Between 2018 and 2020, we saw sustainable and green loan volumes increase from US$70 billion (£50bn €58bn) to US$230 billion (£165bn €193bn) – an increase of over 200%. As the prevalence of ESG-linked debt grows, the details of how sustainability is woven into the financing arrangements and covenants also needs to be clarified.

In the first four months of this year alone, there has been a larger volume of sustainable loan volumes than in the entire year of 2018.

Erica Abisso, senior corporate banker at Intesa Sanpaolo, says: “It is a very strong increasing trend in loan volumes. If we look at the first four months of this year, in terms of EMEA around US$90 billion (£64bn €75bn) has already been spent. It is a global shift.”

As a sector at the forefront of ESG, infrastructure and energy are among the early industries to be toying around with sustainability-linked debt arrangements.

“Infrastructure has had an ESG flavour since the beginning, even before ESG was invented as a concept. Infrastructure is there to support the community and society, so by definition it has an S component,” says Jérôme Neyroud, head of infrastructure debt at Schroders.

Both pull and push factors have a part to play in the upward trajectory of ESG covenants. Investors want the reputational benefit of ESG – as well as the pricing flexibility – while lenders can also make loans conditional on firm-wide investment, such as a moratorium on coal-fired power plants.

“The old rule was that pricing depends on the risk. The new concept is that a company doing harm to the environment is not a good credit because it is not a good risk. Borrowers should be rewarded for good ESG trajectories as well,” says Neyroud.

“The way we finance infrastructure is evolving as society is evolving. This is a long journey.”

Target setting

Lenders are being pushed to set clear and achievable ESG targets for borrowers, primarily to paint a clearer picture of what the expectations and best practices are.

“The market is in an early stage so we have not had enough years to see what the impact is or will be. The expectation is that a large part of the targets should be achieved,” says Luca Matrone managing director at Intesa Sanpaolo.

This perspective is echoed by Abisso, who adds: “This is especially true on the bond markets as the mechanism sees a step-up if a target is not achieved but not a step down in case of target achieved, because the general expectation is that targets are achieved.”

The targets, of course, are downstream of available data, and are set from an understanding of a borrower’s capabilities.

Lucy Jenkins, finance partner at Vinson & Elkins, notes: “Data enables realistic but ambitious targets to be set. Access to and engagement with management, something which is not a given in a debt arrangement, is key to a lender being able to assist its client in the right direction, as well as monitor its likelihood of reaching the targets. Standardisation of practices and processes enables more market participants to engage meaningfully with the relevant products.”

Determining KPIs

Gathering data and getting data certified are the two of the main challenges involved in determining the metrics by which pricing moves on a green loan.

“KPIs need to be married with a considered measurement program – the value in targets is limited without the ability to measure, assess and enforce them. This is another area where further clarity and transparency may be anticipated going forward, given verification is currently not always straightforward,” notes Jenkins.

For banks, the main concern is identifying the most appropriate KPI and setting appropriate targets due to the asymmetry of information between lenders and companies. Data is not entirely comparable even within the same industry.

“Everybody is testing the water and trying to find the right KPI, but they are different for each business. It is difficult to find a common metric at the moment. We have long conversations about what is the right level for KPIs. You cannot have one size fits all for infra because what fits renewables will be different to hospitals so it will remain a diverse crowd,” says Neyroud.

External tools are also available to help, in this respect. Abisso notes the importance of the Sustainability Accounting Standards Board (SASB) materiality map, which shows which dimensions are most likely to materialise in each sector. The materiality map identifies sustainability issues which could impact a company’s performance.

Pricing impact

While increasingly widespread, the phenomenon is still quite new, and the pricing does not yet display a massive difference depending on compliance.

Jenkins notes: “The impact on pricing is not yet significant – margins may move up or down, or both, as a consequence of compliance or failure to comply, but for the most part that movement is in single or low double digits basis points per annum.

Pricing range varies depending on a company’s ESG performance. A strong performance can result in a tightening of pricing and a weak performance can result in a price widening of around 20-40bps. For companies that are typically aligned with ESG criteria, lenders could offer, for example, a range between 150-175bps whereas a less ESG-aligned borrower could be offered 225-250bps.

Therefore, enhanced pricing is not necessarily a pull factor for borrowers at this point.

However, for small- and medium-sized companies, the initial pull factor could be related to margin discounts. The expectation is that this could change as new regulatory framework are enforced.

Regulation

In addition to pressure from the public and LPs, regulation is a significant factor in the implementation of ESG principles. In the EU, new regulation is being introduced this year with the EU taxonomy and the Sustainable Finance Disclosure Regulation (SFDR).

By identifying the degree to which economic activities are environmentally sustainable, the EU taxonomy is a tool for investors looking to put money behind green investments, giving them a “mark” on their ESG and financial performance. Naturally, more money is directed to green taxonomy-compliant initiatives.

As a result of this regulation, all management companies are required to revise remuneration policy to explain how it is consistent with the integration of sustainability risks.

This reflects arguments that are in favour of margins being linked to ESG performance such as reduced coupons for investments that are made in the renewable energy sector.

“One has now to put his money where his ESG mouth is. It is no longer possible to greenwash,” adds Neyroud.

As the reach of legislation expands, private and smaller companies will be required to share information in the future, as larger companies already tend to be required to.

For this reason, Jenkins notes, GPs need to be aware of what their portfolio companies get up to and ensure they are travelling in the right direction to continue getting LP support.

Challenges to overcome

Issues surrounding the integrity of data, requirements clarity, verification of compliance and ESG due diligence in time-sensitive processes such as competitive bids continue to pose challenges. The standardisation of the market will allow a better assessment of climate risk relating to investments and financings.

“The loan market association guideline for sustainability-linked loans introduced the possibility to consider inaccurate reporting (or the failure to deliver information) on the borrower’s sustainability performance targets (SPTs) a breach and may, in some cases, give rise to an event of default. We expect that the impact will be even higher in the future,” says Abisso.

The time-consuming nature of due diligence involved in ESG scores is also viewed as a hurdle in getting ESG-linked debt in place.

According to Jenkins, holding businesses to account is easier for equity holders as they have rights to information and can query actions the company is taking and impose a requirement to remedy inaction or incorrect action taken by the company. However, debt holders find it challenging to implement and monitor ESG-linked debt as they have less visibility and a limited ability to impose direction on a business.