{"id":455,"date":"2023-04-17T11:04:11","date_gmt":"2023-04-17T11:04:11","guid":{"rendered":"https:\/\/finnovateinsights.spjimr.org\/?p=455"},"modified":"2023-08-11T09:45:07","modified_gmt":"2023-08-11T09:45:07","slug":"sustainability-linked-loans-a-primer-for-cfos","status":"publish","type":"post","link":"https:\/\/finnovateinsights.spjimr.org\/sustainability-linked-loans-a-primer-for-cfos\/","title":{"rendered":"Sustainability-Linked Loans: A primer for CFOs"},"content":{"rendered":"

Sustainability-Linked Loans (SLLs) allow CFOs flexibility around fund deployments, provide liquidity, and further opportunities to diversify the lender base while ensuring a good alignment of interests among borrowers and lenders about ESG. Here’s a basic round-up of the financial tool<\/strong><\/p>\n

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Sustainability-Linked Loans (\u201cSLL\u201d) have now emerged as one of the important types of sustainable financings Image: Shutterstock<\/figcaption><\/figure>\n

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.<\/p>\n

Sustainability-Linked Loans (\u201cSLL\u201d) 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\u2014with 614 percent growth (Figure 1). So, it has now become imperative that all CFOs and Treasurers understand SLLs.<\/p>\n

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

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Source: BloombergNEF, Bloomberg L. P.<\/figcaption><\/figure><\/p>\n

History of SLLs<\/h3>\n

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\u2019s 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 \u20b9400 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. <\/p>\n

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.<\/p>\n

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\nSource: SPJIMR<\/figcaption><\/figure>\n

Flexibility<\/h3>\n

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\u2019t 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.<\/p>\n

Liquidity and opportunity to diversify the lender base<\/h3>\n

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\u2019 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.\n<\/p>\n

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.<\/p>\n

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\u2019s expectations from the borrowers.<\/p>\n

Reporting and verification requirements<\/h3>\n

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\u2019s 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\u2019s performance to determine whether the KPIs and STPs have been achieved. <\/p>\n

According to industry experts, SLL lenders typically expect borrowers to meet the following requirements:<\/p>\n