For businesses, "sustainability" and "corporate citizenship" have been key buzzwords for the last couple of years. Environmental, social and governance aspects of business have gained attention not only from regulators and the general public, but also from shareholders and other stakeholders. This requires action. Sustainable debt instruments are among the tools that companies can use in their transition to a climate-neutral and fair business, while at the same time benefitting from lower financing costs. In addition, many investors (including private equity and debt funds) and other stakeholders factor ESG into their investment decisions.

As a result, it is becoming more and more mainstream to incorporate ESG factors into debt capital markets. For a borrower to obtain the maximum benefit of sustainable financing – in terms of financing costs and of accelerating its broader sustainability strategy – a number of key items should be considered.

Sustainable financing instruments

Over the past decade, multiple types of labelled financial products have been developed. For sustainable financing, a distinction can be made between "green instruments" such as green bonds – the proceeds of which must typically be used for predetermined, eligible projects – and "sustainability-linked instruments". In this article, we mainly focus on the latter.

Sustainability-linked instruments (bonds and loans) involve the setting of "sustainability performance targets" (SPTs) for the borrower. Achieving SPTs is usually linked to a certain reward or penalty, depending on whether the target is met or not. For sustainability-linked bonds, the reward can be a step-down in coupon payment. Conversely, the penalty for not meeting the target is a step-up in coupon payment, meaning an increase in the bond interest. For sustainability-linked loans, the reward and penalty generally consist of a margin reduction and margin increase. These are the most common examples of incentives that can be set to reach the predefined SPTs (for more examples, see further below).

Growing market

The market for sustainability-linked loans has grown significantly over the last couple of years. Sustainability-linked loans first emerged in the market in 2017, with five billion euro issued that year. In 2018, this figure grew to EUR 47 billion. In 2020, issuance went up to EUR 120 billion, an increase of over 250% compared to 2018.

This sudden surge in interest in sustainability-linked loans can be explained by how relatively easy there are to use (setting the SPTs), and their economic benefit. They are suitable for borrowers looking to build incentives for the achievement of sustainability targets into their financing documentation, but who do not intend to use the loan proceeds for a particular green or sustainable project. Moreover, they are equally suitable for revolving credit facilities as term loans. Sustainability-linked finance no longer only exists in the realm of the investment grade market; private market investors and PE investors in the high-yield sector are now increasingly integrating ESG standards in their portfolios as well. For example, 13 high-yield issuers issued sustainability-linked loans in Europe in 2021, compared to only two in 2020.

Sustainability-linked bonds are less popular, however. Since their first appearance in 2019, they have been issued only on a limited scale, with a relatively low issuance volume (EUR 11 billion in 2020) compared to sustainability-linked loans. Due to minimum size considerations and extensive prospectus requirements for bond issues, sustainability-linked bonds are less viable for medium and smaller-sized companies when compared to sustainability-linked loans.

Although there is no market standard for these types of products yet, several trade associations have developed ESG guidelines or principles, for the bond as well as the loan sector.

Key considerations for borrowers

Borrowers should consider three important elements when structuring sustainability-linked instruments:

Defining ESG Targets

The focus on the borrower's achievement of SPTs is one of the key features of sustainability-linked instruments. According to the LMA Sustainability-Linked Loan Principles, the sustainability performance targets should be "ambitious" and "meaningful" to the borrower’s business. Targets can be linked to traditional environmental targets, as well as to non-environmental targets (ESG targets). The borrower can set its own targets, tailor-made and appropriate to its own business operations. Examples are:

• E: carbon footprint, energy consumption, water consumption
• S: labour conditions, human rights, food waste
• G: male/female employees, staff shareholdings, gender pay gap, diversity in the workplace

It is also possible to measure sustainability-performance to a certain sustainability rating given by an external reviewer. The sustainability performance targets can be measured by Key Performance Indicators (KPIs).

As the setting of KPIs is still not standardised, issues on measuring performance could arise. Furthermore, setting long-term goals could also be challenging. It is important for companies to remain aware of a changing business environment, and fast adaptation may be required. Companies are subject to external influences (changing market, Covid-19), as well as mergers, disposals and acquisitions that were unforeseeable when the relevant agreement was entered into. The debt instrument's documentation should ideally cater for dealing with such circumstances. These challenges may partly be overcome by flexible (annual) target setting, with opt-out possibilities for borrowers.

Consideration may also be given to the EU taxonomy framework, which classifies green investments. Borrowers may wish to align their targets to this framework, so that the sustainability-linked instrument serves to improve a company's overall sustainability strategy and taxonomy alignment. Moreover, if debt instruments are taxonomy-aligned, this may attract a wider pool of investors interested in sustainable investments.

Consequences of reaching or missing targets

Another key element of sustainability-linked instruments are the consequences and incentives included in the instrument's documentation when targets are not met. Borrowers should consider whether a breach of the relevant provision relating to sustainability and ESG policies should constitute an event of default or that it, for example, only impacts pricing or further use of the facility. Typically, the achievement of targets only has margin grid consequences (up and down). This provides some leeway for borrowers in setting ambitious targets. Margin grid consequences are the most common type of "skin in the game" for borrowers, but other changes to the instrument's characteristics that have a meaningful impact on financing costs, may be used as well. Other examples include changes in maturity, the repayment amount, interest payment dates and the redemption date.

The borrower may choose to invest an equivalent amount of this cost benefit in charitable donations or in its own sustainability objectives. This can add even more to the company's overall reputation on sustainability.

Reporting and verification

To date, there is no globally accepted methodology for reporting on sustainability performance targets. The methodology will be determined according to the chosen targets and the nature of the relevant borrower. Borrowers should maintain up-to-date records on their sustainability performance targets and provide these to the lenders at least once a year. Public reporting is encouraged to facilitate transparency. Borrowers may also decide to incorporate sustainability reporting and monitoring into management reports.

For publicly traded companies, lenders may be comfortable relying on the borrower’s public disclosures to verify performance on sustainability targets. Otherwise, borrowers may have to seek external review of the borrower's performance, which obviously adds costs and an increased burden on the borrower's audit department.

What next

Incorporating sustainability in financing decisions has become increasingly mainstream. It can be a tool for borrowers to attract a wider pool of financiers who are interested in sustainable or ESG investment opportunities.

Sustainability-linked instruments are especially beneficial to borrowers, as they likely improve the company's overall sustainability strategy, and because it may be economically beneficial due to the reduced debt servicing costs. Moreover, companies that already have a robust sustainability strategy in place may use this opportunity to reduce interest margins. The flexibility of the sustainability-linked instrument creates many opportunities for lenders and borrowers to build sustainable and green financing principles into a variety of financing transactions. The use of these types of instruments is expected to become more popular in the years to come.