In our June issue of REF news and viewswe have further explored the growing field of Sustainable Loans (“SLLs”) by introducing and outlining the Principles for Sustainable Loans (“SLLP”) and the SLLP core components (“Core Components”).
As a reminder, the SLLP were published to provide a framework of principles to help market participants understand and identify the key components in establishing sustainability-related lending. Although the SLLP are recommended guidelines, they are currently voluntary and are expected to be applied from deal to deal depending on the underlying characteristics of the transaction.
In addition, the SLLP has also established a framework that allows all market participants to clearly understand the characteristics of an SLL. The framework is based on the five core components, namely:
- selection of Key Performance Indicators (“KPIs”);
- Calibration of sustainability performance targets (“SPTs”);
- loan characteristics;
- reporting progress on SPTs; and
In this Part 3 of our series, we focus on (1) selecting KPIs and (2) calibrating SPTs of the core components (and, in next month’s issue of REF news and views, We will delve more deeply into (3) credit characteristics, (4) progress reports on SPTs, and (5) verification).
Selection of KPIs
An SLL can be granted to any company with a sustainability strategy and can be any type of loan instrument and/or contingency facility (e.g. the achievement (or non-achievement) by the borrower of predetermined SPTs. The SLL will seek to credit the company for achieving those set out in that sustainability strategy Reward targets as long as the KPIs are meaningful to the company’s business and the SPTs are sufficiently ambitious.
The KPIs are the cornerstones on which the SLL market is based. The credibility of the SLL market is essentially based on the choice of KPIs and non-credible KPIs should be avoided.
As recommended by the SLLPs, the KPIs chosen by the borrower should be:
- clearly defined and relevant, core and essential to the borrower’s business and of high strategic importance to its future operations;
- measurable or quantifiable on a consistent methodological basis; and
- Benchmarking is possible, as far as possible using external references or definitions to facilitate the assessment of the level of ambition of the SPT.
The SLLPs recommend that a clear definition of each KPI should be provided that:
- contain the applicable scope or parameters;
- contain the calculation methodology;
- contain a definition of a baseline; and
- where possible, compared to an industry standard (e.g. regulatory standards, from goals and objectives set in international agreements such as the Paris Agreement or the Sustainable Development Goals).
Helpfully, the SLLPs Appendix provides a list of some common categories of KPIs (with an example of the improvements that category may wish to measure) that borrowers can consider when structuring their KPIs and ambitious SPTs. Examples include:
- Energy Efficiency: Improvements in the energy efficiency rating of buildings and/or machinery owned or leased by the borrower.
- Affordable Housing: Increase the number of affordable housing units being developed by the borrower.
- Employee Engagement, Diversity and Inclusion: Improving specific long-term goals related to diversity improvements and education and training.
See this link for more examples.
Calibration of SPTs
The process of calibrating the SPTs against each KPI is key to structuring SLLs and perhaps even more important than the KPI selection. This is because SPTs are key to driving behavior and are intended to reflect the level of ambition that the borrower is willing to commit to.
The SLLP states that the SPTs should be established in good faith and should remain relevant (as long as they apply) throughout the life of the loan. The SPTs should also be ambitious – namely that:
- they represent a significant improvement and go beyond a business-as-usual trajectory;
- compared to a benchmark or external reference where possible;
- they are consistent with the borrower’s overall sustainability/environmental, social and governance (“ESG”) strategy; and
- They are set on a predefined schedule that is set before or at the same time as the loan is made.
Borrower-selected SPTs should be based on current performance levels and be based on a combination of benchmarking approaches. The SLLPs recommend that such approaches include:
- the borrower’s own performance over time as measured against the selected KPIs – the SLLP recommends a minimum of three years;
- the Borrower’s peers – the relative positioning of the SPT against its peers, if available (including average performance and best-in-class performance) or against industry or industry standards; and or
- References to science – such as science-based scenarios, absolute levels or official country/regional/international targets, or to recognized best available technologies or other proxies to identify relevant targets for any ESG topic.
All target-setting disclosures should clearly address (i) timelines for target achievement, (ii) baseline benchmarks, (iii) timing of recalculation, (iv) how the borrower intends to achieve the SPTs, and (v) all other keys relate to factors that may affect the borrower achieving the SPTs.
The borrower and lenders agree and establish the appropriate KPIs and SPTs for a transaction, and a sustainability coordinator or structuring officer may be appointed to assist the lenders in negotiating and calibrating the SPTs with the borrower.
Borrowers are encouraged by the SLLPs to seek input from an external party on the adequacy of the KPIs and SPTs (e.g. by providing a pre-signed second opinion on the adequacy of the agreed KPIs and SPTs as a pre-condition for SLL).
If external input is not sought, the SLLP strongly recommends that the borrower demonstrate or develop internal expertise to verify its methods, including related internal processes and the expertise of its staff (which should be thoroughly documented). Of course, these documents should be made available to the lenders involved in the loan. Market practice as to whether to seek external verification is still evolving and varies from store to store.
In the next installment of this series of sustainability-related loans, we will continue our in-depth look at the core components and delve into the loan characteristics, report progress using SPTs and conduct verification.