ESG in the loans market

Answer

This article was originally published on 27 June 2023.

ESG

‘ESG’ stands for ‘environmental, social and governance’ issues. In recent years ESG has had much impact on the investment landscape with investors and the financial sector as a whole looking to implement environmentally and socially sound principles into practice. There are a number of motivations for this, including:

• investor demand to finance projects that progress environmental and social causes;
• minimising the impact of investments that cause harm to communities and ecosystems; and
• investors building sustainable investment portfolios to protect themselves from potentially negative impact; ultimately all investors want to make a return on their investment and therefore in practical terms there are a number of challenges and risks involved for borrowers and lenders.

Sustainability-linked loans

Sustainability-linked loans (SLLs) refer to loans where a portion of the interest rate is linked to a borrower’s ability to meet sustainability targets. The Loan Market Association (LMA) defines an ‘SLL’ as “any type of loan instrument and/or contingent facility that will incentivise the borrower to achieve ambitious, predetermined sustainability performance objectives”.

A borrower’s sustainability performance is measured using sustainability performance targets which include key performance indicators (KPIs), external ratings and/or equivalent metrics that look to measure improvements in the borrower’s sustainability profile.

The LMA’s Sustainability Linked Loan Principles provide a framework to articulate the fundamental characteristics of SLLs. This is based around five core components:

• selection of KPIs;
• calibration of sustainability performance targets;
• loan characteristics;
• reporting; and
• verification.

Green loans

A green loan is exclusively to finance or re-finance, in the whole or in part, new and/or existing eligible green projects.

The LMA defines a ‘green loan’ as “any type of loan instrument made available exclusively to finance or refinance, in whole or in part, new and/ or existing eligible green projects”. Green projects generally cover, among other things, renewable energy, energy efficiency, climate change adaptation and green buildings that’ll meet standards or criteria that are recognised on a regional, national or international basis.

The LMA’s Green Loan Principles provide a framework of green loans based on four key components:

• the use of proceeds;
• the process for project evaluation and selection;
• the management of proceeds and tracking to maintain transparency; and
• reporting the use of proceeds and the allocation among green projects. Green projects categories may include but aren’t limited to renewable energy, pollution prevention, biodiversity conservation, green technologies.

Integration of ESG in the leveraged loans market

The leveraged loan market has been slower to adopt sustainable finance but there are a number of initiatives to encourage interest and engagement. This includes the latest publication of the Green Loans Principles and Sustainability Linked Loan Principles in February 2023 and the UN Principles for Responsible Banking (sustainability framework).

Key drivers for integration include:

• Demand from stakeholders/ investors – with an increased commitment to international policies and standards. Stakeholders are demanding ESG-specific investments and also for financial analysis to be supplemented with ESG analysis to allow for a full assessment of ESG impact.
• Improved financial performance – integrated ESG analysis during the investment and deal cycles may improve financial performance, while ESG risks may indicate potential financial losses.
• Reputation – reputational risks are a key concern to avoid an image of ignoring the push for positive ESG impact and sustainability.
• Improved prospects at exit – integrating ESG principles across the activities of private companies may strengthen the selling position when managers plan for an exit.

Challenges

However, with the increased focus on sustainability and implementing ESG principles there comes a number of challenges and risks.

How do you determine which companies, or their business models can be classed as environmentally and/or socially sound? This requires an assessment of not only the product or service provided by the company, but also the raw materials required, manufacturing process, distribution and the impact of each step on the environment and society.

There are a number of challenges to integrating ESG principles:

• Lack of data – there’s an insufficient amount of data for many leveraged borrowers as they’re typically unlisted companies and therefore aren’t subject to the same disclosure standards. Some companies are new and so may be starting from the beginning when it comes to the creation of policies, including ESG strategy.
• Consistency of information – investors in leveraged finance will likely gather information on ESG risk from several sources and so the quality and availability of such information will vary.
• Economics – the market is tightly priced and highly competitive, as such additional cost and effort to issue and maintain sustainability-linked loans may act as a deterrent for both lenders and borrowers.
• Stranded assets – there are concerns that leveraged issuers in more problematic sectors such as oil and gas, and shipping are at risk from being excluded from financings as these deals will likely be more difficult to syndicate.
• Greenwashing and social washing – this refers to the practice of making misleading claims about environmental or social practices, performance, or products. Covid-19 has led to an increased emphasis on the social element of ESG and has heightened the issue of social washing.

Greenwashing

Some investments are advertised to be for green or social initiatives but on a closer look are found to have misleading qualities such as ambiguity, empty claims, omission and exaggerated impact. There’s also an issue with ESG terminology being used incorrectly or in a misleading manner.

Greenwashing is the process of conveying a false impression or misleading information about how a company’s products are environmentally sound. Greenwashing involves making an unsubstantiated claim to deceive consumers into believing that a company’s products are environmentally friendly or have a greater positive environmental impact than they do.

In addition, greenwashing may occur when a company attempts to emphasise sustainable aspects of a product to overshadow the company’s involvement in environmentally damaging practices. Performed through the use of environmental imagery, misleading classifications and hiding trade-offs, greenwashing is a play on the term ‘whitewashing’, which means using false information to intentionally hide wrongdoing or error in an attempt to make it seem less bad than it actually is.

In recent months, there have been increasing concerns that financial institutions are misrepresenting their sustainability efforts. In particular, EU regulators have found widespread greenwashing across the financial sector with concerns that many financial institutions, asset managers and insurers are overstating climate credentials. This shift in the regulatory landscape demonstrates the permanence of ESG initiatives in the banking industry.

Key observations in ESG lending in 2022

• Approximately 70% of new corporate loans in the UK and Europe incorporated an ESG-linked component in the year of 2022.
• The majority of ESG-linked loans were found to be sustainability-linked loans whereas a small proportion were green loans.
• Further standards need to be developed to aid with transparency and measurement of ESG loans so that concerns of greenwashing can be reduced going forward.

In March 2023, the European Commission proposed a Green Claims Directive, which would lay down detailed rules on the substantiation, communication and verification of voluntary environmental claims and label used by traders that market products to consumers in the European Union. This directive is intended to complement the commission’s March 2022 proposal to amend the EU Unfair Commercial Practices Directive and Consumer Rights Directive.

Monica Shah is a trainee solicitor in the debt finance team at White & Case LLP.

Any views expressed in this publication are strictly those of the authors and should not be attributed in any way to White & Case LLP.