With greater focus on corporate social responsibility and achieving a more sustainable society as we emerge from the COVID-19 pandemic, the banking and finance industry in Australia has taken new strides in introducing sustainability linked loans to their commercial loan practice. We are at a particular tipping point in Australia, and the importance of finding new innovative ways to combine finance and the betterment of society is only growing. As Larry Fink, chairman and CEO of the world’s largest asset manager, BlackRock, told COP26 participants, “We need to reimagine finance. We have the most magnificent global capital markets we ever imagined. We can make it happen if we do it together.”
The Sustainability Linked Loan is one such reimagining.
Sustainability linked loans or environmental, social and governance loans (SLLs) are loans which incentivise ‘the borrower’s achievement of ambitious, predetermined, sustainability performance objectives’. The borrower’s performance in achieving the fundamental objectives is measured using predefined sustainability performance metrics or key performance indicators (KPIs).
One of the distinguishing characteristics of a SLL is that an economic outcome is linked to whether the KPIs are met during the term of the loan. For example, the interest rates under a SLL facility may be reduced where the borrower satisfies the predetermined criteria. However, unlike green loan facilities where the purpose of the loan must be linked to a ‘green project’, sustainability linked loans offer a significant amount of flexibility with the loan purpose. The purpose of the linked loans is not pertinent to the availability of a loan. Instead, the focus is the pricing mechanism benefits which is linked to predetermined sustainability performance criteria. This makes usage of SLLs much more attractive across the industry and affords greater accessibility to borrowers who may simply require general working capital, but which to receive a benefit and reward for their environmental and social governance.
The encouragement of sustainable practices with decreasing margins and interest rates acts in harmony with the recent increased focus on companies’ net-zero emissions target and environmental, social and governance portfolios. This also provides an opportunity for corporations to look at their business models, and either implement or ramp up sustainability strategies with a view to building these into funding strategies. In working with their financiers to structure the loans, the borrowers need to plainly communicate their rationale for eligibility, being specifically the criteria relating to materiality and relevance, for the selection of its KPIs and the motivation for the targets. These targets could, for instance, relate to ambition level, consistency with overall sustainability objectives as set out in their sustainability strategy and benchmarking approach. What is clear however is that each KPI must be ambitious and far greater than in scope than what is already expected of the industry.
The United Kingdom and greater Europe have led the market in SLLs, having introduced and expanded this area of the industry in 2018 and 2019 respectively. In Australia however, SLLs have only recently starting emerging in practice towards the latter half of 2021 and present a unique opportunity to provide a fresh and flexible loan product, capable of also benefiting society at large.
Although SLLs sound incredibly attractive, it is an emerging market faced with its own specific set of challenges and risks.
The principle of ‘greenwashing’ occurs when a corporation publicly markets that they are leading sustainable practices, but in reality are doing very little or nothing to justify this rhetoric. These marketing tactics could be as subtle as a misleading packaging choice all the way to a fossil fuel company openly representing itself as being an eco-champion. Either way, greenwashing is a harmful and deceitful way of advertising that a company is greener than it is in reality. The set targets and economic outcomes of the SLLs help to ensure that the ‘greener’ behaviour is actually afoot, and the incentive of lower margins should theoretically push corporations to achieve their targets. However lenders will still need to be painfully aware of ‘greenwashing’ risk as this will in turn bleed out to the lender’s own reputation and potentially impact the legitimacy of a lender’s sustainable lending practices. Lenders can avoid being exposed to ‘greenwashing’ by ensuring that selected KPIs are appropriately drafted and ambitious, and that the borrowers it seeks to work with, have a demonstrated ability to achieve any such targets.
Despite financial incentives in pricing and reduced covenants being an integral part of SLLs, one of the main challenges with SLLs is the increased transaction costs associated with finalising a suitable framework for achieving set targets and monitoring the ongoing reporting requirements. This is generally due to the underdeveloped market practice for sustainability linked loans.
Australian regulators are seemingly looking to create new structures and principles to minimise costs and remove obstacles for easier access for borrowers to these facilities. In some nations, such as Singapore, the Monetary Authority has instilled a new Green and Sustainability-Linked Loans Grant Scheme. This scheme provides economic relief for transactional costs for both borrowers and financiers, thereby increasing the accessibility of such facilities being funded, particularly for small and medium-sized enterprises (SME). If similar policies are adopted in Australia, it may provide a welcome opportunity for lenders, borrowers and advisers to invest in the development of the SLL market in the context of SMEs. Presently, SLLs are only attractive to larger institutional clientele, but if real and significant change is to be effected, accessibility to SLLs need to increase at all levels of lending.
Another key consideration for these loans in respect of lending is potentially the overly ambitious or underwhelming sustainability targets set in the KPI framework for SLL. This area of financing is somewhat untested.
The Loan Market Association, Asia Pacific Loan Market Association (APLMA) and Loan Syndications and Trading Association published the Sustainability Linked Loan Framework which sets out useful principles for these linked loans. The framework comprises that the performance targets ought to be meaningful and ambitious based on recent performance levels of the borrower. There is a requirement that the borrowers’ environmental, social and governance performance is carefully and independently verified. Ensuring that KPIs strike the careful balance between being ambitious enough to effect real change, yet remaining viable and realistic, will be a constant challenge in this market. Targets that are overly ambitious may remain unfulfilled, which defeats the broader aim of SLLs in producing sustainable long term outcomes. Likewise, underwhelming goals are not likely to drive effective change, which also defeats the purpose of establishing a SLL. The creation of a KPI framework will be incredibly industry specific and will need constant revision and consideration.
A potentially unforeseen challenge in the Australian market will be how such KPIs and pricing incentives are drafted and documented in SLL facilities. There is presently no market established SLL facility, and while APLMA has released its SLL Principles, these are merely guidelines. The drafting will need to be developed and the market will need to decide what is commercial and what market practice is. A question arises in how lenders should treat borrowers who completely fail to achieve their KPIs. Should the facility remain as a SLL, and should some kind of financial penalty or event of default apply? If not, are the loans truly being established to provide long term, sustainable solutions to social, environmental and governance issues?
In the context of the SME market, SLLs become an even more curious case. Could a lender imposing an overtly ambitious KPI be setting its borrower up for failure? And if so, would these be manifestly unfair, leading to potential implications in respect of the ever growing unfair contract regime in this space.
These are all drafting considerations which will continue to evolve with time.
We are excited to see the introduction and gradual developments of SLLs in Australia. While it may not become as common place as the ‘construction facility,’ SLLs present a real opportunity for lenders and borrowers to collaborate and effect positive change for the betterment of society. Our office has been incredibly fortunate to be involved in several SLL initiatives and we hope to see continued growth in this space.
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Martin Nguyen, Partner
Annalise Kennedy, Lawyer
 2020, Loan Market Association, Asia Pacific Loan Market Association, Loan Syndications & Trading Association, Sustainability Linked Loan Principles: https://www.lma.eu.com/application/files/5115/8866/8901/Sustainability_Linked_Loan_Principles_V032.pdf