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In our June issue of REF News & Viewswe further explored the burgeoning field of sustainability-linked lending (“SLL”) by introducing and describing the principles of sustainability-linked lending (“SLLP”) and the basic components of SLLP (“Components of base”).
As a reminder, the SLLPs were published to provide a framework of principles to help market participants understand and identify the key elements in establishing sustainability-related lending. Although SLLPs are recommended guidelines, they are currently still voluntary and should be applied on a case-by-case basis depending on the underlying characteristics of the transaction.
In addition, the SLLP has also defined a framework allowing all market participants to clearly understand the characteristics of an SLL. The framework is based on the five main components, namely:
- selection of key performance indicators (“KPIs”);
- calibration of sustainability performance targets (“SPTs”);
- loan characteristics;
- reporting on progress against SPTs; and
In this Part 3 of our series, we’ll focus on (1) selecting KPIs and (2) benchmarking core component SPTs (and, in next month’s edition of REF News and Views, we will dive deeper into (3) loan characteristics, (4) progress reports against SPTs and (5) verification).
Selection of KPIs
An SLL can be granted to any business that has a sustainability strategy and can be any type of loan instrument and/or conditional facility (e.g. line of surety, line of guarantee or letter of credit) where there is an economic impact related to the achievement (or failure) by the borrower of the predetermined SPTs. The SLL will seek to reward the business for achieving the goals set out in this sustainability strategy as long as the KPIs are meaningful to the business of the business and the SPTs are ambitious enough.
KPIs are the cornerstone on which the SLL market is built. The credibility of the SLL market is fundamentally based on the selection of KPIs, and KPIs that are not credible should be avoided.
As recommended by the SLLPs, the KPIs selected by the borrower should be:
- clearly defined and relevant, essential and important for the business of the borrower and of great strategic importance for its future operations;
- measurable or quantifiable on a consistent methodological basis; and
- benchmarkable, as much as possible using an external benchmark or definitions to facilitate the assessment of the level of ambition of the TPS.
SLLP recommends providing a clear definition of each KPI, which should:
- include scope or applicable parameters;
- include the calculation methodology;
- include a definition of a baseline; and
- benchmark against an industry standard where possible (such as regulatory standards, goals and targets set in international agreements such as the Paris Agreement or the Sustainable Development Goals).
It is worth noting that the appendix to the SLLPs contains a list of some common categories of KPIs (along with an example of the improvements this category might seek to measure) that borrowers can consider when structuring their KPIs and SPTs. ambitious. Examples include:
- Energy efficiency: Improvements in the energy efficiency rating of buildings and/or machinery owned or leased by the borrower.
- Affordable Housing: Increase in the number of affordable housing units developed by the borrower.
- Employee engagement, diversity and inclusion: improving specific long-term goals related to improving diversity, training and continuing education.
For more examples, please see this link.
The process of sizing SPTs against each KPI is critical to structuring SLLs and is perhaps more important than even KPI selection. This is because SPTs are key driving behaviors and are designed to act as an expression of the level of ambition to which the borrower is willing to commit.
The SLLP states that SPTs must be established in good faith and must remain relevant (as long as they apply) throughout the term of the loan. Should SPTs also be ambitious? namely that:
- they represent a material improvement and go beyond a “status quo trajectory”;
- as far as possible, be compared to a benchmark or an external reference;
- they are consistent with the borrower’s overall sustainability/environmental, social and governance (“ESG”) strategy; and
- they are determined according to a predefined schedule, fixed before or at the same time as the origination of the loan.
The SPTs selected by the borrower should be based on recent performance levels and be based on a combination of benchmarking approaches. The SLLPs recommend that these approaches include:
- the borrower’s own performance over time, measured against selected KPIs – the SLLP recommends a minimum period of three years;
- borrower peers – the relative positioning of the SPT against its peers when available (including average performance and best in class performance) or against industry or sector standards; and or
- references to science – such as science-based scenarios, absolute levels or formal national/regional/international targets, or recognized best available technologies or other indicators to determine relevant targets for all ESG themes .
All target setting disclosures should clearly refer to (i) timelines for achieving targets, (ii) baseline benchmarks, (iii) when recalculations will occur, (iv) how the borrower intends to achieve the SPTs and (v) any other key elements. factors that may affect the borrower in achieving the SPTs.
The borrower and lenders will agree and define the appropriate KPIs and SPTs for a transaction, and a sustainability coordinator or structuring agent may be appointed to help lenders negotiate and calibrate SPTs with the borrower.
Borrowers are encouraged by SLLPs to seek an external party’s opinion as to the suitability of KPIs and SPTs (e.g., through a pre-signed second party notice as to the suitability of agreed KPIs and SPTs as prerequisite for the SLL being made available).
Where no external input is sought, SLLP strongly recommends that the borrower demonstrates or develops internal expertise to verify its methodologies, including related internal processes and the expertise of its staff (which should be carefully documented) . Naturally, this documentation must be provided to the lenders participating in the loan. Market practice regarding whether or not to require external verification is still evolving and varies from transaction to transaction.
In the next installment of this series of sustainability-related loans, we’ll continue our in-depth analysis of core components and look at loan features, SPT progress reporting, and verification.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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