives more flexibility to CFOs, it is important that SLLs still drive a positive impact on the ESG agenda. So, lenders are keen to determine compliance with KPIs and SPTs. But the credit policies and environmental risk assessments associated with SLLs are still under development. UN’s Global Compact CFO Taskforce intends to engage CFOs to establish universal standards for setting, measuring, and reporting sustainability targets. However, in the interim, till universal reporting standards are developed, lenders depend on annual reporting and external verification of the borrower’s performance to determine whether the KPIs and STPs have been achieved.

According to industry experts, SLL lenders typically expect borrowers to meet the following requirements:

• To develop a sustainability framework to conduct annual verification of agreed KPIs/SPTs, preferably by second-party opinion (SPO) providers, and
• To establish ESG rating as an additional benchmark for meeting sustainability targets

So, CFOS must have a good understanding of the reporting requirements before embarking on SLL issuance.

KPIs, the pivot from a lender’s perspective

Lenders have a set of KPIs for themselves, related to the share of impact investing within their lending books. According to research by S&P Global Ratings, the need for enhancing the share of impact financing within lending books has been one of the key drivers for growth in sustainability-linked debt among banks.

The Capital Requirements Regulation set by the European Parliament and the Council of the European Union establishes a framework of regulatory capital, liquidity, and leverage applicable to European credit institutions and investment firms. The framework offers preferential treatment of financings to projects that meet certain environmental and sustainability objectives. Long-term asset owners, like pension funds, have shown that sound, sustainable management improves long-term risk-adjusted returns. These improvements show up in letters or numbers, like credit ratings and capital adequacy ratios, and are reflected in the costs of borrowing and the prices of securities.

So corporate treasurers and CFOs need to appreciate lenders’ requirements for KPIs that can be monitored and improvements in KPIs that constitute a significant positive sustainability impact. Alternatively, borrowers can set targets beyond ‘business-as-usual’ or goals that exhibit a higher annual change in comparison with previous performance or outperform industry peers or align and outperform international standards. Recently, Mercedes-Benz converted an €11 billion revolving credit facility into a sustainability-linked loan, with KPIs chosen through a materiality analysis in line with the company’s sustainability strategy. So materiality of KPIs is the cornerstone of robust sustainability-linked finance.

Concerns around SLLs

Although SLLs look attractive, they are an emerging product with a specific set of challenges and risks. One of the concerns is increased transaction costs associated with finalising a suitable framework for achieving and monitoring KPIs. This is generally due to the underdeveloped market practice for SLLs. In some nations, such as Singapore, a new Green and Sustainability-Linked Loans Grant Scheme has been established to provide economic relief for borrowers and financiers. This can increase the accessibility of SLLs, particularly for small and medium-sized enterprises (SMEs). Similar policies can be implemented in other nations to increase accessibility to SLLs, particularly SMEs.

Another concern is borrowers mislabelling their loans as SLLs and making unsubstantiated claims of sustainability. Such allegations can be damaging for both the companies as well as lenders. Adding fuel to this concern, a new segment of the SLLs is emerging titled ‘Sleeping Sustainability-Linked Loans’. These SLLs enable a company to issue a loan on the condition of stating the sustainability performance targets later. While the Loan Market Association is working on guidance to regulate Sleeping SLLs, these transactions are sending out worrisome signals.
Benefits and Challenges

Way Forward

SLLs have emerged as an attractive option that ensures a good alignment of interests among borrowers and lenders about ESG. SLLs also bridge the gap between traditional and sustainable financings as businesses begin their journey to net zero. So, the SLL market looks poised to grow further, and all CFOs must have a good awareness of SLLs.

This article was originally published in Forbes India.

Link to the article: https://www.forbesindia.com/article/bharatiya-vidya-bhavan039s-spjimr/sustainabilitylinked-loans-a-primer-for-cfos/84437/1

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ESG—Environmental, Social, and Governance factors to evaluate the companies and countries on how far they can contribute towards sustainability—has been a buzzword in the policy forums and corporate boardrooms in recent years. All thanks to the initiatives such as the United Nations’ Sustainable Development Goals (SDGs), the Paris climate agreement, the Global Sustainable Initiative (GSI), and COP-26. The Global Sustainable Investment Alliance (GSIA) reports that sustainable investments across five markets, including the United States and the European Union, reached $35.3 trillion in assets under management, which is close to 36 percent of all professionally managed assets in these markets (Figure 1).

Figure 1: Global assets under management 2016-2018-2020 (USD billions)

However, the world seems headed towards an inflexion point, where a lot of experts are undertaking well-meant ESG initiatives to reverse climate risk, while another set criticizes ESG as being lopsided and often a smokescreen. Is that really the case?

ESG: Well-meaning but flawed?

‘Greenwashing’ is threatening to derail the ESG focus. It is a deceitful marketing technique by which the companies hide the damage they cause to the environment and nature, and use advertising and public messaging to appear environmentally sustainable. For instance, recently, a lawsuit has been filed against one of the largest apparel brands in the world, alleging that the brand was using false sustainable marketing. Such high-profile investigations into greenwashing have prompted questions about the purpose and value of ESG. People are now criticizing ESG as “woke” politics. ESG is becoming a political fight due to the observers pointing to two potential factors. One is that ESG is becoming deeply ingrained in corporate America and financial markets focusing more on environmental issues, than on maximizing returns on government funds. Second, where Republicans are trying to score political points ahead of the elections. For instance, recently, the governor of Florida Ron DeSantis’s office declared ESG language as a threat to the vitality of the American economy, while US Republican lawmakers frame ESG investment efforts as a threat to employment and revenue.

The ESG framework was created to assist companies in managing environmental and social risks and to incentivise them to contribute to greater social and environmental impacts. Unfortunately, today there is a dizzying array of ESG objectives that fails to provide a comprehensible guide for investors and institutions. Further, due to cumbersome reporting systems and problematic applications of the framework, the very essence of ESG is at risk. Moreover, the world is moving towards an outsized focus on “E” i.e., environmental aspects. Perhaps, this is myopic and may have far-reaching ramifications in the future. This outsized focus on environmental aspects is about mitigation and transitioning businesses to a cleaner, environmentally sustainable way of operations. But environmental issues should equally be about adaptation. Adaptation is in the context of environmental changes, and how individuals, communities, and societies adjust to take advantage of these new opportunities. For instance, between 1990 to 2015, when humanity doubled its carbon emissions, the poorest 50 percent contributed just 7 percent of the emissions. However, the impact of climate change events is harshly felt across low-income countries. So, these countries have very little to contribute towards mitigation and transitioning. They have to focus on how to adapt to the evolving climate change impacts over which they have very little control. So also, the role of governance in pushing transparency and accountability cannot be emphasized enough. “G” in ESG is responsible for managing the risks that may be faced by those who are not a part of the investment decisions. Hence, ESG can fulfil its potential only if the world truly appreciates how E, S, and G are interconnected. The current reductionist approach is misleading & myopic.

Is accountability to ESG becoming lip service?

Since the mid-2000s, ESG has become a core part of business planning and operations. However, measuring the impact of ESG Goals is complicated with the absence of internationally accepted standards. The Reserve Bank of India (RBI) finds most of the available data on climate finance insufficient for an appropriate assessment of climate-related financial risks. To make India’s financial system resilient to climate-related risks, RBI issued a discussion paper on climate risk and sustainable finance and sought suggestions for devising regulations.

The various rating agencies provide different ratings with diverging scores. According to the McKinsey Sustainability Reporting Survey, 75 percent of investors prefer a single sustainability reporting standard compared to multiple reporting standards (Figure 2).

Figure 2: Investors and Executives on the number of sustainability reporting standards

So, clearly, in the absence of an internationally accepted reporting standard, how do you measure accountability?

Is a meaningful relationship with financial performance possible without accountability?

In the absence of internationally accepted reporting standards, it is hard to measure the impact of climate risk on financial performance. Private ratings and score providers such as MSCI, Refinitiv, and S&P Global are competing to provide an insightful measure of ESG performance. But we need to appreciate that there is a possibility that current positive correlations between ESG and financial performance may not be causative and can perhaps be explained by other factors. For example, industry sectors like technology and asset-light companies exhibit higher ESG ratings due to their relatively low carbon footprint and not necessarily because of the ‘Do Good’ initiatives of these companies in the ESG space. And it is very well acknowledged today that climate risk is real and will adversely impact financial performance in the long run. So companies need to identify the ESG risks material to their business and adopt a thorough and long-term perspective to value creation. But until accountability is established, we are compelled to rely on the handful of “forward-looking companies” that tend to approach ESG from a rigorous, strategy-driven viewpoint; which may hitherto not be comprehensive across “E”, “S” and “G”.

Overall, it is heartening that we have finally woken up to climate risk and ESG. A lot of well-meant initiatives are being undertaken around the world. However, one cannot deny that absence of international standards is leading to ESG often being used as a smokescreen. The world is at a precipice of irreversible change and we owe it to our future generations that we do everything in our power to ensure ESG does not become a smokescreen.

This article was originally published in Forbes India.

Link to the article https://www.forbesindia.com/article/bharatiya-vidya-bhavan039s-spjimr/is-esg-at-the-risk-of-becoming-a-smokescreen/80133/1

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