Some UK banks have begun creating “sustainability linked loans,” which include reductions in interest rates and fees if their large business clients meet ESG benchmarks. Currently, there are few standards regarding sustainability improvements and even fewer experts to create and audit progress toward these often nonfinancial goals. (Most would assume that these ESG loans would link directly to forecasted improvements in cash flow—or, at a minimum, would “ratchet” as measurable business risks were reduced (because, for example, of fewer employment lawsuits, reduction in leverage, or environmental penalties)). This should be the impact of a business’s efforts to achieve better sustainability.
So far, however, typical ESG-based commercial credit products are linked to the same financial covenants as other bank loans, which incentivize business borrowers to reduce leverage and improve their financial standing during the lending period. Less exposure means that traditional margin ratchet products benefit the business with lower interest charges.
New products link to a business’s sustainability goals—and, of course, they allow for adjustments in interest rates both down and up. The uncertain part of these loans occurs while both parties try to negotiate the triggers that adjust fees and interest rates—and how, and by whom, they are tested.
Most terms to date appear related to carbon intensity, as reviewed by the Big Four annually, but now some are even mentioning indicators such as meeting ESG disclosure and reporting requirements (even if not yet mandatory) or board diversity improvements.
One analyst commented that “lenders will be keen for these goals to be tested regularly, and ideally by a third party with specific expertise but at the moment … such experts are few and far between” and the process is costly (and inconsistent or subject to suspicious reporting), often eliminating much of the benefit to a business that achieves any ESG or sustainability covenants.
Most major UK lenders are bringing these products to market now, so, whatever the problems, it’s likely that business valuers will need to understand their role in cost-of-debt analyses.