Episode 34: SPTs, KPIs, Green Project Guidelines and Digging Deeper into Sustainable Debt (Victoria Judd)

Joel Simon: ESG has been prominent in corporate headlines and in the boardroom lately, starting with a focus on the “E” in ESG. And Europe has been at the forefront of this with the U.S. to a certain extent playing catchup. Can you start us off with an introduction to some of the vocabulary and explain to us the difference between the terms “green” and “sustainability-linked”?

Judd: Sure, Joel. You’re quite right. There is an increasing amount of vocabulary in this area and a lot of TLAs or three-letter acronyms—ESG, SLL, SPT, KPI, SPO, just to name a few. But let’s just go back to the starting point. There are really two main types of financial products in this area. One is the green bond, and the other is the sustainability-linked loan, or SLL for short. The green bond is the most popular example to date of a use of proceeds financial product. And financing is raised to fund a specific project or a series of projects, and they are identified in a purpose clause of the document informing the rationale of the investment. Of course, I say “green bonds,” but there are also “blue bonds” which are for water-based products. ESG can mean sustainable bonds, which have a more generic environment, social and governance goal. Or social bonds which fund social projects. And then you have the other side of the picture, where you have sustainability-linked loans. These are loans which contain sustainability performance targets, or another three-letter acronym—an SPT. And they are set to be specific and ambitious for the relevant borrower. SPTs are then linked to a margin ratchet, so if you don’t comply with the required target, then you end up paying more interest. You may hear people talk about KPIs and SPTs. KPIs are key performance indicators, where the indicator that the company chooses to comply with, for instance say, greenhouse gas emissions. And the SPT is the target threshold that needs to be met so that you’re on the right side of the pricing mechanic in the loan. And SLLs—we talked about green bonds—SLLs can have E, S or G elements to them, so environmental, social or governance. And sometimes they can have only one or up to about three separate targets in the loan. You can obviously get financial instruments that fall somewhere between green bonds and SLLs using various combinations—financial markets are adaptive and creative. You can get, for instance, a sustainability-linked bond, which is a bond with the ESG linkage. Or you can get a green loan, which is a loan with a green purpose, or you can find things like U.S. private placements that would include one of the two mechanisms.

Simon: It’s fascinating how the market is evolving in that way. Could you describe some of the types of projects that are recognized as green and also maybe talk about outside organizations perhaps that dictate what qualifies as a green project?

Judd: Sure. Generally speaking, for the purpose of use of proceeds financial instruments, green projects are simply projects that are sustainable or socially responsible—so, good for the environment. There’s no real definition as to what consists of a green project, but the green bond principles which are produced by ICMA do provide an indicative list of the types of projects that are covered. In that list you’ll have things like renewable energy, energy efficiency, clean transportation and responsible waste management. But it’s broader than that still, because you can also have things like green buildings and ecoefficiency and pollution prevention and control. So there’s a trend here. If it’s good for the environment, then you can probably qualify. It will fit within the concept of a green bond. You could definitely have a green investment arm that’s looking to invest in certain environmentally friendly or you could also have a renewable energy company that’s looking just for money to fund something that is for its corporate purposes. There is a range of things you can do. The green bond principles that I mentioned from ICMA also have other aspects to them. It helps you choose how you select your projects, to make sure that they’re environmentally sustainable and have the right objectives and transparency. It helps you say how you should manage your proceeds—for instance, tracking them using targeted accounts. And then the third aspect—there’s ongoing reporting requirements to just make sure that we keep people up to date and provide details as to how money is allocated towards certain projects.

Simon: And how does that contrast with SPTs and KPIs that you spoke about earlier? And who, if anybody, sets the substance and/or the matrix for those criteria in the sustainability-linked products?

Judd: SPTs and KPIs are a little different approach. Instead of looking at the whole project, they’re looking at certain targets being achieved by the borrowing company or the group. In an SLL, money would be used for general corporate purposes. But then the company has to achieve certain ambitious and predetermined sustainability targets. You can negotiate those and set them depending on the position of the borrower and the sector that it’s in. The key requirements here—and again, there are some SLL principles much like the green bond principles—the key requirements are that they should be ambitious and meaningful and tied to sustainability improvements. That means that you would look at something that’s already being measured, for instance in the last six to 12 months to set them. And that you’ll also set them by reference to the sector and area that a company is in. So if you’re a supermarket chain, then perhaps decreasing the amount of plastics or ensuring new recycling might be appropriate. Whereas if you’re an energy company, then the greenhouse gas element might be something you want to report on. The key point, as with green bonds, is about transparency, and very much borrowers are encouraged to report their data rather than to SPTs on a public basis.

Simon: Right. So, you mentioned the concept of a pricing ratchet. I know that in a green debt instrument, the pricing tends to be locked in and takes in to account the nature of the project. But with a sustainability-linked debt instrument, there is a ratchet. How does that work?

Judd: The pricing ratchet is a mechanism whereby the margin flexes in the event that the SPTs are breached. For instance, you’ve got a company that has three targets, three SPTs. And then it gets tested for compliance on an annual basis. It has complied, hurray—the margin will go down, and the company will pay less interest going forward. If, however, the company didn’t comply, then the margin would stay at the previous level without any penalty. Now, that’s the simplistic model, and obviously these things are negotiated and you can have lots of variations. One of the more common variations at the moment is that the margin can go up if you fail to comply, as well, so you can get sort of a two-way mechanism. This has actually attracted some criticism in the market, because the idea is then that the banks are making money if people are failing to comply with ESG, which doesn’t sort of paint the right picture, if it’s the banks who are sponsoring the deals. One way around that is to have a lock-up account or to pay money to an NGO or charity if things go wrong. You can also have several step-downs that do different things to encourage movement across the term of the loan. Today, we usually have about five to 15 bits of variation on pricing, but who knows if that will increase in the future when people want to incentivize borrowers more. At the moment, there’s no linkage to an event of default, so the only consequence for noncompliance is a greater margin and paying more interest. That said, it’s all negotiable, so I guess we’ll see what will happen in the future.

Simon: Very interested to see how that develops in the market. Turning now to reporting obligations, I guess it would seem that those and external reviews by independent third parties could play a significant role in these financings. And there must also be some important differences between how the loan market versus the bond market would handle those requirements. What can you tell us about that?

Judd: Whether you’re actually referring to a green bond or an SLL, reporting is key. For bonds, that means keeping a record of how monies are applied and allocated to projects. For SLL, it means keeping a record of the data relevant to the SPTs. In each case, public disclosure is recommended. There’s less control in terms of reporting for bonds, just by virtue of how the money is applied. Once you’ve applied the money in the right way, there’s sort of no real ongoing control, save obviously the reputational damage if you suddenly pivot all your projects to something that isn’t ESG-friendly anymore. So certainly more limited control in those cases. With SLLs, the control tends to be more continuous, in that you have to continue to declare and say on a 12-month basis, you have an ongoing compliance covenant. Firms can try to refer to external parties to make sure they are reporting data properly. And this is where the second-party opinion comes in. For bonds, you’ve got a third party to come in to say that indeed the proceeds were used toward the right purposes. For SLLs, although this is slightly less common for SLLs, what you’re doing is getting the sustainability criteria of the KPI and calibrating the SPT to be controlled by that third party. In both cases, you’re looking at increasing credibility and getting external assurance for your financial product. At the moment, second-party opinions and this third-party validation isn’t mandatory—it’s just an extra level of comfort for the company. Given that green washing is a fact in the market, it helps you avoid that. (Green washing is really misrepresenting the facts in a way to benefit from an environmentally friendly image.) By getting a third party to come in and say, “These SBTs are in line with market,” or competitive compared to what everyone else is doing and this is indeed meaningful and ambitious. Then you are protecting yourself from accusations of green washing. You can also get third parties to come in and count things like greenhouse gases or give you an ESG rating, so there are other ways to get that third-party validation.

Simon: It’s good to see Europe leading the way on products like this, rather than taking a backseat to the U.S. It must be nice for you being based in London to be on the cutting edge of this type of product development.

Judd: It is. It’s super fun. These products have been developing for a while, so even before the green bond principles came out, you could invest in green projects, right? And the green bond and the SLL principles have taken something and sort of established a standardization. That’s the exciting part—there’s a bit of a roadmap in terms of how people can apply ESG and really apply it to their businesses. But the fun part is, like you say, seeing these metrics evolve and working out what suits our clients best because it’s still reasonably borrower driven—it has to fit their businesses. It has to fit their strategy and really be something that they can work toward. Given the new administration in the States, I’m sure the U.S. will catch up soon, and China and Asia Pacific are not far behind.

Simon: Let’s definitely keep our eyes on that. Thanks for a great discussion today, Victoria and I hope you’ll come back again with another exciting topic for us.

Judd: Thank you Joel. It’s been a pleasure to join you today and I’d be delighted to return.

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