The agenda for COP26's finance session on 3 November is aimed at mobilising and upscaling the public and private financing of mitigation of and adaptation to climate change. Climate related finance products are not new to the market but the arrival of COP26 in Glasgow got me thinking about current environmental finance trends and what might be available for borrowers mindful of the environmental impact of their businesses.
Green finance and sustainability linked finance have been available for several years now but there has certainly been a greater emphasis on the latter more recently. Whilst green loans and bonds are those which exist for the purpose of financing or refinancing specific green projects (and therefore may not be accessible to all borrowers), sustainability linked products can be used for any corporate purpose and are designed to encourage borrowers to achieve certain targets linked to environmental, social and/or governance challenges so as to improve a borrower's sustainability profile over the term of the facility. Sustainability linked products should, in theory, be more accessible to a wider range of borrowers for that reason and can be offer some benefits to borrowers. For example:
The issuance of a sustainability linked bond or the borrowing of a sustainability linked loan product sends a clear message to the market and to a business' customer base that the business takes its sustainability seriously. In some markets and industries, that message (and the action taken by a business to support it) may improve the availability of further finance and investment particularly from institutional investors who are themselves subject to increasing reporting pressures and a need to demonstrate improvements in their own sustainability strategies and targets. For many businesses, sending the right message to the market about their commitment to environmental and social sustainability may also help to attract and retain the best talent in the market, with many candidates now placing greater importance on potential employers' sustainability, diversity and inclusion strategies and valuing those alongside salary and benefits packages.
Sustainability linked loan products align the terms of the loan to the borrower's performance against agreed key performance indicators (KPIs). If those KPIs are met or exceeded, there will be a positive economic outcome for the borrower. For example, the facility documentation may contain a margin ratchet such that the margin payable decreases when the KPIs have been satisfied (or a premium may be payable on failure to meet those KPIs) or there may be a waiver of certain fees payable in connection with the facility.
Accessibility of future finance
Financial institutions and lenders are, on the whole, becoming increasingly interested in how their borrowers operate and the steps being taken by them to mitigate their environmental and social impact. There are elements of the credit assessment process of many lenders in the market which are now underpinned by environmental and sustainability factors and current market trends indicate this will likely continue to evolve over time, such that a failure to demonstrate a shift towards more sustainable business practices may impede future access to certain lenders and their products.
It should be borne in mind that, for some businesses, the benefits offered by sustainability linked products might be outweighed by the cost involved in getting ready to apply for such a product. Borrowers need to be able to demonstrate the product is appropriate for them for they apply. In particular:
Borrowers need to have a sustainability strategy in place before approaching lenders for this type of product. For those who do not already have a strategy, thought must be given to the current environmental impact of the business and borrowers should aim to measure that impact with a view to identifying possible improvements and, from that, viable KPIs. It can take considerable time, cost and effort to create and implement a strategy, particularly for borrowers who need to enlist the help of specialist strategists and ESG ratings providers as part of that process.
Borrowers should consider spending time speaking to their existing advisers and to competitors who may already have been through the process. Borrowers need to properly understand the metrics involved and need to ensure that any KPIs are challenging, not only at the point of application but further down the line. Targets need to be achievable but stretching throughout the entire term of the product, so as to avoid any suggestion of green or sustainability washing.
Some businesses already have teams whose sole purpose is to improve their sustainability. Clearly, that type of resource is more readily available to larger businesses so it may be harder for smaller businesses, at least initially, to access sustainability linked loan products. The process involved, both in creating a strategy and then agreeing viable KPIs is time consuming and involves a number of specialist employees, advisers and third party stakeholders. Once identified and agreed, KPIs need to be independently verified, monitored, measured and periodically reported to the relevant stakeholders, including lenders who have provided these products. KPIs are more than a box ticking exercise - the initial identification and agreement is simply the first step in the process. Borrowers need to be committed to the longer term process, both in terms of the associated financial cost and to the additional resource required.
It will be interesting to see how the sustainability linked loan market evolves in the future but current market intelligence would certainly suggest such products are here to stay and are likely to feature more prominently as the market develops.
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