Trends in ESG loans

Lenders are increasingly interested in loans that have a positive environmental, social and corporate governance (ESG) impact.

Regulatory requirements (particularly those being proposed by the European Union) and pressure from equity investors have made the funding of socially positive investments a key strategic imperative for bank lenders going forward. Non-bank lenders are also motivated by a shift in institutional investors’ thinking on ESG issues from avoiding a prescribed set of harmful industries, such as fossil fuels, to actively seeking out a broader range of borrowers that are contributing to a sustainable, progressive or green economy. Borrowers can take advantage of this increased demand to reach additional sources of debt capital, lower their borrowing costs and enhance their broader corporate and public reputation.

The evolution of green loans

The loan market’s first ESG product was the “green loan”, a loan in which the permitted use of proceeds is limited to funding environmentally positive projects or initiatives (read “Green bonds and beyond: sustainable finance in the capital markets” for a broad survey of sustainable financing trends). An example is the loan to finance the construction of the Tapestry at Victoria Harbour, an energy efficient residential development in British Columbia. While the scope of acceptable green projects is broad, including corporate initiatives to increase energy efficiency or reduce waste as well as more prototypical renewable energy project financings, the focus of green loans is limited to environmental sustainability issues, a subset of the broader ESG universe.

Over the last few years, much of the loan market’s ESG focus has shifted to sustainability linked loans (SLL). SLLs are loans for general corporate purposes so proceeds are not limited to funding green projects or initiatives. Instead, the loans periodically track specified sustainability-based key performance indicators (KPIs) and measure them against pre-negotiated targets and reward (or punish) borrowers for their progress with interest rate adjustments. This approach fits into the basic architecture for interest rate step-downs and step-ups that track financial-based adjustments (such as those based on leverage) that have long been prevalent in the loan market. Supplementing financial metrics with ESG-based KPIs in setting margins (a proxy for the lenders’ perceived risk of repayment) demonstrates that lenders are placing a value on borrower’s social as well as financial performance. Globally, SLL volume was estimated to be $143 billion in 2019, a large increase from $49 billion in 2018 and $5 billion in 2017, when the products first entered the market¹.

The latest development in the loan markets has been the broadening of KPIs to include social and governance goals beyond environmental ones—adding the “SG” to the leading “E”.

The specific KPIs of an SLL should be unique to each borrower, as the intent is to create incentives to address issues that are material to a borrower’s specific business, industry and circumstance. For example, Brookfield Renewable Partners’ January 2020 SLL tracks the company’s production capacity of renewable and clean electricity as well as the reduction of carbon dioxide emissions. Target levels for pricing reduction are generally based on the borrower’s recent actual results for the relevant KPI with negotiated levels of improvement. Most SLLs have had relatively short terms (generally one to three years), which has fostered the development of tangible, near-term KPI targets. While there are no market standards for developing or monitoring KPIs as of yet, lenders generally require third-party verification of KPIs on closing and target testing dates, particularly for private companies lacking relevant public disclosure.

While the magnitude of pricing reductions has varied from deal to deal, potential reductions have generally been meaningful to date. The development of SLLs greatly broadened the scope of potential borrowers from green loans—while only a limited number of corporate borrowers have significant green capital projects to finance, every corporate borrower has areas of its businesses where it can reduce its environmental impact. Given the broader scope of potential borrowers, it’s no surprise that the volume of SLLs has grown to far exceed that of green loans².

Expanding scope

The latest development in the loan markets has been the broadening of KPIs to include social and governance goals beyond environmental ones—adding the “SG” to the leading “E”. Examples include injury incidence rate (Ontario Power Generation Inc.), higher share of management positions held by women (WSP Global Inc., a leading Canadian engineering and design services firm), Indigenous cultural awareness and mental health and first-aid training (Downer EDI, an Australian engineering firm), and percentage of equity holdings meeting a broad set of ESG goals (Neuberger Berman, a U.S. asset manager). Some of these precedents include a mix of environmental and social KPIs. These loans suggest that the basic framework of SLLs can be replicated to address an unlimited scope of ESG issues as long as they can be tracked as numerical KPIs.

Lenders are also increasingly focused on ESG issues even in connection with loans that do not have KPI-linked structures. ESG matters have become a focus of due diligence, for example. Accordingly, the distinction between ESG and non-ESG loans is eroding, and, increasingly, lenders are viewing ESG matters as a key element of corporate performance. In that sense, all corporate loans will be ESG loans in the near future.

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¹ Available here.

² Available here.