ESG linked-financings and investments - addressing environmental and social challenges

This article provides an overview of the current relevance of sustainability considerations for banks and investors, the types and structural elements of sustainable lending products, such as green and sustainability-linked financings, and the associated challenges.[1]  

Since the report "Our Common Future"[2] by the Brundtland Commission of the United Nations in 1987, sustainability considerations have become increasingly important in the global corporate world. This is a consequence of legislation and recognition that social and environmental criteria should be regarded as an important component when making business decisions.

In recent years, sustainability considerations have become even more significant due to requests and expectations from investors, initiatives and responses from the financial sector as well as increasing focus and demands from public interest. Investors, including private equity funds, are giving more attention to environmental, social and governance (ESG) standards in their investment strategies and decisions. Studies, such as the Private Equity Responsible Investment Survey 2019 by PwC, are evidence of this process. The financial sector has developed and supported their customers and clients by arranging sustainable lending products beyond the traditional green financings. The Italian energy company ENEL, for example, recently issued the first bond linked to the UN Sustainable Development Goals. A recent German market example is the engineering firm Dürr AG, which entered into the first sustainability-linked Schuldschein issue. This trend of focusing on ESG standards reflects the general public interest in investments, products and services which comply with ethical standards.

All of these developments are to be welcomed and it is important that the corporate sector addresses the global environmental and social challenges of our time, which are predominantly caused by human behaviour, being on the one hand, the steady increase of greenhouse gases and the correlating increase of temperatures, and on the other hand, social inequality. 

ESG-linked financings and investments 

The core concept of sustainability-linked financings is not new. The principle that the value of a financial investment should not only be measured by its financial return but by the investment’s environmental or social impact (or both) on the world is at the core of impact investors and impact financings. Applying the concept that corporate success should not only be measured by the immediate financial return which a business generates but also by its ESG impact, even if a business is not directly active in any industry closely-related to environmental or social change, is a relatively new development for general corporate purpose financings.

Green financing

Sustainability-linked financing is closely related to green financings. Green financing originated in the bond market with the so-called “green bond”. The first green bond was issued in 2007 by the European Investment Bank. In comparison to the overall global securities market, which according to the Securities Industry and Financial Markets Association has a volume of approximately USD 100 trillion, the green bond market remains relatively small. However, the green bond market has exponentially grown over recent years. The International Capital Markets Association (ICMA) forecasts that the total size of bonds labelled as green bonds will be around USD 180 billion in 2019, an increase of 8% in comparison to 2018.

As a consequence of the rapid growth of the green bond market and in order to provide guidance to issuers and investors, ICMA published the “Green Bond Principles" in 2014.[3] The Green Bond Principles establish voluntary process guidelines for market participants for the issuing of green bonds.

In the Green Bond Principles ICMA currently distinguishes between four categories of green bonds which differ on the rights of the investors to take recourse and the green element. The four categories referred to in the Green Bond Principles are set out below:

In order to call a bond a green bond in accordance with the ICMA rules, issuers have to comply with four components:

1. Use of proceeds: The use of the proceeds should be limited to certain projects which qualify as green projects. ICMA defines green projects as projects which “provide for a clear environmental benefit”, such as projects related to renewable energy, energy efficiency or pollution prevention and control.
2. Project evaluation and selection: The environmental objectives should be defined in the documentation and clearly set out. The bond can be issued to either finance specific projects or a specific type of project as long as it is clear to the investors for which project or type of project the bond proceeds are used for.
3. Management of proceeds: The proceeds should be tracked, either by crediting the proceeds to a specific account, or otherwise earmarking them. The management of proceeds should be set up in a transparent way, which makes it possible to track the funds’ allocation.
4. Reporting: The issuer should have in place a reporting system which enables investors to control and understand how the bond proceeds have been allocated. The reporting should, in addition, also include reporting on qualitative and quantitative performance measures, to the extent feasible. 

While the opportunity to enter into green financings was first limited to the bond market, this is no longer the case. As a response to the growing market of green loans, the Loan Market Association, together with the Asia Pacific Loan Market Association (APLMA) and the Loan Syndication and Trading Association (LSTA), published in 2019 similar guidance for the loan markets entitled “Green Loan Principles”. The Green Loan Principles have been developed to replicate the Green Bond Principles for the loan market. This is to ensure consistency across both the bond market and the loan market. 

Green financings have become an established financial instrument. In the German debt market green financings can take the form of bonds, loans or the German Schuldschein loan. The first Schuldschein marketed as a green finance instrument were placed in 2016, namely the EUR 550 million Schuldschein issued by the German wind turbine manufacturer Nordex and the EUR 500 million Schuldschein issued by the Dutch power grid operator TenneT. Both issuers are active in the renewable energy market. Green projects are at the heart of their respective businesses and it was therefore not difficult for both companies to access green funding.

The restriction of green financings to green projects and the focus on projects and companies, which provide an environmental benefit, make it difficult for companies which do not have green projects to access this funding market. At the same time, ESG goes beyond green projects. This is where sustainability-linked or ESG-linked financings come in to close the access gap in the market.

Sustainability-linked financing

The purpose of sustainability-linked financings is not limited to projects that benefit the environment but where funds are made available for general corporate purposes. The link to sustainability objectives is commonly made by the terms of the loan agreement, which includes provisions to improve the borrower’s overall sustainability profile.

The guidance for sustainability-linked loans is relatively new. In 2019 the LMA, AMPLA and LSTA published the “Sustainability Linked Loan Principles”. The Sustainability Linked Loan Principles are voluntary guidelines. Similar to the Green Loan Principles and the Green Bond Principles, there are four components which must be adhered to when structuring a sustainability-linked loan:

1. Sustainable objectives: The terms of the loan agreement should reflect the borrower’s sustainability objectives as set out in its corporate social responsibility strategy, policy or processes. This requires that the financing is tied to specific objectives or the overall corporate social responsibility strategy of the borrower. There are many sustainability objectives. The “Sustainable Development Goals” (SDG) of the United Nations contained in the 2030 United Nations Agenda split the sustainability goals into 17 different categories. These include, for example, transforming the world into one with no poverty and where people have access to quality education. The 17 SDGs are shown in the graphic below:

1. Target Setting and measuring: The facility agreement should include targets for the borrower to pursue and which result in the improvement of its sustainability profile. This requires that mechanisms are in place to measure the borrower’s actual sustainability profile and its development.
2. Reporting: There should be a reporting element to facilitate transparency. The reporting must be made available to the finance provider and, preferably, also disclosed to the general public. 
3. Review: The reported information should be reviewed, either internally by the borrower itself (provided the borrower has the necessary resources and expertise) or by an external auditor. Desirable is an independent external review by a qualified external expert or independent rating agency.  

Sustainability-linked loans are not only related to green loans and green bonds but also to blue bonds, social bonds and sustainability bonds. Bonds qualify as blue blonds if the proceeds are used to finance marine and ocean-based projects which support the ocean economy and that have a positive environmental effect. The first sovereign blue bond was issued by the Seychelles with support of the World Bank in 2018.

ICMA also published guidelines on the process for issuing social bonds and sustainability bonds in June 2018. The guidelines follow the structure for green bonds with the difference being that proceeds of social bonds are used to finance social projects. Social projects are projects to promote affordable basis infrastructure, such as access to clean drinking water, food security or access to essential services, such as education. Sustainability bonds are bonds with the purpose of financing projects with a beneficial social and environmental effect. 

Structural elements of sustainable finance

The documents published by ICMA, LMA, APLMA and LSTA provide guidance to the market participants and there are certain provisions which are regularly used in the documentation of sustainable financings:

1. Purpose: As in any other credit facility agreement, sustainable financings have a purpose clause. In green financings, this purpose is related to specific projects or types of projects, which have a beneficial effect on the environment. The purpose of a sustainability-linked financing is commonly to provide funding for general corporate purposes. The sustainability components are included by way of the terms of the credit facility agreement.
2. Margin Ratchet: One feature of a sustainable finance transaction is usually, but not always, a margin ratchet which incentivises the borrower to pursue and implement the sustainability objectives that the borrower committed to. If the borrower over-achieves its sustainability goals, then this corresponds to a lower margin, lowering the financing costs of the borrower. If the borrower is not able to achieve its sustainability goals, the borrower is penalised by a higher margin and higher funding costs. 
3. Review and reporting requirements: The review and reporting requirements depend on the level of agreement between the commercial parties. In the case of a margin ratchet, a reliable review and reporting mechanism is a necessity and should not simply be structured as a self-certification by the borrower.
4. Representations and undertakings: Sustainable financings usually come with specific representations and undertakings which relate to the financed project or other aims agreed between the borrowers and lenders. To what extent the representations and undertakings are hard- or soft-covenants is subject to negotiations and commercial agreement. Most borrower-friendly is, however, if the covenant package constitutes soft covenants only. The strictest approach is to qualify the sustainability covenants as any other covenants, which provide the lenders in the case of a breach and subject to the terms of the credit facility agreement, with the right to a draw stop regarding new funds and the right to accelerate outstanding loans.  

Comment

The focus on sustainable lending has increased and this will only intensify in the future. Banks will expand their range of sustainable lending products. Moreover, banks have the opportunity to show that they can play a vital role in driving a change to more sustainable values in business activities. The banking sector seems to be willing to take this opportunity. In September 2019, during the annual United Nations General Assembly, 130 banks from 49 countries signed-up to the Principles of Responsible Banking (PRB). The Principles for Responsible Banking have been developed by banks in connection with the United Nations Environment Programme - Finance Initiative (UNEP FI) and provide a frame of reference for banks to better align business strategies with the 17 SDGs. According to the PRB, banks in particular commit to analyse the impact of their own business activities on society, the environment and the economy but also encourage their customer and clients to do the same. Living up to this standard could result in the banking sector becoming an important and relevant vehicle in the transformation to more sustainable business activities. 

Investors are also further extending their activities in sustainable investments, thereby requesting from business leaders, who want to attract capital investments, to do the same. This equally applies to private equity investors for which the sustainability approach is not at all new. In 2005, a group of international institutional investors together with UNEP FI launched the Principles for Responsible Investment (PRI). Signatories to the PRI commit to consider ESG related issues in connection with analysing investments and the investment decision making process, thereby becoming an advocate for ESG excellence in the name of their clients. Institutional investors, such as BlackRock in their 2018 report "Sustainable investing: a "why not" moment", find that risk-adjusted return and ESG are not mutually exclusive. This recognition will create further pressure on businesses to factor in their ESG impact when developing their overall strategies and, in particular, their strategies for obtaining financings and investments. Legislative initiatives, such as the proposal by the EU for a detailed taxonomy of sustainable activities, can increase the pressure as it provides further guidance for investors to categorise ESG impact of business activities. This will help investors ask the relevant questions and companies to analyse their economic activities in light of sustainability requirements. 

However, in order to accelerate the development of sustainability-linked financings and sustainable investments, meaningful data must be available. The corporate sector must continue in its efforts to collect data to measure the ESG impact of its business activities and to disclose ESG related data, which is then assessed and rated in a similar way to which financial information is currently assessed and rated. Legislative efforts, such as the non-financial reporting directive (Directive 2014/95/EU) for which the EU Commission published in 2019 non-binding guidelines on reporting climate-related information, will promote the collection and disclosure of relevant data. In the end, it is likely that market forces will not be sufficient to drive companies to collect and publish ESG related data so that further legislative effort is required. The push for a greater harmonisation of reporting standards, such as the initiative of the Global Reporting Initiative and the Sustainability Accounting Standards Board, is a further step in the right direction. However, as with the development of the acknowledged financial metrics to assess financial performance, the harmonisation of ESG metrics will take time.

In the end civil society - customers, consumers and business decision makers - can play a pivotal role and affect the timing of all these developments. The intensity of their requests for more sustainable business activities and their decisions in favour of more sustainable products and services will decide whether there will be a transformation of business to sustainability-linked activities and from thereon, maybe even to sustainability-led activities. 

[1] The research, views and opinions in this article are solely the author's own and do not purport to reflect the views and opinions of his employer.

[2] All links were last accessed on 6 October 2019.

[3] The current version of the Green Bond Principles is dated June 2018.