Use of proceeds loans and sustainability-linked loans (SLLs) are the two most common types of loan instruments available to companies to finance their sustainability goals.
Use of proceeds loans provide financing for individual ‘green’ and/or ‘social’ projects while SLLs encourage borrowers to foster sustainability. Currently, SLLs tend to be the more favoured instrument as the proceeds of SLLs may be used to finance any kind of business activities that the borrower is pursuing. The principles of sustainability-linked bonds (SLBs) follow the same principles as the SLLs but SLLs are the focal point in the following.
The economic outcome of SLLs is linked to whether certain pre-defined and externally verified ESG objectives are met. These objectives are evaluated using predetermined KPIs and are measured against predetermined Sustainability Performance Targets (SPTs).
When using SLLs, it should be an ambition to create ambitious ESG targets, e.g. KPIs on CO2 emissions and energy efficiency. Fundamentally, the loan is linked to interest rate adjustment, whereby the interest rate on the loan is subject to adjustment, with a higher interest rate applied if the borrower does not meet the specified SPTs in the manner set forth in the agreement. There are numerous variations of this as well as specific adaptations made to the particular industry of the borrower.
To be classified as a SLL the loan should comply with the SLL principles. Firstly, the selection of KPIs must be relevant to the borrower's business now and to its future operations, the KPIs must be measurable and measured on a consistent basis and should be able to be benchmarked against an industry standard or similar.
Furthermore, annual SPTs for each KPI should be established every year of the loan term. The SPTs should most importantly show a material improvement and thus indicate a substantial enhancement in the individual KPIs, surpassing both the expected "business as usual" progression and the regulatory targets. The borrowers should on an ongoing basis provide the lenders with sufficient information to enable the lenders to monitor the results of the borrower's SPTs and should seek independent, external verification.
As the SLL market matures and comprehensive data becomes available, it is now possible to evaluate borrowers' ability to achieve their SPTs in different industries. Some sectors such as the energy and utilities sector have been impacted by changing market conditions and macroeconomic factors, which may increase the difficulty for borrowers within these industries to meet their targets.
Finally, loan agreements often include ESG reporting obligations of the borrowers that are intended to enable banks and financial institutions to comply with the lenders' own ESG reporting obligations. Initiatives have been taken in some industries to develop a set of standard covenants such as the Poseidon Principles that are used in the shipping industry.