[authors: David O’Donovan and Elizabeth Gavin]

The present and future impacts of climate change, human rights violations, environmental, labor and regulatory violations and poor corporate governance on the quality of investments and credit risks have spurred widespread recognition for the importance of environmental, social and governance (ESG) considerations in lending and investment activities.

The rapid development of the sustainable finance sector seen in 2019 has continued into 2020. “Sustainable finance” is a very broad term, but in short, it is any form of financial service and/or product which integrates ESG criteria into business, financing or investment decisions. The financial markets are now starting to possess a range of tools in the “sustainable finance” space.

The value ascribed to robust ESG credentials also continues to grow. Companies and financial institutions are increasingly seeking ways in which they can conduct business in an environmentally-conscious manner and minimize ESG risks. Attention is coming from all sides – from activists such as Greta Thunberg; from regulators, with Mark Carney recently pronouncing on the integration of climate-related financial risks into day-to-to-day supervisory work of the regulators of the financial sector; and from investors such as BlackRock. Also, in the “BNP Paribas ESG Global Survey 2019” 78% of respondents stated that ESG is either playing a growing role or becoming integral to what they do as an organization (including in respect of what they investor in and/or who they lend to).

With the focus on sustainability and ESG only increasing, the appetite for sustainable finance products is set to continue to increase in 2020 and beyond.

Rise in Popularity of Sustainability-Linked Debt Products

There have always been compelling environmental reasons for sustainability-linked financial products and yet it is only recently that the economic rationale for such investments has come to the forefront. 2019 was a record year for sustainable finance, with more sustainable debt issued globally than ever before. The total raised was US$465bn globally, up 78% from US$261.4bn in 2018, according to Bloomberg data.

The key instruments from a pure financing perspective currently appear to be “Green Loans/Bonds” and “Sustainability-Link Loans/Bonds”.

It is important to know that “Green Loans/Bonds” and “Sustainability-Link Loans/Bonds” are different.

• “Green Loans/Bonds” use the proceeds of such instruments to finance green projects or related capital expenditure (e.g. renewable power generation, carbon reduction and waste reduction).
• “Sustainability-Link Loans/Bonds” do not have a dedicated use of proceeds and are not linked to green projects or green business (more flexible than “Green Loans/Bonds” but nevertheless, a good way for a company to demonstrate its ESG credentials). Rather, they include performance criteria linked to sustainability or ESG criteria/targets. Such criteria/targets can be measured by way of a general ESG rating or specific agreed criteria/targets. If the borrower hits the relevant sustainability or ESG criteria/targets, the loan will be cheaper. Recent deals have also adapted a two-way pricing structure, with the price of the loan increasing if the borrower fails to meet its ESG targets, further incentivizing the borrower to meet its ESG targets.

However, “Sustainability-Link Loans” are a relatively recent development in Europe. For example, it was reported that:

• in May 2019, Masmovil Group, the Spanish telecom operator, was the first European borrower to include an ESG-linked margin ratchet in leveraged loan facilities, being a 15 basis point pricing adjustment linked to its third party ESG score (but noting that the pricing adjustment only applied to the capex and revolving credit facilities and not the much larger term loan debt); and
• in December 2019, Jeanologia, a Spanish developer of eco-efficient technologies for the apparel & textile industry, completed the first sponsor-backed (Carlyle) ESG-linked term loan. The margin is directly linked to a sustainability performance indicator produced by the borrower, related to its water-saving processes. If the borrower meets its targets, the margin tightens, while if the target is missed by 15% or more, the margin ratchets upwards.

In addition, the Loan Market Association (LMA) published the Sustainability Linked Loan Principles (SLLP) in March of 2019, which provide suggested criteria for setting and monitoring sustainability targets of “Sustainability-Link Loans”. The criteria are meant to be ambitious and meaningful to the borrower’s business. The metrics vary and there is no market standard, from ESG scores (provided by third party ESG rating agencies) to borrower led / specific targets (as seen in the examples above). As such, the SLLP recommend they should be negotiated on a deal-by-deal basis. However, on a related point, the European Leveraged Finance Association (ELFA) has started, together with the LMA, to engage with borrowers, private equity sponsors, arrangers, rating agencies and others in order to develop a standard set of the most relevant disclosures for the purpose of making informed ESG-related investment decisions.

Legislative Change on the Horizon

There are many legislative changes on the horizon in relation to the development of robust sustainable lending products and sustainable finance more generally. These include: (i) the Taxonomy Regulation, which is expected to be formally adopted, introducing an EU-wide classification of environmentally sustainable activities; (ii) the Disclosure Regulation (main provisions coming in to force from March 2021), which will impose new transparency and disclosure obligations on certain firms; (iii) the Low Carbon Benchmark Regulation, effective as of December 10, 2019, which will continue to set out minimum requirements for EU climate transition benchmarks and ensure that these benchmarks can work alongside other pre-existing ESG objectives; and (iv) the development of technical standards by the ESMA on disclosure provisions for sustainable investments during 2020. From an investor/lender perspective, the Disclosure Regulation (noted at (ii) above) will be key, as it will require certain firms, including asset and fund managers, to comply with new rules on disclosure, as it regards to sustainable investments and sustainability risks.

Furthermore, it was reported this week that the current European Commission is prioritizing climate change in all sectors, including in financial services. An update to the law known as the “Green Taxonomy” would require banks, insurers, and listed companies with more than 500 staff members to report how much of their expenses are put towards environmental initiatives such as reduction of greenhouse-gas emissions. In a quest to widen its net, the European Commission is hoping to broaden the scope of the non-financial reporting even further in the legal proposal that is due by the end of 2020. The proposal likely seeks to cover asset managers, as well as large unlisted companies. Although some unlisted companies, such as Ikea, already do produce voluntary reports on sustainability, these new requirements may come less favorably to those companies seeking to avoid higher reporting burdens by staying off the public markets or to companies headquartered in more climate-skeptic countries.

Although changes to the regulatory capital treatment of sustainability linked debt are in contemplation at both a European and UK level, they are in their infancy. Currently, the focus of regulators appears to be on driving a conscious governance and disclosure framework and on integrating ESG risks into the management policies of regulated firms.

Recent Reports and Strategy Statements

Several reports and strategy statements have been published in recent weeks by a variety of prominent industry regulators and trade bodies in respect of ESG. Some highlights include:

The European Securities and Markets Authority (ESMA) published its Strategy on Sustainable Finance on February 6, 2020, setting out how ESMA will prioritize sustainability by embedding ESG factors in its work. The key priorities for ESMA include transparency obligations, risk analysis on green bonds, ESG investing, convergence of national supervisory practices on ESG factors, taxonomy and supervision. Steven Maijoor, Chair, said: “The financial markets are at a point of change with investor preferences shifting towards green and socially responsible products, and with sustainability factors increasingly affecting the risks, returns and value of investments. ESMA, with its overview of the entire investment chain, is in a unique position to support the growth of sustainable finance while contributing to investor protection, orderly and stable financial markets.”

The Investment Association (IA), the trade body that represents UK investment managers, published its Shareholder Priorities for 2020 report in January of this year. In the report, the IA noted its support for the recommendations made in the Green Finance Strategy released in early July 2019 by the UK government. Such recommendations set out two objectives: 1) to align private sector financial flows with environmentally sustainable growth that is supported by government action; and 2) to increase the competitiveness of the financial sector in the UK.

The UK Sustainable Finance and Investment Association (UKSIF) published a report on February 6. The report found that pension scheme trustees are failing to comply with their investment duties. Following a change to the law in 2019, trustees must publish their approach to protecting people’s pension savings from the financial risks of climate change and other ESG issues. UKSIF report: 1) found that only one third of a representative sample of trustees have complied with the legal transparency requirements and are calling for the Pensions Regulator to carry out a review to investigate levels of compliance across the UK’s pensions sector; and 2) looked at the different policies trustees have adopted to comply with the new regulations. It found that although most trustees say they believe ESG issues will affect the financial performance of their scheme’s assets, most trustees have adopted “thin and non-committal” policies to manage ESG financial risk.

Summary

In short, ESG is no longer a peripheral exercise thanks to investor demand, regulation and greater certainty about the link between ESG risks and long-term financial performance. And as noted above, the focus on sustainability and ESG is only increasing.