Making specialty finance even more special or at least greener

Introduction

In recent years, green and environmental, social or governance ("ESG") financing (also known as sustainability linked lending) has been increasingly popular across a wide range of asset classes, and the entrepreneurial and innovative market that is speciality finance is no exception. This market boasts a number of lenders keen to be at the forefront of driving green and ESG change through financing products – it is after all becoming ever more clear that financial stability is intrinsically tied to sustainability and ESG risks.

Elements of an ESG or Green Financing

Green or use of proceeds financing

While much of the focus on ESG lending is on 'ESG' lending, we should not discount green lending as also having a role to play.  Green loans are loans made for a specific green purpose which do not necessarily have pricing mechanics attached to them but rather a specific (usually green) commitment to make investments meeting this green purpose.

While being lent for a specific purpose has the potential to make them less flexible than their sister the ESG loan, such loans can be utilised to invest in 'Green' strategies, for example, the financing of electric cars.

ESG Financing

ESG sustainability linked lending is the provision of (usually) a revolving credit facility which includes certain ESG related key performance indicators ("KPIs"), achievement of which links to a pricing toggle.  In a nutshell, ESG or sustainability linked lending is like any other loan to a speciality finance business, except with an additional layer of reporting (whether by a third party verifier, auditor or the business itself) on specific ESG/sustainability KPIs developed in respect of that business.  This expands the universe of borrowers and industries that can access the sustainable finance market by enabling financers that do not have an eligible project to still incorporate ESG considerations into their financing.

As ESG finance becomes increasingly popular, we have no doubt that market norms will emerge but at this stage no substantive market norms as regards documentation and practices have been established although some trends are beginning to come to light.

1.  Margin Adjustment

A margin discount goes hand in hand with ESG or sustainability linked finance (unlike green loans/finance which does not necessarily offer a pricing adjustment) but consideration will need to be given as to what the appropriate level is to which this discount should be applied.

Generally the market appears to have started from a position where a simple discount is applied when the relevant business hits the requisite KPI and the discount is then disapplied when the relevant KPI is not met.  However as the market becomes more sophisticated, the spread for the margin incentive linked to KPIs becomes wider.  In particular an upwards and downwards margin ratchet linked to KPIs is now trending in certain markets - this means that if the KPI is met, then there is a downwards movement and if the KPI is not met then the margin goes up.

Thought should be given to what the business will be encouraged to do (if anything) with any discount achieved.  We have increasingly seen examples in some markets of borrowers agreeing to donate any discounts achieved to environmental charities or to demonstrate that such savings are applied to ESG purposes and would expect this to also become a feature of speciality finance ESG or sustainability linked financings.

2. Key Performance Indicators

KPIs are at the heart of an ESG financing and the KPIs for each financing in the speciality finance market will be unique and accordingly will need to be discussed and considered in context.  While discussions regarding ESG finance often focus on the environmental gains to be made, consideration should also be given to the social and governance aspects – are there, for example, gender, diversity or governance improvements that could also be measured?

Regardless of what they relate to, we expect the KPIs to take into account considerations such as:

• the term of the loan – the longer the term of the loan, the more consideration should be given to the suitability of the KPIs towards the end of the loan.  Should the KPIs be incremental, increasing year on year?   Or is a mechanism required to revisit the KPIs periodically to reassess their suitability?
• number and nature of KPIs – where there are numerous or complex KPIs, thought should be given to whether these are likely to be better monitored by third parties with appropriate knowledge of the complexities of said KPIs.  Consideration should also be given to the administrative burden (for both the borrower and lender) resulting from including numerous KPIs and if quality should be preferred over quantity.
• what is being measured – is it just the loan book/portfolio that should be tracked against KPIs, or are there other business level metrics that should be considered, whether environmental, social or governance related (e.g. a recycling target, reduction in energy use, moving away from single-use plastics or diversity KPIs)?
• what are the consequences of non-compliance with that KPI – while the obvious answer here is some upwards adjustment to the margin, query if that should be the only consequence.  Should some KPI's be hurdles / ones that have to be achieved before any other discount flowing from KPI achievement can be unlocked?  Could KPIs be included that are not linked to margin adjustments but rather aimed at reputational motivation?  This will likely require public disclosure of the relevant KPIs but to the extent business are simultaneously making public commitments to ESG goals, such business are being increasingly held to account by stakeholders in any event.

What's next?

Whilst the market for ESG loans is still in its infancy, our view is that ESG loans will become a core feature. The next 12 months may well bring us a renewed focus on social and governance elements of ESG but we also expect that the environmental focus will remain strong as the speciality finance embraces and adopts ESG financing into its core.