Sustainability-linked loans: Update of LMA, APLMA and LSTA principles | In Principle

In our previous article we discussed the recent amendments to the Green Loan Principles and Social Loan Principles, and accompanying guidance. Today, we will focus on the Sustainability-Linked Loan Principles. Here, the amendments are more extensive.

The SLL Principles help market participants understand what characteristics sustainable loans must possess. Five core components serve this purpose: selection of key performance indicators (KPIs), calibration of sustainability performance targets (SPTs), loan characteristics, reporting, and verification.

Practically every part of the SLL Principles (which date to 2019) has been revised, although the accompanying guidance was published relatively recently (in March 2022). All loans issued, extended or refinanced after 9 March 2023 must be adjusted to the updated version of the principles.

The most important amendments

The SLL Principles now state that the aim of sustainable loans is to facilitate and support the key role that the loan market can play in funding and encouraging borrowers to contribute to sustainable development. A sustainability-linked loan is designed to encourage borrowers to achieve material, ambitious, predetermined, regularly monitored and externally verified objectives, backed by KPIs and SPTs.

The definition of sustainability-linked loans has been amended. The term now applies to “any types of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) for which the economic characteristics can vary depending on whether the borrower achieves ambitious, material and quantifiable predetermined sustainability performance objectives.”

We should note that the way the loan proceeds are used does not determine whether the loan will be classified as “sustainability-linked.” In most cases, a sustainability-linked loan will be used to finance the borrower’s operations.

The SLL Guidance emphasises that a sustainability-linked loan is intended as a transitional tool to support the borrower in its efforts to improve its sustainability performance. Sustainability-linked loans should be available to all borrowers, regardless of sector, geography, or the borrower’s level of sophistication in sustainability performance. But the loan must be aligned with each of the principles’ core components.

The materiality and ambitiousness requirements for KPIs and SPTs have been clarified to place more emphasis on benchmarking. Currently, the principles recommend an assessment of materiality as a good practice in the KPI selection process. In turn, the SPTs should go beyond the legal requirements (as well as beyond “business as usual”), and must be set annually and remain ambitious throughout the life of the loan.

The guidance indicates that only after the KPIs and SPTs have been established and other elements of the principles have been met can the loan be referred to as sustainability-linked. However, in exceptional cases, a sustainability-linked feature can be added to a non-sustainable loan after conclusion of the loan agreement.

The section of the guidance entitled “Verification” now includes more specific information on pre- and post-signing reviews and the expected content of the verification report. These reviews can be opinions or KPI/SPT assessments, depending on the entity preparing them.

The section on documentation has been removed. Recently, the LMA released an SLL Rider that contains draft language for a number of provisions of sustainability-linked loan agreements for use by the parties.

Core components: Loan criteria

The five key elements that sustainability-linked loans must meet have been expanded.

1. Selection of KPIs

The requirement that KPIs be relevant to the borrower’s core sustainability strategy has been introduced. An additional consideration is whether a particular KPI is critical to the borrower’s business.

The guidance clarifies what “materiality” means in the context of KPI selection. It may be assessed from the point of view of:

• Strategy, i.e. by analysing the ESG challenges most relevant to the borrower and the sector
• Sustainability, i.e. analysing the ESG issues with the greatest impact on the society/environment.

In benchmarking KPIs, a clear requirement has been introduced to consider other industry stakeholders, as well as industry standards. It is good practice to assess the materiality of the proposed KPIs. For this purpose, some borrowers engage ESG consultants, but it is common to identify and evaluate the KPIs as part of the borrower/bank relationship.

Appendix 1 of the principles, which listed examples of KPI categories, has been removed. Instead, there is a cross-reference to the guidance, with examples of benchmarks, standards and frameworks that can be used to establish the KPIs.

2. Calibration of SPTs

A requirement was introduced that SPTs be established in good faith and remain “relevant” and “ambitious” throughout the life of the loan. They should go beyond the requirements set by law and the practices of “business as usual.” If the SPTs are set in good faith and remain relevant and ambitious, they can be drawn from the borrower’s publicly announced targets. The principles also include a new recommendation that annual SPTs be set for each KPI for each year of the life of the loan.

The guidance on SPT calibration (i.e. the basis on which they should be established) states that SPTs can be:

• External and set by reference to science
• External and set against a borrower’s ESG performance in relation to its peers
• Internal and bespoke to the borrower’s business, referencing past performance where possible, or
• A combination of the above.

This confirms that the selection of both KPIs and SPTs (and their materiality/ambitiousness) must be driven by the context, i.e. taking into account both the borrower’s business sector(s) and geographical conditions. If feasible, the SPTs should be set in line with or even exceed the official national, regional or international targets.

According to the guidance, SPT calibration is a process that includes benchmarking and periodic review. The principles and guidance note that lenders and borrowers may require some support in this process. For this purpose, the principles section on SPT calibration articulates the role of sustainability coordinators, although appointment of a coordinator is not mandatory. The guidance also reminds lenders of the need to review the SPTs themselves (even if a coordinator is appointed).

3. Loan characteristics

This section continues by stating that the most important feature of a sustainability-linked loan is that its costs are tied to meeting SPTs. For example, the margin will often be reduced when the borrower satisfies an SPT or increased when an SPT is not satisfied. It is noted that in some cases, the mechanism may provide for a period in which no margin adjustment applies.

4. Reporting

Currently, the borrower must submit documents to the lender annually to prove compliance with the SLL obligations. In addition to up-to-date information sufficient to allow the lender to monitor the performance of SPTs and determine whether the SPTs remain ambitious and relevant in the context of the borrower’s business, these documents also encompass a sustainability confirmation statement with verification report attached (discussed below).

5. Verification

A third-party pre-signing external verification to assess whether the loan meets the five core components of the principles remains only a recommendation and not an obligation. The position that the need for such an audit would be considered on a deal-by-deal basis was maintained. The principles continue to note that the borrowers themselves may have the expertise to ensure that the loan complies with the principles, but must document their competence to do so. External verification can take the form of an opinion from another party or KPI/SPT assessment pre-signing.

However, the reference to obtaining external verification pre-signing as a condition precedent to the loan has been removed. Instead, post-signing verification is mandatory. Before, the principles required external reports at least once a year. As of 9 March 2023, verification of the borrower’s performance against each SPT for each KPI is required for each date or period relevant to assessment of SPT performance leading to a potential margin adjustment. The verification should be conducted by a qualified external reviewer with relevant expertise, such as an auditor, environmental consultant, or independent rating agency.

The SLL Principles and Guidance set forth and clarify many of the issues surrounding sustainability-linked loans raised by market participants. However, they are still only recommendations, and deliberately leave the parties a great deal of flexibility for shaping sustainability-linked loans. In this regard, the recently published SLL Rider (available to LMA members) will be helpful. The SLL Rider includes proposed language for a number of specific clauses that can be used by the parties in a sustainability-linked loan agreement.

Ewa Winiarz, attorney-at-law, Banking & Project Finance practice, Wardyński & Partners