The evolution of the sustainable finance market is generating opportunities for borrowers across the full range of sectors, sizes and sustainability objectives. NatWest's Gustavo Brianza and Nick Bulloch dig into the details of sustainable loan and private placement structuring.
Environmental Finance: A growing number of borrowers are looking to influence and report climate action across their supply chains and, as part of this, include KPIs and sustainability performance targets (SPTs) for Scope 3 emissions in their sustainability- linked loans (SLLs). What should they bear in mind?
Gustavo Brianza: We are seeing a growing expectation that borrowers work with their supply chain on climate action and thus include, for example, Scope 3 targets within their sustainability-linked instruments, ideally reflecting the borrower's most material Scope 3 categories. This is most important where Scope 3 represents the majority of their greenhouse gas (GHG) emissions. Scope 3 SPTs can be set on, for example, absolute emissions, which is the most comprehensive measurement, emissions intensity, or on supplier engagement metrics.
However, the continued challenges around the availability of high-quality chain climate data as well as over control and influence, continue to constrain borrowers' ability to create SPTs which reflect the entirety of Scope 3 material emissions. Alternatively, some borrowers include partial Scope 3 KPIs, covering the most material and accurately reportable categories. Borrowers have also used proxy KPIs, which influence specific Scope 3 categories – such as the percentage of suppliers with their own Scope 1 and 2 reduction targets, or which target an increase in the use of sustainable materials and resource efficiencies across the value chain.
EF: To what extent can targets aligned with the Science Based Targets initiative (SBTi) stand in for explicit Scope 3 targets?
Nick Bulloch: Up to a point. For companies with a large Scope 3 footprint (more than 40% of total emissions), SBTi alignment requires targets to cover at least two-thirds of Scope 3 emissions. In the past, that alignment was typically considered the gold standard for lenders. However, we're now seeing increased information requirements about these SBTi targets, given methodology changes, including on the temperature alignment targeted, Scope 3 categories covered, and type of target set. This is the result of wider scrutiny of the SBTi's methodology and demands for increased transparency. Consequently, companies are pushing to target the most material of the 15 possible Scope 3 categories, align the ambition of SPTs within the 1.5°C scenario, and provide more granular and transparent disclosure on SPTs.
"Green use-of-proceeds loans or green asset finance can help suppliers fund emission reduction eligible activities, thereby reducing buyers' Scope 3 emissions" - Nick Bullock
Lenders and borrowers also need to consider the SBTi's evolving minimum acceptable thresholds. For example, the SBTi's Forest, Land, and Agriculture Guidance (FLAG) requires companies to publicly commit to zero deforestation in addition to their emission reduction targets. Helpfully, the SBTi's new supplier engagement guidance and training can support companies in engaging with suppliers to holistically target Scope 3 emissions (including with training packs, for example).
This engagement could also extend to educating suppliers on how they might finance projects to reduce emissions. For example, green use-of-proceeds (UoP) loans or green asset finance are being introduced by buyers and banks – including NatWest – to help suppliers cost-effectively fund emission reduction eligible activities, which helps reduce Scope 3 supply chain GHG emissions for the buyer.
EF: How much interest are you seeing in green and sustainable committed UoP loans, compared with SLLs? How can they be deployed?
GB: In the bond market, UoP (green) bond volumes dwarf sustainability-linked bond volumes. It's the other way round in the loans market. However, a UoP loan can provide 'ESG- labelled' financing for smaller projects or suppliers to effect climate action. For example, NatWest can extend UoP loans of less than £1 million ($1.3 million), compared with UoP bonds which usually demand hundreds of millions in funding requirements. UoP loans are thus ideal for funding ESG projects that have lower capex requirements, such as social projects and local environmental projects (e.g., biodiversity or 'quick-wins').
While they are in the process of developing company-wide KPIs and SPTs for potential SLLs, borrowers could also use UoP instruments to fund eligible projects in specific areas of their business which would not be material enough for a business-wide KPI, or which take longer to deliver impact than the typical tenor of an SLL. UoP instruments are therefore ideal for long-term 'project finance' style loans.
As Nick mentioned, UoP loans can also have an important link to Scope 3 emission reductions of large corporate buyers, by providing attractive financing for their smaller suppliers to fund projects which reduce suppliers' own Scope 1 and 2 emissions. Both banks and large corporates can thus have an incentive to suggest such financing alternatives to their suppliers. For example, NatWest has partnered with McCain Foods to help its potato suppliers access finance for transitioning to sustainable agricultural practices.
EF: What about combining UoP instruments and SLLs?
NB: A UoP facility can be used alongside a sustainability-linked instrument to illustrate a company's holistic sustainability strategy, showing the full range of ESG projects that the company undertakes, while KPI-linked borrowing can show the company's transition on the most impactful topics within its materiality matrix. As part of a wider financing, UoP loans can represent a smaller tranche of a larger facility, which is used to fund eligible green and/or social projects (for example at a lower cost) while the rest of the facility is used to fund general corporate purposes.
EF: What are the key considerations for lenders with respect to missing SLL targets as documented in loans?
NB: Lenders are aware that SPTs in SLLs are an illustration of a company's transition, and wider context on a borrower's transition is vital to understand its overall impact. In our view, borrowers should be more worried about easily achieving their SPTs every year, as it could imply the targets were insufficiently ambitious. The Loan Market Association (LMA) SLL Principles and Guidance are clear that borrowers should set ambitious targets, and it's important to have solid evidence and narrative for discussing with lenders why targets are ambitious and were or were not achieved. SLLs are private transactions, and therefore aren't subject to the same public scrutiny as sustainability-linked bonds – this allows for greater dialogue with lenders about these topics
For example, an SLL with interconnected KPIs could see a company missing one SPT while achieving another more urgent one, such as achieving a GHG emissions reduction SPT while missing an SPT for the percentage of electric vehicles (EVs) in its fleet. Missed targets might also be influenced by the non-linear implementation timelines of environmental or social initiatives, by wider geopolitical and economic shifts (such as EV supply chain delays), or by material corporate events, including M&A and divestments. For all these reasons, transparency and dialogue with lenders on SPT performance are crucial.
Just as performance share plan awards typically have a threshold target, with a success range of incremental targets, SLL SPTs could be viewed similarly: as long as a clear rationale has been provided for performance, with context on why and by how much the borrower missed the target. For example, some sectors might be relying on future technology, the deployment of which might be delayed. Here, the company might want to show the amount invested in R&D and provide further context on future impact.
There are a number of approaches and innovations for borrowers to consider when structuring SLLs, which can amplify an SPT's materiality and ambition:
- Tiering targets: SPTs can include three target ranges for the margin adjustment: 1) at a discount, 2) at no adjustment, or 3) at a premium. These thresholds allow the borrower to increase the ambition of the discount target which could, for example, be more ambitious than the 'public' target with the rationale that only achieving the most ambitious SPT range triggers a discount (and reaching the public target triggers no adjustment).
- Expanding methodologies: In some health and safety KPIs, companies have expanded the KPI to include contractors and subcontractors (who typically have higher incident rates) or include 'near misses' via a serious incident frequency metric. This can provide a more proactive metric in comparison with the 'lost-time injury rate', which can be more reactive. Another example is to expand the target population for diversity KPIs beyond board or executive level.
- Weighting economic impact: This involves increasing the number of KPIs included in an SLL while weighting the margin adjustment to the most material ESG-topic KPIs. This allows for the inclusion of additional KPIs that illustrate less material but nonetheless important ESG elements within a company's transition.
- Setting two KPIs for one SPT: This can involve setting, for example, an individual Scope 1 and 2 KPI alongside a separate Scope 3 KPI to achieve one overall GHG emissions SPT. We believe this can add transparency and specificity to SPTs in some situations. A company could, for example, combine SPTs to reduce total food waste and increase food donations. Given that food waste is typically created within the supply chain, at point of sale, and by the end consumer, companies typically target total waste, driven by the limited materiality of food donations versus total food waste. By incorporating this two-KPI structure, the company can show and incentivise its impact on total food waste with environmental and social lenses.
Similarly to looking at ESG ratings and credentials, lenders usually read the borrower's broader sustainability disclosures to ensure wider progress regardless of SPT and SLL performance.
EF: What alternatives to the loan market exist for KPI-linked and UoP financing?
GB: Although the bond market is the largest ESG-labelled market, accessing this capital requires borrowers to issue in considerable size, with specialised bond documentation, in structures aligned to International Capital Market Association (ICMA) standards, and in line with a formal published ESG framework with an accompanying public second party opinion. These elements can be costly, time-consuming and limit bond issuance to large corporates with material financing needs.
"Given growing investor demand for sustainable assets of all types, ESG-linked or UoP private placements can be an appealing alternative for companies seeking
relatively straightforward financing options which build on their existing sustainable loans" - Gustavo Brianza
However, the private placement market provides access to institutional investor funds (that is, it is not a bank market) but resembles the loan market in terms of ease of access. The documentation required is similar to loan documentation allowing UoP and/or KPI-links to be reflected relatively simply within the financing document, with the ESG element of the labelled financing being aligned to LMA and/or ICMA standards. Such placements do not require an ESG framework or second party opinion and can allow for financing in smaller sizes than bonds, with flexible maturities, and at competitive costs. Moreover, the LMA's SLL documentation rider is easing the documentation process of including sustainability clauses within SLLs, and conversely private placements aligned to LMA standards. Flexible use of this structure can be seen in the recent £241 million loan and private placement transaction from Zenobē, working with NatWest.
Given growing investor demand for sustainable assets of all types, ESG-linked or UoP private placements can be an appealing alternative for companies seeking relatively straightforward financing options which build on their existing sustainable loans.
Gustavo Brianza is managing director, ESG Advisory, Debt Advisory, and Nick Bulloch is vice president, ESG Advisory at NatWest in London. E-mails: gustavo.brianza@natwest.com, nicholas.bulloch1@natwest.com
