A wave of ever-increasing investor focus on sustainability and environmental, social and governance (ESG) issues has elevated the prominence and visibility of sustainability-linked loans in the global bank financing market. As issuers ranging from renewable energy producers, oil majors and manufacturers enter into these loans, they face a very difficult challenge: differentiating a high-quality transaction from something less credible.
Market demand for sustainability-linked loans has risen rapidly: U.S. sustainability-linked loans have reached over $68 billion in volume by the end of May, according to BloombergNEF. Investor demand for such financings is expected to continue to surge and drive growth in the market through 2021 and beyond.
For many organizations, a key strategic goal/objective, from the perspective of its business and lending practices, is to demonstrate sustainability leadership. Demonstrating this leadership can have various tangible benefits and impacts for an organization — strengthening employee morale, addressing shareholder questions and concerns, fostering strong government relations, and enhancing/protecting a company’s reputation.
So, the questions for an organization are these: How do sustainability-linked loans thread the needle of all these prospective tangible impacts? And how are they generally structured?
Borrower’s commitment to achieving sustainability goals
Separating high-quality transactions from less credible prospective deals requires the evaluation, in specific detail, of how well a sustainability-linked loan achieves its purpose: emphasizing the borrower’s commitments on material and strategic ESG issues.
Sustainability-linked loans are much like any other loan, with one main differentiator: The borrower’s costs may fluctuate depending on performance related to sustainability.
This fluctuation is typically an adjustment to the borrowing costs in the form of a discount (for strong performance) or premium (for weak performance) tested and applied annually. The magnitude of the applied adjustment is typically in the range of 0.01-0.05 percent. Performance related to sustainability is most often assessed by sustainability-related key performance indicators (KPIs), such as amount of greenhouse gas emitted, and in the minority of cases by third-party ESG ratings.
It is not a simple task to create meaningful KPIs from ESG issues. As a tangible example, a successful translation of a borrower’s identified significant ESG issues into KPIs can be seen in the recent sustainability-linked loan transaction by U.S.-based global manufacturer Jabil. For context, Jabil had more than $29.3 billion in revenue in its latest fiscal year and operates 100 sites in 30 countries including China, Malaysia, Mexico, Singapore, the United States and Vietnam.
[Continue the dialogue about ESG and green finance with the invitation-only audience of sustainability, finance and investment leaders at GreenFin 22, taking place in New York City, June 28-29.]
Jabil’s sustainability-linked loan features margin adjustments tied to three KPIs, focusing on both a universally important ESG topic (greenhouse gas emissions) and two business-specific issues material to the borrower’s industry. Key points to note about the differentiation and uniqueness of the KPIs:
- Jabil’s efforts to improve social, environmental and economic conditions in the global manufacturing supply chain are captured with a KPI consisting of the average score received by its facilities on a leading audit protocol (the Validated Assessment Program of the Responsible Business Alliance, or RBA). Although this KPI had not been known to have been used in prior transactions, supply chain conditions are a potential ESG opportunity for Jabil and other global manufacturers to differentiate themselves as a partner of choice with their global client bases.
- With a focus on the health and safety of its workers, Jabil is using a first-of-its-kind KPI focused on environmental, health and safety considerations: an index of six metrics ranging from the well-known and backward-looking, such as total recordable incident rate, to the innovative and proactive, such as on-time management of projects and a custom management maturity model.
- Greenhouse gas emissions reduction is a third key KPI for Jabil. The company set a target for emissions reduction aligned with scientifically-based trajectories for limiting global warming to 1.5 degrees Celsius.
Customization of sustainability-linked loans products is labor-intensive and requires a well-articulated ESG vision from the borrower. Just as there are no shortcuts in improving ESG performance, there are no shortcuts in structuring a high-quality sustainability-linked loan.