DealMakers - Q2 2023 (released August 2023)
Using sustainability-linked financing for impact to achieve ESG goals
by Khurshid Fazel
The adoption of sustainability-linked financing (SLF) instruments by borrowers is primarily driven by their growing realisation that these instruments are a valuable tool to achieve their ESG objectives, which outweighs the associated costs.
This was the topic of a recent podcast hosted by Khurshid Fazel, in a discussion with borrowers and a lender.
The banks’ financing decisions shape the economy, so the way that they structure SLF can be used to bring about positive impacts. SLF presents borrowers with an opportunity to embed sustainability into their operations and activities in a manner that promotes accountability. In this way, SLF creates a symbiotic relationship between lenders and borrowers.
Two examples of how SLF was used to achieve impact outcomes are demonstrated by a property group and a diversified industrial group.
The property group secured SLF to install solar PV on the rooftops of its warehouses, for its tenants. The lending bank discussed appropriate key performance indicators (KPIs) and milestones that had to be achieved in order to obtain preferential terms, and the achievement of these targets had to be independently verified. This data helps to give confidence to investors, lenders, and the property organisation that it is following the right path.
The advantages for tenants in this example were not only that the solar PV reduced their energy cost and provided reliable power, but also that some of them have international customers that impose certain sustainability requirements on the companies with which they do business. Taking steps to be a sustainable business can help a business get more contracts. Also, with reliable and relatively cheaper power, tenants can produce more efficiently and price more competitively. The driver of SLF in this case was accountability and commitment. For the borrower, what gets measured, gets done.
In a second case, a diversified industrial group with operations in Africa and Asia has put considerable effort into programmes that epitomise sustainability. This group, which publishes its sustainability KPIs on its website, has taken on four financing instruments that are ‘green’ or sustainability-linked, including a gender bond which is listed on the JSE.
The listing of the gender bond introduced new global investors, enabling the business to tap new sources of funding. Impact investors are looking to invest in companies that contribute to the common good while delivering a return. The gender bond has two goals: transforming the gender ratio of employees, and seeking more female-owned businesses to participate in the supply chain. After the launch of the gender bond, female-owned businesses have come forward, instead of having to be searched for. In this example, SLF was used to raise awareness on an important issue for the borrower, and to inspire action on the issue amongst its stakeholders.
Accountability, awareness and action are drivers of SLF
Setting out sustainability KPIs on a public platform means that the world can see them. If a business does not fulfil its commitments, not only will there be a pricing adjustment on the SLF, but the public will be aware that the business fell short, which carries reputational risks. Companies that claim a commitment to sustainability but whose actions do not reinforce the message are likely to be accused of greenwashing.
There are often significant costs for the borrower associated with putting the necessary systems in place to fulfil its commitments, pursuant to the SLF.
Firstly, the commitments require buy-in from the whole organisation and key stakeholders, because sustainability touches on many different aspects.
Secondly, the sustainability programme must have oversight from the board of directors. A company that thinks carefully about what is important to its stakeholders and community, and tailors its funding and strategy around those objectives, may be better able to achieve its KPIs than one which is merely pursuing sustainability because everyone else is.
Thirdly, a company may already have certain sustainability objectives, but taking on SLF and making its KPIs public is likely to make fulfilment faster and more effective than if the goals are internal, with moveable deadlines. But this comes with reputational risk if targets are missed.
Some borrowers may consider the marginal adjustment on the SLF that is gained by meeting the KPIs agreed with the bank as insufficient to offset the cost of putting measurement systems in place and bringing in verification agencies. But the margin adjustment on the loan does not appear to be the ultimate driver or advantage of SLF. The starting point should be a careful consideration of the levers of sustainability that the business should put in place to drive revenues, keep costs down, and build a brand in the market. Purpose is important, but so is profit.
Setting stretch targets
A borrower has to travel a journey with its lender before reaching the stage of drawing up a term sheet. Some borrowers have established sustainability strategies, but if their targets are not particularly ambitious, the bank is likely to raise the possibility of doing more. In evaluating whether the current targets are ambitious or not, it will look at how the organisation has performed in the last two to five years or against its peer group, and how material its commitments are to its size and power. For some borrowers who do not yet have the building blocks in place, the bank can give advice.
One of the ancillary benefits of setting sustainability targets, taking on an SLF instrument and monitoring progress against KPIs is that it helps to strengthen governance in an organisation. As SLF matures in SA, it will become more regulated – the JSE has already put out sustainability disclosure guidelines – and choosing legal and financial partners who understand the underlying values of SLF will smooth the journey.
Fazel is a Partner | Webber Wentzel.