ESG principles start to shape Dutch debt financings

The Loan Markets Association (LMA), which is the driving force behind standardisation of loan documentation as well as initiatives such as interest rate reforms in the Netherlands, originally published sustainability linked loan principles (SLLPs) in 2019. 

The SLLPs were structurally revised in 2021 and their use is becoming increasingly more common in the corporate loan markets, as well as the leveraged and real estate markets. 

Incentivising ambitious goals 

Under the principles, sustainability linked loans (SLL) incentivise a borrower's achievement of ambitious, predetermined sustainability performance objectives. The borrower's sustainability performance is measured using predefined sustainability performance targets (SPTs). These targets are measured by predefined key performance indicators (KPIs), which may comprise or include external ratings and/or equivalent metrics. The KPIs measure improvements in the borrower's sustainability profile. 

The sustainability goals – the SPTs – are determined and set by the borrower and its lender group, often represented by one or more sustainability coordinators. The SPTs will be tied to one or more environmental social and governance (ESG) considerations, which are usually borrower specific. Capital intensive companies may have a focus for environmental improvements or decarbonisation, while others may emphasise having an equal level playing field for men and women. 

Key for complying with the SLLPs is that the SPTs are sufficiently ambitious and the monitoring of performance is transparent and objectively assessable. A further important consideration for the SLLPs is that the focus is on incentivising the borrower's efforts to improve its sustainability profile. The use of proceeds of a SLL is not a core determinant, in contrast to "green" or "social" loans that have their own set of principles published by the LMA. 

SLL's five components 

Each SLL has five core components. 

• Calibration of SPTs. Methodologies for the selection of SPTs can include: ambitious ESG metrics and targets, external analysis to establish sector specific ESG-criteria and performance and verified industry metrics reported against certain frameworks. Materiality assessments identify the most important ESG considerations for the borrower's business and its relevant stakeholders.
• Selection of KPIs. There should be a clear definition of the KPIs and an applicable scope has to be set out for each; for example, the percentage of the borrower's total CO2 emission to which a target is set. How the target is linked to the borrower's sustainability strategy and the calculation methodology have to be precisely defined. 
• Documenting a SLL. The source for the KPIs/SPTs and the level thereof should be clearly identified in the facility agreement. It may be necessary to give attention as to whether performance is measured as a change in absolute value of a metric or as a percentage change. A failure to meet KPIs usually does not result in an event of default that can result in acceleration. However, non-performance against the ESG criteria can have an impact on the interest rate. It is quite common for an SLL to punish a standstill or modest improvement against the KPIs and SPTs through an increase in the margin. Likewise, performance, as a function of an ambitious sustainability programme, can be rewarded by margin decreases. In the Dutch loan market, the "delta" in margin adjustments is usually relatively low; however, there have been up to 15-20 basis-point margin discounts in UK midmarket deals.
• Reviewing. The LMA acknowledges that to date there is no generally accepted methodology for reporting on SPTs. Borrowers are expected to report at least on an annual basis and are encouraged to share details of the underlying methodology and assumptions. Public reporting is encouraged where appropriate.
• Verification (external). The need for external review is usually under quite some scrutiny and should be considered on a deal-by-deal basis. The responsibilities of an external reviewer are likely depending on the nature of the transaction and the scope of the external review. However, whilst the cost aspect of an external validation can be significant to a borrower, pressure is on SLL borrowers to both at signing as well as during the lifetime of the facility engage external reviewers. This can be in the form of an independent audit or assurance statement of the performance against a borrower's SPTs. 

Osborne Clarke comment

Loans that do not adhere to the SLLP cannot be treated or referred to as SLLs. The fact that a skilled sustainability coordinator and, often, external reviewers are involved should ensure that the label "SLL" is used for those borrowers that have an ambitious and objectively assessable ESG programme. 

For most companies, this is a journey that takes longer than just one round of financing. What we often see is that the parameters are set within which a borrower can, after signing the facility agreement, agree a sustainability configuration including STPs and KPIs during the course of the loan.

Discussing and implementing ESG frameworks in loan documentation is a common feature on most deals and a sign that the loan markets take the drive towards net-zero emission in 2030 very seriously.