Imagine your bank rewarding you with reduced interest for improving your company's eco-footprint. That's essentially the idea behind the "Sustainability Linked Loan Principles" recently published by the Loan Market Association (LMA).
The principles consist of four key components which have been developed by syndicated loan market representatives and aim to facilitate and support environmentally and socially sustainable economic activity and growth. The parties may use these principles as a guideline for their loan facility, if they wish.
In a nutshell, a borrower who intends to take out a "sustainable loan" should communicate its corporate social responsibility (CSR) strategy to the lender consortium. The parties, probably assisted by a Sustainability Structuring Agent, will then define and negotiate specific sustainability performance targets (STPs) for the borrower and the specific transaction. STPs should be aligned with the borrower's overall sustainability efforts but also require an improvement in relation to a pre-determined target benchmark.
Crucially, the loan terms (e.g. interest margin) are aligned with the borrower's performance against the STPs. In other words: the better the sustainability performance of the borrower, the better the conditions of the loan. This incentive should improve the borrower's sustainability profile. Compliance is ensured and verified by regular reporting obligations as well as internal or external review. These loans are not to be confused with Green Bonds which are tied to green projects while sustainable loans can be applied to general corporate aims.
Now, why would lenders or borrowers opt for a "sustainable loan" in the first place? The benefit for borrowers is easy to grasp: expenditure for sustainable investments can be set-off against reduced financing costs. From a lender's perspective, the upside is less obvious but nonetheless compelling: clearly defined sustainability targets which are subject to (third party) review should "serve to organize and measure the best of the borrower's energies and skills" and thereby increase the quality of its governance and management. Further, a growing market in sustainable finance will open the door for new products (e.g. securitisations of sustainable loan products, etc.) which will be welcomed by investors and the lenders' own shareholders.
Two reasons, however, advocate for "sustainable loans" more than all other: The first one is an ever increasing pressure on investors and borrowers alike to pro-actively consider the impact of their activities on their environment, with a view to understanding and mitigating potential risks, and (irrespective of their legal compliance) the need to answer for their corporate activities in the global court of public opinion. The second one is a very real potential for future regulatory changes, which may entail beneficial regulatory treatment of "sustainable" loan instruments.
Sustainable finance has been around for some time already. It seems that – fueled by a strengthening business case for sustainable investments and increasing public concern for a sustainable economy – several factors are now contributing to what could become a critical mass for "sustainable products" entering the mainstream. The "Sustainability Linked Loan Principles" are one step in this direction; and a noteworthy one indeed.