The basics: What is ESG Lending?

This article looks at what ESG means, what we really mean when we talk about ‘ESG lending’, and the types of ESG lending available.

When people talk about ‘ESG Lending’ they’re often talking about sustainable lending - encompassing social loans, green loans and sustainability linked loans. Potentially available to all businesses, now is a great time to get familiar with these types of products, as well as the corresponding jargon.

ESG

‘ESG’ stands for Environmental, Social and Governance. Each component represents a group of factors against which a business can assess its actions and behaviours, and on which some (and soon to be most) businesses are required to report. 

The three factors are currently considered to be a driver of value for organisations in terms of access to capital, regulatory compliance and customer satisfaction and cover  issues as broad as climate change and pollution to community and customer relations, customer satisfaction, Diversity, Equity and Inclusion, ethics, compliance and corporate transparency:

Environmental

Impact on the environment and sustainability. Often focussed on greenhouse gas emissions including scope 1 (emissions made directly, such as burning fuel), scope 2 (indirect emissions, like those made generating energy used by the business) and scope 3 (emissions up and down a business’ value chain), but also covers any other steps towards net zero as well as biodiversity and waste.

Social

Impact on employees, communities and society as a whole, and how to better them. At a local level looking at equality and diversity, training provision, wellbeing support and community projects and more widely, looking at these issues up and down a value chain as well as considering e.g. human rights, modern slavery and health and safety.

Governance

Ensuring accountability by having clear and fair policies, procedures and commitment to compliance with them, with sufficient transparency for this to be checked and corroborated.

For more information on the benefits of boosting your ESG credentials, please see our article ESG for mid-market borrowers: now is the time to get ahead.

Sustainable lending

There are three types of sustainable lending typically available in the mid-market (we are not covering green bonds in this article). The terms ‘ESG loan’, ‘Green loan’ and Sustainable loan’ are often used interchangeably to describe them but a Green Loan and a Sustainable Loan have distinct characteristics. 

The Loan Market Association have provided clear and succinct principles and guidance on each type of loan which should guide lenders, borrowers and lawyers when negotiating a deal and working on any corresponding documents. It should be noted that the LMA principles should act as guidance only. Each Lender will have requirements for their own Green and Sustainable products which will need to be complied with. 

A very brief explanation of the LMA guidance and principles on each type of loan is set out below:

Green Loans

The proceeds are used for a green project (and related costs) – one that provides ‘clear environmental benefits’.

Social Loans

The proceeds are used for a social project (and related costs) – one that ‘mitigates social issues / achieves positive social outcomes’.

Sustainability Linked Loans (‘SLLs’)

The most common of the three, there is no requirement that SLLs are used for a specific purpose. These are loans designed to encourage positive business models and behaviours by incentivising through ‘economic outcome’ based on performance against KPIs, and as such are used as a transition tool. Sustainability Performance Targets (SPTs) are set - these are measured and reported throughout the term, and economics adjusted accordingly. The SPTs which are required to be meaningful and ambitious and are intended to “stretch” the borrower to ensure they are striving to behave in a measurably better way.

Any entity can qualify for a SLL loan but due to the need for SPTs to be ambitious they are typically better suited to those already committed to a sustainability strategy. 

Often the ‘economic outcome’ is a margin ratchet. These typically allow upwards and downwards adjustments, so there must be a genuine commitment to improving performance against SPTs, rather than a ‘just in case’ approach. Sometimes there is a requirement that funds saved are reinvested in sustainable activities, and so the improvements become self funding. For more information, see our article Margin Ratchets in Environmental, Social and Governance Loans.

How to prepare

Businesses which qualify for Green or Social Loans will usually have a green and/or social focus and as such will be applying time and resource to ESG already. SLLs are potentially available to all businesses, and now is a great time to look at what you can be doing to boost your ESG credentials.  

It is generally considered to be best practice for a borrower to benchmark its KPIs by arranging a materiality assessment of itself and also its industry. This helps identify what is ambitious for that borrower but more importantly what is relevant. For a high level compliance audit, you may find our ESG 360 tool useful – available here, without charge. 

The LMA Sustainability Linked Loan Principles (updated February 2023) are a good place to start, there is also a wealth of information online, and if you have any queries our team would be happy to help.