Investors pushing for tougher green debt performance regimes

Borrowers and lenders remain keen on participating in green debt markets, but tensions are opening up between them over performance metrics, with some lenders pushing to be able to revise initial KPIs to reflect evolving scientific or industry standards, according to experts at law firm Herbert Smith Freehills (HSF).

Stacey Pang, senior associate  in the corporate debt and acquisition finance team at Herbert Smith Freehills (HSF), points to the law firm’s recent survey of finance and treasury professionals which showed that out of 80 large UK corporates (FTSE 100 and FTSE 250), more than two-thirds (71%) of respondents expect to include ESG or sustainability features in their next financing.

At 47%, sustainability-linked loans are the most likely to be implemented by firms surveyed, followed by sustainability-linked bonds (SLBs) and green bonds, each at 28%, respectively.

“When we are speaking to our borrower clients, it is clear no one wants to be left behind. Most of them are very keen to at least consider incorporating sustainability features into their financings,” says Pang.

Wary investors

Beneath the surface of this promising outlook for green debt markets, however, tensions are mounting between borrowers and lenders over performance regimes.

“Borrowers are cautious that they are not agreeing to regimes where there are moving goalposts or the lack of autonomy and transparency as the criteria against which they will be judged,” says Pang.

“They are being very careful not to agree to a regime with the lender, which exposes them to reputational risk for what is otherwise a relatively small margin and benefit for them.”

Nevertheless, HSF is seeing that lenders are becoming increasingly sensitive to any criticisms of greenwashing and that has led to a tightening of borrowing terms.

“We recently had an experience of lenders insisting upon calculation methodologies which are adjusted in accordance with developing scientific or industry standards,” Pang explains.

“Borrowers though see this as a moving goalpost and a risk that KPIs set at the outset of the financing become unrealistic, and unattainable over time.”

Minolee Shah, a professional support consultant in the debt capital markets (DCM) practice at HSF, says investors’ ESG expectations are intensifying across the DCM space.

“ESG is now very much a front and center issue for investors in debt capital markets. Their focus now is such that we are getting to the stage where in some industrial sectors they are starting to require or expect an ESG element in bonds,” says Shah.

Moreover, she notes these investors are also showing a keen interest in the wider narrative of how the ESG debt financing fits in with an issuer’s wider sustainability strategy.

Guarding against greenwashing

Investor concern over performance regimes stems to a large extent from their worries about greenwashing and reputational damage that can flow from it.

Shah says some debt products are more susceptible to greenwashing than others, with SLBs particularly worrisome to investors as issuers can use proceeds for general corporate purposes. This means they can be used to directly fund projects that have no clear beneficial impact and are susceptible to green washing.

“There is concern that sometimes KPIs and targets are not ambitious enough and that it is becoming increasingly difficult for investors to make an assessment as to how green or sustainable a bond really is,” says Shah.

“External verification is going to be important in the future, and I think we will see more regulating of providers too going forwards.”

Shah welcomes new guidance issued by the International Capital Markets Association (ICMA) in June that aims to help such address concerns by increasing SLB market transparency.

The guidance includes an updated registry of around 300 KPIs for the SLB market; new definitions for green securitisations to clarify terminology and market practices; and Q&A-based guidance  that addresses the materiality assessment of KPIs – an exercise designed to help identify and understand the relative importance of specific ESG and sustainability topics to the organisation.

The new ICMA guidance also includes a new climate transition finance methodologies registry to help issuers and investors validate their emission reduction pathways as science-based.

Give and take

Looking ahead Pang anticipates borrowers and investors will remain keen to explore sustainability linked loans, but there will need to be give and take on both sides to address investor concerns over performance regimes and greenwashing.

“Borrowers and lenders will need to work together to strike a balance between wanting to ensure that the sustainability performance targets are challenging and achievable,” Pang says.

They will also need to navigate through the concerns around greenwashing, but also ensure that borrowers remain in the “driving seat” as to setting appropriate KPIs and targets that can work for the company, she adds.

Pang notes that notwithstanding the keenness shown by borrowers for green debt across the board, she suspects they will still not welcome any suggestions that failures to meet sustainability performance targets will result in defaults into their loan financings.

“Borrowers would be wary, very wary of consequences of breach, whether contractual law or reputational,” she says.

Shah meanwhile highlights three trends she believes will gain in momentum.

“Firstly, I think we will see more in terms of legislative initiatives that are driven by a desire to improve transparency and standardisation. We may see more in terms of minimum ESG disclosure requirements in bond prospectuses,” she says.

Shah also sees issuers placing an increasing emphasis on the ‘S’ in the ‘ESG’. “Here, we are looking at incorporating social KPIs into their sustainability linked bonds or issuing sustainability bonds with a mix of social and green eligible products,” she says.

Thirdly, Shah expects that the sustainability linked bonds market will continue to grow fast.

“The SLB market grew by 75% last year compared to 2020. We expect that trend to continue and to probably attract more small sovereigns and more emerging market issuers. More issuers from the hard to abate sectors [such as cement, steel and chemicals] will hopefully consider SLBs as well,” she says.