A deep dive on structuring SLLs

SMBC Group's Natalya Tueva outlines best practice for KPI selection, identifying materiality and target ambition, and the value of third-party verification for sustainability-linked loans.

Environmental Finance: How should borrowers and lenders approach KPI selection?

Natalya Tueva: When it comes to sustainability-linked loans (SLLs), the core objective is to incentivise a borrower to achieve material, ambitious, pre-determined, regularly monitored and externally verified sustainability objectives. For a borrower, it is an opportunity to demonstrate the connection between their financing and sustainability strategy.

The Sustainability-Linked Loan Principles (SLLP) by the Loan Market Association (LMA) state that KPIs must be relevant and material to the borrower's overall business. They must also be measurable and able to be benchmarked, where possible. Therefore, materiality is key. Materiality shouldn't be looked at through the lens of the borrower only, however. Equally important is how material the KPI is within the sector and how it links to what that sector is trying to achieve overall with respect to decarbonisation and the wider sustainability goals.

When it comes to Sustainability Performance Targets (SPTs), they must remain ambitious and relevant throughout the life of the financing. It is also important to identify what data is available because targets are driven by the data.

Benchmarking is a key determinant of materiality. The SLLP state that where possible the SPTs should be benchmarked against peers, industry, or international or national frameworks. This is not always easy if there is not enough data. Another challenge is if it is a completely new KPI for a business and there is no historical data available. Then, how do you conduct the benchmarking?

The SLLP now recommend annual targets for each KPI, for each year of the loan term. However, data can be an issue here as well so exemptions may be applied. For example, if Scope 3 emissions represent a material portion of the greenhouse gas (GHG) footprint of the borrower, then including them in a KPI makes sense. However, given the indirect nature of Scope 3 emissions, if a borrower has limited control to influence the outcome, and if there is insufficient data available on Scope 3, then, depending on the nature or tenor of the facility, a different approach to SPT frequency could be more appropriate: for example, every two or three years.

The SPT trajectories must also make sense. It is important to understand how a target compares with past data and how it aligns with the future objectives of the business. Where a company has a sustainability-linked programme issuance, it makes sense that the SPTs for the KPI applied across various financial instruments are aligned. Targets should not be taken in isolation but should be a part of the sustainability story of the business overall.

We often get asked the question: "What is the right number of KPIs to have?" We believe it is about the quality of the KPIs rather than the quantity. We rarely see structures with just one KPI, but if that one KPI is fully material and is in line with the type of financing needed, then one KPI could be the right choice.

So, as you can see, there are numerous factors to ensure KPIs and their targets meet the high standards set by the SLLP.

EF: Why do some KPI incentives have different basis point rates associated with them?

NT: If the materiality of the KPIs varies, considering different weightings or rates for the KPIs can be appropriate. In EMEA, we commonly see SLLs with two to four KPIs per transaction. If the materiality of a certain KPI differs quite considerably to the rest and the attribution of a different penalty or benefit – via a step-up and step-down incentive – relates to a target that is particularly important to the business and its sector, then it makes sense for this to be reflected in the weights or rates.

It also helps to pinpoint to the lenders where materiality focus lies. With different rates, you can also channel the ESG focus or journey of the company in a specific direction or sequence. For example, you could structure it so that a specific set of KPIs must be met before any adjustment can be applied, and that will direct the focus of the business to address specific material issues first.

EF: Are sustainability-linked structures converging? If not, where do necessary differences remain?

NT: The market is seeing an increased level of convergence between sustainability-linked instruments. We consider this as a positive development. This allows an issuer to have consistency in its approach when issuing an instrument in both loans, bonds, private placement, or another form of finance.

The market likes consistency across financing structures. The Principles across capital markets need to continue to be aligned so that it is less onerous for the companies to issue across multiple formats.

"The market likes consistency across financing structures. The Principles across capital markets need to continue to be aligned so that it is less onerous for the companies to issue across multiple formats."

There are some differences, however. I've mentioned that loan targets are typically set on an annual basis. When it comes to bonds there are usually just a couple of observation tests throughout the life of the instrument. It remains to be seen if this could change to annual tests as well. That's a question for the market and whether it is ready for such a development.

Furthermore, loans usually have step-up and step-down incentives. Whereas in the bond formats, there are usually only step-ups. There is a debate in the market regarding whether this should be adopted for bonds as well, but there isn't a consensus.

Ultimately, it makes sense that sustainability-linked bonds (SLBs) and SLLs converge as much as possible to streamline the approach and the processes, whilst not jeopardising the integrity of the market. Differences will remain because SLBs and SLLs serve different audiences and certain elements address the different needs of those audiences.

EF: How do you balance the need to set an ambitious target with a fear of failure of hitting it? Should it be ok to fail?

NT: Loan capital markets are largely a private market and therefore, unless you were in that deal or it was publicised in the media, you wouldn't know the ESG performance of the borrower. So, it is unlikely that a borrower is going to publicise their failure.

"The market likes consistency across financing structures. The Principles across capital markets need to continue to be aligned so that it is less onerous for
the companies to issue across multiple formats."

Regardless, the sustainability-linked market needs to get comfortable with the fact that not all KPIs can be achieved, and this shouldn't be seen as a failure. The real failure is when an SPT is set too low or does not demonstrate sufficient ambition. In situations where the bar was set too high, but the SPT was not achieved, depending on the SPT failure margin, there could be an argument that the business is pushing the boundaries and could be seen as a leader in the market. A company could miss the SPT but still outperform the industry average.

If the missed target is comfortably above the industry average, then it shouldn't be seen negatively. In the case of GHG emissions targets, if the company's transition journey is in line with its ambition and goals, then they are on the right track and are clearly pushing themselves hard to decarbonise or to transform the business. It's about having that conversation with the company. However, if the company's ESG performance was below the industry average, then it's a different conversation.

EF: With stakeholder scrutiny set to grow, will external verification become increasingly important?

NT: Second party opinions (SPOs) play an important role in the overall sustainable finance market, including sustainability- linked structures, in that they help bring additional level of comfort to the financiers – particularly in those examples where the transaction is not a clear-cut case. For example, in a hard-to-abate sector, the KPIs might be linked to a new technology which is not yet well understood by the market. Therefore, third-party verification or an additional level of objectivity would bring significant value. Where a transaction is being syndicated and depending on the market, there might be regional differences in SLL structuring, including the need for an SPO. Separately, in those instances where the financing targets institutional investors as prospective lenders then an SPO would be particularly relevant. A positive SPO could further demonstrate alignment with relevant Principles and increase the robustness of the financing structure.

Currently, there is no standardised approach across the SPO providers in terms of how the opinion is written or the methodology used. Care should be taken to assess whether the SPO includes any qualifications – and these are not always easily spotted. As such, when choosing a provider, it's important to identify what experience they have in providing SPO services in the relevant sector or jurisdiction for the loan. It is also important to identify who forms a part of the SPO assessment team and what technical knowledge they have. This will become increasingly important as the market develops further, and new decarbonisation technologies emerge.

EF: Do you think the SPO market should be regulated? If so, by whom?

NT: It is foreseeable that they will be at some point. SPO firms appear to be preparing internally for such a scenario.

It may be beneficial for the SPO industry to be regulated in a similar way to the credit rating services, for example. The challenge will be achieving a certain level of standardisation. That is difficult to achieve across ESG in general. There are so many elements to the equation of measuring ESG progress – many of which are often completely outside of a borrower's control. That ability to measure objectives or progress will also differ from sector to sector. How do we ensure the ability to compare?

EF: How has the market changed since inception?

NT: The market has been changing significantly, including from the start of this year. Two years ago, if we led a transaction, we would expect to receive a certain number of questions at a particular level of granularity. What we are seeing now is much greater levels of granularity. This is a welcome development because it demonstrates there is a desire to try and push the market in the right direction.

However, we should be mindful not to make the product unattractive or inaccessible to certain borrowers or sectors. Therefore, the right balance needs to be maintained to allow for the continued development of the sustainable finance market.

It is easy to work with companies who have already achieved a certain level of decarbonisation or progress in sustainability. They represent only a small portion of the economy. There is a lot of important work that is required for companies which are earlier on their journey. It means working with the carbon-intensive sectors and building solutions for the companies operating in those sectors, while maintaining the integrity of sustainable finance products and what they can deliver. 

Natalya Tueva is executive director, head of sustainable finance, Loan Capital Markets EMEA at SMBC Group.

For more information, see: www.smbcgroup.com/emea/