As with many areas of finance and investment, Environmental, Social, and Governance (ESG) consideration have increasingly made their presence known in the world of loan issuance. According to BloombergNEF, more than US$1.6 trillion in sustainable debt instruments were issued in 2021.[1] Nearly one-third of this activity occurred in loans rather than bonds. Several factors across the entire lending value chain have led to this point: convergence of broad societal interest in better outcomes, lender efforts to create a more sustainable portfolio, demand for investors to support sustainability, and sustainability commitments made by investors.

We expect that these stakeholder-led factors will continue to influence lending activity. From an agent and trustee perspective, we are looking at ESG lending implications in three areas: documentation and standardization, margin ratchets that adjust interest rates based on the borrower’s performance against ESG targets, and data and reporting needs. Quality and reliability questions remain in each of these three areas, but it is reassuring that market participants are working together to help progress on those fronts.

Categories of ESG Lending

In some cases, borrowers seek funding directly attached to projects promising ESG outcomes. The use of proceeds determines the ESG status of such loans. For example, in December 2018 (updated February 2021), leading global lending industry groups the LSTA, LMA, and APLMA published a set of Green Loan Principles, which offer a framework for loans used to finance green projects. Eligibility includes categories such as energy, resource and land use, biodiversity, transportation, water, and eco-efficient products.[2],[3]

The same consortium of groups has also published Social Loan Principles (most recently, in April 2021), where proceeds must finance eligible projects, including affordable infrastructure, housing, food security, job creation, and equitable socioeconomic development.[4]

In other cases, called “sustainability-linked loans,” the loans create incentives for borrowers to improve their sustainability profile by tying margin to specified sustainability objectives. The LSTA, LMA, and APLMA published a separate set of Sustainability Linked Loan Principles in March 2019 (updated March 2022).[5] Notably, so far these norms have emerged from industry efforts rather than from regulatory pressures alone.

 Like many banks, M&T Bank is increasing its focus on ESG in lending.

Our Environmental Risk group conducts due diligence on all commercial loans secured by real estate, to evaluate the environmental liabilities. For example, properties may be undergoing remediation under the Brownfields Program. This ensures that our financing is responsible, allows us to assist the remediation, redevelopment, and reuse of contaminated property, and helps to avoid financial losses arising from environmental issues with the collateral… qualitative assessments of the credit materiality of environmental risks consider a sector’s unmitigated exposure to five categories of environmental risk: carbon transition, physical risks, water management, waste and pollution and natural capital.

… 

Meeting the financial needs of organizations that serve our communities is a critical element of our work. Our Commercial Bank houses expert teams dedicated to providing guidance and financial services to nonprofits, education and healthcare organizations. As of December 31, 2021, there was approximately $8.01 billion in outstanding balances for commercial loans made to nonprofits, education and healthcare organizations. These organizations focus on alleviating poverty, combating hunger and malnutrition, providing basic services, supporting the healthcare needs of the underinsured and uninsured and delivering education.

Source: M&T Bank | Wilmington Trust | Together We Can: 2021 Environmental, Social and Governance Report)[6]

Green and social loans have their own specialized dynamics, requiring borrowers to provide regular (i.e., annual) reports to lenders on the use of proceeds throughout the term of the loan. As such, they will remain a discrete segment of the loan market.

However, sustainability-linked loans (SLLs) have the potential to expand. In principle, any loan could include provisions that impact loan terms based on the achievement of ESG targets by the borrower. The first six weeks of 2022 demonstrated that SLL activity remains in an upswing, with $40 billion of volume globally announced, up more than 50% from the $25.6 billion raised during the same period in a record-breaking 2021.[7]

It is also very plausible that more lenders, bank and non-bank, will seek SLLs to respond to various stakeholders, from shareholders or limited partners to regulators. In theory, SLLs can help reduce lenders’ exposure to sustainability-related borrower or collateral risks such as the impact of litigation from environmental or social harms. As standards and practices for SLLs evolve and as regulators continue to promote sustainable finance, greater market maturity may well drive further uptake of the model.

Documentation and Standardization

According to the most recent Sustainability Linked Loan Principles, “the borrower’s sustainability performance is measured using predefined sustainability performance targets (SPTs), as measured by predefined key performance indicators (KPIs), which may comprise or include external ratings and/or equivalent metrics, and which measure improvements in the borrower’s sustainability profile.”[8] In turn, targets and KPIs become part of the standard loan documentation.

Typically, a borrower in an SLL selects KPIs that measure progress against relevant sustainability targets in environment and social categories. Targets and KPIs will vary based on the borrower’s activities. In other words, an oil field services company will have different green sustainability criteria than those of a software manufacturer or media company. Likewise, a U.S.-based commercial builder or grocery retailer will have different social criteria than one with operations and markets in other regions.

Once the borrower determines targets and KPIs that are acceptable to lenders, they become part of the loan’s terms throughout the life of the loan. Borrowers must then report that information, which loan agents pass on to lenders.

However, this structure is not as simple as it seems. Sustainability criteria can include a mix of qualitative and quantitative data. The market is still learning what constitutes a relevant and material KPI, how to measure and benchmark it consistently, and whether to look to third parties to audit and validate borrower reporting. Self-reported and qualitative data, understandably, raises a certain degree of cynicism as investors, regulators, and the general public scrutinize whether ESG claims have any real-world impact.

Over time, we expect similar developments in ESG ratings to those in credit ratings. Many providers are currently emerging to provide and verify ESG metrics, though as yet, there is no recognized short-list of providers and agencies with widespread trust in the quality of their ratings. Just as credit ratings have evolved from the first publicly available bond ratings from Moody’s in 1909 and continue to change in response to market events and policy approaches, third-party ratings and scores will stabilize and, ideally, converge to consensus.

Without such consensus, the onus for clarity and reliability lies on the loan documentation. Only loan documents can address the current risks of ambiguous terms, vague target setting, and unvalidated borrower representations

Margin Ratchets

Depending on the terms of the SSL, failure to achieve specific targets results in an increase in the loan’s interest rate by a pre-determined number of basis points. Conversely, success in achieving targets can result in a reduction in interest rates. Increases or decreases depend on the specifics of the loan. Private lenders typically have more flexibility in defining the loan characteristics, margin impacts, and expectations for reporting.

Margin ratchets pre-date SSLs, but the concept has been used in this market to help create borrower incentives. According to Baker McKenzie, the typical range of an ESG ratchet is 5 to 15 basis points per increment compared to a range of 10 to 50 basis points for ratchets tied to more traditional financial ratios, payment history, and similar factors.[9]

Typically, the borrower represents to the agent that the KPIs meet or exceed the targets as determined by the loan documentation. The agent then confirms that the information provided by the borrower meets the terms of the loan and, if so, passes the borrower’s representation along to lenders, along with any margin impacts. As with other areas of loan servicing, the agent only carries out what the loan documentation says. As a result, it is critical to review any terms related to sustainability targets and their impact with scrutiny and to put a team in place with an in-depth understanding of deal specifics.

Data and Reporting Needs

The content and frequency of sustainability information to be provided by the borrower also depend on adequate transparency in loan documentation. Guidance from industry groups has defined the contours of what standardization will mean, but a lot of work remains to fill in those contours. Like other asset classes, there is a great appetite for consistent and credible data on sustainability, including agreement on what the metrics are and how best to report on them.

For agents and trustees, the ability to support more information and data around ESG will be paramount, no matter what format it takes, including unstructured, qualitative information. Our approach at Wilmington Trust has been to upskill teams to understand the nuances and extend our systems and workflows to accommodate new types of data from new sources.

Use of such data will also play a crucial role in the movement toward ESG in the CLO space. Citigroup has estimated that 20%-40% of U.S. CLO managers will incorporate ESG factors into new issue CLOs in the next two years.[10] In Europe, ESG criteria are also coming into play, primarily due to the EU’s Sustainable Finance Disclosure Regulation (SFDR).

In earlier stages, CLOs focused on “negative screening,” which used broad industry criteria to filter out loans (such as loans to toxic chemical producers or tobacco companies). Today, however, CLOs are looking to “positive screening,” where specific sustainability thresholds are set, from rating levels to metrics such as percent carbon reduction. This evolution depends on having high-quality data in the broader loans ecosystem, equivalent to more established data and compliance such as credit ratings and collateral testing.

Conclusion

The more activity we see tying loans to sustainability (either of outcomes or the borrower), the more we expect industry norms to coalesce. After all, ESG is still a relatively recent aspect of capital markets of all kinds, including loans. Getting there simply takes the participation and flexibility of everyone in the loans ecosystem, from borrowers and lenders to intermediaries and service providers. But, with the ultimate promise of using capital markets to achieve a greener and fairer world, it will be worth the effort.

 

Disclosures

Wilmington Trust’s domestic and international affiliates provide trust and agency services associated with restructurings and supporting companies through distressed situations.

This article is intended to provide general information only and is not intended to provide specific investment, legal, tax, or accounting advice for any individual. Before acting on any information included in this article, you should consult with your professional adviser or attorney. Facts and views presented in this report have not been reviewed by, and may not reflect information known to, or the opinions of professionals in other business areas of Wilmington Trust or M&T Bank.  M&T Bank and Wilmington Trust have established information barriers between their various business groups.

Wilmington Trust is a registered service mark. M&T Bank Corporation’s European subsidiaries (Wilmington Trust (UK) Limited, Wilmington Trust (London) Limited, Wilmington Trust SP Services (London) Limited, Wilmington Trust SP Services (Dublin) Limited, Wilmington Trust SP Services (Frankfurt) GmbH, and Wilmington Trust SAS) provide international corporate and institutional services. M&T Bank Corporation’s US subsidiaries [Wilmington Trust Company (operating in Delaware only) Wilmington Trust, N.A., M&T Bank, and certain other US affiliates provide various fiduciary and non-fiduciary services, including trustee, custodial, agency, investment management, and other services. Loans, credit cards, retail and business deposits, and other business and personal banking services and products are offered by M&T Bank, member FDIC. Not all services are available in all jurisdictions.

A strategy that integrates environmental, social, and governance (ESG) factors into the investment process may avoid or sell investments that do not meet criteria set forth by the investment manager. Such investments may perform better than investments selected utilizing ESG factors. There is no assurance that any investment strategy will be successful.

M&T Bank  Equal Housing Lender. Bank NMLS #381076. Member FDIC. 


[2] LSTA: Loan Syndications and Trading Association

LMA: Loan Market Association

APLMA: Asia Pacific Loan Market Association

[6] See https://ir.mtb.com/static-files/1dd4dd34-1fc3-4cca-a539-21ef5da2da19 , pp 32 and 60 last accessed 2022-04-29.