Sourcing sustainability: the maturation of ESG lending

December 2022  |  COVER STORY | BANKING & FINANCE

Financier Worldwide Magazine

December 2022 Issue

Across the length and breadth of the finance and investment landscape, environmental, social and governance (ESG) issues are increasingly making their presence known – potentially influencing every facet of an organisation’s sustainability posture.

In the realm of loan issuance, sustainability-linked loans (SLLs) have certainly become a hot topic in recent years, a shift that has led to the emergence of ESG lending as one of the fastest-growing areas of the sustainable investing market.

ESG loans, as defined by ETBFSI.com, incentivise companies’ commitment to sustainability by linking the financial terms of a loan to predetermined sustainability performance targets (SPTs) that are measured by key performance indicators (KPIs). SPTs are also determined on the basis of companies donating to environmental charities or to other ESG projects.

“In some cases, borrowers seek funding directly attached to projects promising ESG outcomes,” states Wilmington Trust in its 2022 analysis ‘The Rise of ESG Lending: Trends and Considerations’. “The use of proceeds determines the ESG status of such loans. For example, leading global lending industry groups the Loan Syndications and Trading Association (LSTA), the Loan Market Association (LMA) and the Asia Pacific Loan Market Association (APLMA) published a set of ‘Green Loan Principles’, which offer a framework for loans used to finance green projects. Eligibility includes categories such as energy, resource and land use, biodiversity, transportation, water and eco-efficient products.”

Additionally, the same consortium of groups published ‘Social Loan Principles’ in April 2021, guidance which recommends that proceeds finance eligible projects, including affordable infrastructure, housing, food security, job creation and equitable socioeconomic development.

Further broadening the application of loans in incentivising and promoting sustainable development more generally, ‘Sustainability-Linked Loan Principles’ put forth by this group has paved the way to link sustainability performance to the terms of general purpose loans unhindered by use of proceeds restrictions.

“ESG loans enable borrowers to credibly signal their ESG commitments to external stakeholders, who increasingly require transparency on firms’ responsible investment and financing practices,” states the 2022 study ‘ESG Lending’ by Sehoon Kim and Nitish Kumar at the University of Florida, Jongsub Lee at Seoul National University and Junho Oh at Hankuk University of Foreign Studies. “Lenders are also incentivised to supply SLLs because of the downside protection that good ESG practices can provide, or in response to regulatory and governmental pressure on banks to conduct their lending businesses more responsibly.”

Niche no more

While prevalent now, perhaps remarkably, up until just a few years ago, ESG lending was generally perceived as a niche market for large industrial corporates looking to finance projects with an environmental angle – a perception that had held sway for some time.

“Until around 2020, the primary focus of sustainable lending was very much on the environment, an area driven and supported by science, global goals and taxonomies,” says Gemma Lawrence-Pardew, head of sustainability at the LMA. Shortly after, the coronavirus (COVID-19) pandemic brought the ‘social’ aspect into sharp focus. “At the same time, the social impact of the pursuit of environmental goals was starting to be better understood. The focus in the future is likely to be on a more complete ESG picture, taking into account the ‘just transition’ and how best to shift society as a whole onto a more sustainable path.”

So, as a result of greater understanding and appreciation of the concept, today ESG lending is one of the first topics of conversation in financing discussions between lenders and borrowers – a transformation that has been nothing less than extraordinary.

Testifying to this is the 2022 ‘ESG Lending’ study, which reveals that the ESG lending market has grown exponentially from $6bn in 2016 to over $320bn in 2021, with most of this growth driven by the proliferation of ESG-linked loans (or SLLs), which are general-purpose loans whose loan spreads are tied to the borrower’s post-issuance ESG performance according to highly customisable sets of KPIs.

“The SLLs market alone amounted to $290bn in annual issuance in 2021, eclipsing the size of the markets for use-of-proceeds based green bonds or green loans, and dwarfing the nascent sustainability-linked bond market,” adds Sehoon Kim, assistant professor at the Warrington College of Business at the University of Florida, and co-author of the study.

In terms of mid-market lenders, a Grant Thornton survey of UK-based lenders (including large clearing banks and smaller alternative lenders), found that: (i) 57 percent of lenders surveyed have an ESG lending strategy; (ii) 93 percent expect ESG-related lending in the mid-market to increase in the next few years; and (iii) 85 percent of lenders stated that a firm’s ESG status, or its ability to transition to net zero, influenced the credit risk assessment.

“While ESG lending to date has been dominated by large, listed companies, there has been an important change in the direction of travel with lenders increasingly focusing on ESG for the mid-market,” says Schellion Horn, partner and co-head of economic consulting at Grant Thornton. “As the importance of ESG factors increases for investors, consumers and regulators, the relationship between ESG and the value of a firm will grow stronger. In some cases, ESG issues may even be pivotal to its long-term viability.”

Lending growth factors

Drilling down, while regulatory considerations and stakeholder demands are doing much to drive the growth of sustainable finance, they represent just some of the numerous factors driving the rise in borrowers’ and lenders’ consideration of ESG issues.

“A confluence of factors is driving the growth of SLLs for borrowers and lenders,” affirms Tess Virmani, head of ESG at the LSTA. “Borrowers are gravitating to SLLs as a means of communicating their commitment to sustainability to their stakeholders. As management increasingly integrates ESG factors into its business plan, an SLL offers further support for that plan, potentially raising the stakes by tying an interest rate penalty to missed targets.

“Lenders are incentivised to offer these loans as a means of supporting their clients in their transition, fulfilling commitments and pledges they have made as well as meeting shareholder expectations,” she continues. “Disclosure is a key driver. The mandatory reporting on a borrower’s material KPIs – as selected at origination of the loan – inherent in an SLL offers more robust disclosure on material ESG matters than a lender would otherwise receive.”

Moreover, while an SLL enables borrowers to credibly signal their ESG commitments to external stakeholders that are increasingly requiring transparency on organisations’ sustainable practices, according to the ‘ESG Lending’ study SLLS often feature distinct characteristics, as outlined below.

First, an SLL loan tends to be large – with an average deal size of $937m, they are nearly 80 percent larger than regular loans. They tend to be issued to larger, safer and publicly listed borrowers, consistent with the idea that large and economically important firms have strong incentives to demonstrate ESG-friendly practices, given their high visibility and scrutiny from stakeholders.

Second, they are structured mainly through revolving credit facilities and are more likely to be syndicated by larger groups of lenders (often global banks) that have previous relationships with the borrower and have past sustainable lending experience.

Third, they are priced similarly to regular loans at issuance, suggesting that borrowers that meet future ESG performance targets may enjoy lower spreads, according to their ESG performance pricing contracts.

Fourth, they can be used to effectively monitor, enforce and renegotiate ESG contingencies in lending contracts, given that banks, after all, specialise in screening and monitoring their loan portfolio.

“Heightened public scrutiny by a broad spectrum of stakeholders over the sustainability of corporate operations plays a critical role in stimulating the growth of sustainable finance,” adds professor Kim. “Indeed, large publicly listed national champion firms and global dominant banks that face high visibility and stakeholder pressure are much more likely to participate in ESG lending contracts than smaller borrowers and lenders that comprise the typical corporate syndicated loan.”

Another key growth factor stems from global ambitions such as the 2015 Paris Agreement and the ‘Race to Zero’ – a United Nations (UN)-backed global campaign to take rigorous and immediate action to halve emissions by 2030 – as well as regulatory considerations, including jurisdictional taxonomies and disclosure requirements.

“That said, the fundamental driver is the general public,” asserts Ms Lawrence-Pardew. “Sustainability is an issue being discussed by every generation in every household globally. It has captured the public’s interest in a way rarely seen and it is influencing their decisions – decisions which directly impact upon borrowers. Sustainability is an issue borrowers must address, with the financial sector supporting.”

Challenges and potential concerns

With organisations under mounting pressure to demonstrate their green credentials, a key challenge is the issue of greenwashing, generally defined as an unsubstantiated claim that a product or service is environmentally friendly.

According to a 2021 European Commission (EC) report – ‘Initiative on substantiating green claims’ – which analysed green online claims from a range of business sectors, the claims of 42 percent of organisations were exaggerated, false or deceptive and could potentially qualify as unfair commercial practices under European Union (EU) rules.

“The most significant challenge for sustainable finance is the potential concern that issuers and investors may engage in such deals for greenwashing purposes,” concurs professor Kim. “In other words, to showcase an empty emphasis on ESG to stakeholders without following up on their commitments. Certainly, it is difficult to measure and evaluate the ESG performance of firms in relation to their stated commitments.”

Justifying these concerns, the ‘ESG Lending’ study found that although organisations with better ESG profiles self-select into ESG-linked loan (SLL) deals, borrowers often exhibit deterioration in their ESG ratings after the issuance of these loans, especially for loans where the level of transparency regarding the ESG-contingent contractual details is low.

Not helping is the reality that the overall quality of publicly available information regarding what specific KPIs are used in ESG-linked loans and how they are linked to loan terms is generally poor.

“These findings are consistent with widespread concerns that it is difficult to verify ESG loan labels or measure and evaluate the real impact of ESG-linked loans in disciplining borrowers on sustainability issues,” contends professor Kim. “This challenge is only exacerbated by the fact that even currently available metrics of ESG performance are often opaque or misleading, presenting a pervasive problem for stakeholders.”

To alleviate these problems and to facilitate the disciplining role of sustainable financing, professor Kim believes it is crucial to have rules and requirements in place that ensure transparent disclosure regarding ESG-related contract terms in sustainable financing arrangements.

Alongside greenwashing, another key challenge that runs across all channels of sustainable finance and affects it to varying degrees is the need to have access to reliable and standardised data.

“This, to some extent, is also influenced by the fragmented landscape of ESG regulations, where some regions such as Europe are frontrunners while others are trying to pick up pace,” explains Achin Bhati, head of ESG at Acuity Knowledge Partners. “ESG awareness and full reporting are underdeveloped in a large section of small to mid-size firms in emerging and frontier markets.

“Additionally, the absence of standardised ESG-integrated investment or financing models perpetuates the problem of ESG data being measured, reported and integrated in different ways,” he continues. “For instance, the lack of ESG data and a clear methodology for ESG KPIs necessary for SLLs impedes the proliferation of sustainable finance to entities in emerging and frontier markets.”

Mainstream

Given the regulatory direction of travel in terms of reporting requirements, ESG oversight is well on the way to becoming a mainstream factor for consideration on all lending transactions – a transition from the exception to the norm.

“Stronger ESG integration, the large funding gap and robust growth in the past three years indicate that the sustainable finance market will transition to a mature phase,” contends Mr Bhati. “Improving regulations and product innovations will continue to support growth, while lenders have embarked on aggressive sustainable finance targets as ESG loans still represent a low proportion of their overall loan exposure.

“They are also ramping up their internal systems to support the promising growth opportunity,” he continues. “From a product perspective, SLLs and debt issuances that are tied to a borrower’s performance against ESG-related KPIs and provided to borrowers from a wide range of sectors are becoming increasingly attractive for lenders over green or social loans that are based purely on use of proceeds.”

For professor Kim, the explosive growth of ESG lending in recent years shows few signs of slowing down. “As of 2022, the share of ESG loans in the global corporate syndicated loan market in terms of annual issuance amount has reached an estimated 20 percent, indicating that one in every five dollars borrowed by organisations is now tied to ESG performance,” he concludes. “Therefore, in a sense, ESG lending has already become mainstream.”

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Fraser Tennant