Sustainability-linked loans are one of the fastest-growing segments of green finance, yet the returns are not great. Simon Watkins reports.
Green finance takes many forms, from green bonds to transition bonds and sustainability-linked loans. But underlying all sustainable debt structures such as these is a simple premise: cheaper borrowing in exchange for commitments to sustainability.
Green bonds issued on public markets (or green loans on private markets) are the clearest model in which lending is earmarked for specific environmental projects.
But the fastest-growing segment of the green finance market is the sustainability-linked loan (SLL), the principles of which were first laid out in 2019 and defined by the Loan Market Association.
SLL volume in 2021 was at US$601.419 billion, compared to roughly $130 billion in 2020, according to Lipper data. Although global sustainable finance volume – including green bonds, green loans and SLLs – was down 15% year-on-year at $734 billion in the first six months of 2022, SLL volume was far greater than other instruments. In the second quarter, for example, SLL volume was at $179.3 billion, versus $120.1 billion for green bonds and $15.9 billion for green loans.
“Over the last two years, despite the economic uncertainty and Covid-19, demand for sustainability-linked loans dramatically increased, with Q2 2021 posting the highest European volume since the product was defined in 2019,” says Bradley Davidson, ESG lead at RBS International (RBSI).
The appeal of SLLs stems from their relative simplicity and from the fact they can be applied to a wide range of investments and not only those that are explicitly environmental, such as wind farms. There are also the crucial elements of financial and reputational benefits.
SLLs are structured as financial agreements with economic measures attached to predetermined, ambitious and material key performance indicators (KPIs) across a range of ESG measures.
Some, such as RBSI, are marketing SLLs to private equity funds as a means for these funds to obtain basic financing needs. The argument is that raising fund finance through the SLL vehicle will help funds demonstrate their ESG authenticity to investors.
Davidson adds: “In practice, the structure allows a fund manager to align finance structures with their ESG strategy and potentially be rewarded with a lower cost of capital for meeting their targets. The additional benefit is they can deliver a strong message to both the market and investors, which remains the predominant benefit for sustainability-linked loans.”
Access to capital and reputation
The financial benefits to a borrower of green finance, and of SLLs in particular, are not great. While every deal is different, a five basis points (0.05%) discount on the cost of capital if ‘green’ targets are met by the borrower is a very rough guide to the financial dimension. In very large-scale and long-term financing, this can be material – but, says Marc Finer, debt advisory director at KPMG, in some circumstances it is clearly not the financial benefit that is the main motivation.
“If the benefit is, say, five basis points, that could be marginal in the context of what the borrower is signing up to. In some cases, you will need a second-party opinion on the integrity of your ESG targets, and then through the course of the facility, you have to monitor the targets. There’s potentially quite a lot of cost involved in that, which could well be larger than those five basis points,” says Finer.
“In very large-scale transactions, five basis points, if that is what it is, can make a meaningful difference to finance costs, but generally it’s not about the pricing. Sustainability is currently an ‘access to capital’ issue, not a cost of capital issue – pricing is a red herring,” Finer adds.
“Sustainability is currently an ‘access to capital’ issue, not a cost of capital issue.”
Reputation and targets are key factors. SLL and other green financing structures represent a commitment from a borrower that goes beyond well-meaning words. The financial benefit (or penalty for failing to hit targets) may not be huge, but a contractual arrangement speaks volumes about commitments and accountability.
While SLLs are typically linked to two or three key performance indicators, these rarely sit in isolation and typically reflect a much wider and deeper sustainability commitment. As Davidson at RBSI says: “A sustainability-linked loan is a reflection of the maturity of an ESG strategy and the client’s willingness to attach a potential economic penalty, as well as benefit, to what they are doing.”
Green finance necessarily comes with a stick as well as a carrot. The financial cost may not be overwhelming, but the risk to an issuer of claiming green finance credentials that cannot be proved, or for which targets are missed, is likely to become more onerous.
At the end of June, the Financial Conduct Authority (FCA) announced its intention to apply greater scrutiny to how issuers market green bonds, social bonds and sustainable bonds, to ensure the frameworks around them are matched in reality.
Richard Butters, senior ESG analyst at Aviva Investors, says: “They [the FCA] have found instances where sustainability frameworks used in bond marketing documentation do not reconcile with bond prospectuses, which could mislead investors. We’re supportive of this announcement – it’s crucial for issuers to be held accountable to ensure investors and their clients’ money deliver the sustainability goals they are expected to achieve.”
While the FCA announcement did not mention SLLs, few doubt the intention of the regulator is to keep a close eye on the credentials of green finance, and that this scrutiny is only likely to grow.
More than just ‘green’
SLLs have not only grown rapidly in their first three years of existence, but they are also evolving. The issues of environment and climate change have so far dominated the ESG agenda, but the S (social) and the G (governance) are increasingly part of the mix. This, in turn, means SLLs too are developing from being just about ‘green’ to reflecting responsible investing in a far wider sense.
“It’s been positive to see the social and the governance issues now coming into the majority of KPIs [key performance indicators],” says Bradley. “We often talk about a just transition, which reflects the fact that climate change on its own doesn’t just deliver environmental impacts. There is also a social cost attached to climate change. So, you need to look across the board at a holistic ESG strategy and financing structure.”
This development also means new metrics. Climate change as an issue is highly amenable to scientific measurement. The various emission types – Scopes 1,2 and 3 – and the existence of the Science-Based Targets Initiative (SBTi) mean climate targets on reducing greenhouse gas emissions across a business can be measured. The social and governance agenda is less well advanced in defining such clear metrics suitable for use as a KPI. Diversity can be measured, but concepts such as transparency, anti-harassment and anti-discrimination initiatives are less amenable to a numerical score.
The need for a broad and integrated view of sustainability is echoed by Aviva’s Butters. “The market is fairly well established, continues to grow, but still provides opportunity for improvement. To reduce risks of greenwashing, we believe investors need to assess the overall ESG profile and strategy of an issuer. We can achieve more by focusing on what strategically matters across a firm, rather than focusing on individual securities.”
Borrowers, and lenders, looking for a tick in the sustainable finance box will increasingly need ‘holistic’ sustainability strategies if the full range of E, S and G are to be included in SLLs and other green financing structures.
Is a label required at all?
There is another approach to green (or sustainable) finance which is less concerned with the formal labels and even with explicit upfront financial incentives.
Vincent Noble, head of asset-based lending at Federated Hermes, agrees the labels are potentially useful but far from essential. Indeed, Noble has not made any SLL loans.
“For a house that is known as a responsible investor, that might surprise people,” says Noble, “but I would argue that once you look at the way we engage with our borrowers on what they should do, the practical difference between the impact of our loans and of those that are labelled as green is basically none.”
For Noble, the fact that net zero is a necessary target makes the question of whether a loan is formally green or almost not irrelevant, particularly in his field of real estate where ensuring new developments are green and retrofitting existing assets is just one of the basics.
“There are certain requirements there, and the implication that in return for those requirements you get a margin discount, we don’t feel is an appropriate vehicle,” says Noble.
It sounds harsh, but Noble’s contention is that the incentives for real estate assets to be turned green is built in. The financial upside of investing in sustainability improvements is a natural part of the investment process. Energy-efficient buildings are more valuable, and they will command a higher rent – there is no need to gild the lily with a margin cut.
There is no sign of the growth in SLLs declining, but the trend is towards an evolution in which social responsibility and governance issues are also part of the equation. Inevitably, as more fund finance becomes green, the question will not be whether finance can be secured at a beneficial rate but whether finance not underpinned by sustainability will be available at all.
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