In a position paper reflecting Redbridge’s views on sustainable financing, Muriel Nahmias, Managing Director – Debt Advisory, analyzes the consequences of a foreseeable disappearance of the incentives (bonuses) commonly granted in the context of ESG financing.
For a company seeking liquidity, integrating the ESG dimension into its financial strategy has become key. Today, while numbers are still low in the US, more than 30% of syndicated loans in Europe and nearly 40% of bond private placements (notably EuroPP) include objectives based on criteria of this nature (source: Redbridge). In the euro public bond market, 26% of the amounts raised last year by all non-sovereign issuers were in the form of green, social, sustainable, or sustainability-linked bonds vs. 17% in 2020 (sources: Bloomberg, Natixis).
Sustainable finance will continue to grow until it becomes the new norm in the near future, in Europe as well as in the US. On the supply side, banks are repeating their intention to reallocate their balance sheet resources to clients committed to corporate social responsibility, while an ever-increasing proportion of fund managers’ inflows are directed towards SRI-labeled or equivalent funds.
On the demand side, the “greening” of liabilities has also become a priority for many finance departments. Last September, Redbridge surveyed European and American corporates on this topic: 61% of them had already issued ESG financing or were considering doing so in the next 18 months. Over a five-year horizon, 41% even anticipated that more than half of their financing resources would come from instruments that integrate a sustainable dimension.
Heterogeneous ESG structures
For the past four years or so, this trend towards sustainable finance has been focused on sustainability-linked financing, both in the banking sector (sustainability-linked loans) and in the bond sector (sustainability-linked bonds). These general corporate purpose finance products aim to encourage the borrower / issuer to expand its CSR approach by including a number of environmental, social, or governance objectives (usually two or three) in the financial documentation. Depending on whether or not these objectives are met, the borrower’s credit margin or the issuer’s coupon may fluctuate by a few basis points, either upwards (malus) or downwards (bonus).
In this respect, the deal structuring varies from one transaction to another. Our recent survey showed that two thirds of the sustainability-linked loans raised by the corporates surveyed incorporated a bonus/malus mechanism, and one third a malus mechanism only. For sustainability-linked bonds, the ratio was 75% to 25%. Regarding the size of the bonus/malus, it is generally +/- 5 bps for bank loans and RCF facilities, and between +/- 5 bps and +/- 10 bps or more for bonds.
A virtuous but perfectible approach
Designed to be virtuous, the bonus/malus mechanism deserves to be improved to achieve greater materiality.
First, the purpose of ESG financing is to encourage a company to grow in a more responsible and/or sustainable way. However, the bonus is far too low to be a real incentive, at an average of 5 bps in bank financing. In this respect, sustainable financing serves more to reinforce an existing CSR strategy than to give a boost in this area.
Secondly, banks like to present this bonus as a way to reward their clients for their efforts in favor of major issues, such as energy transition and social inclusion. However, as a reminder, the purpose of the credit spread is to compensate the lender for the default risk of the borrower not being able to make payments. Therefore, the ESG bonus tends to distort pricing and benchmarking. The mechanism further opacifies the banking market, insofar as lenders integrate this potential future bonus into their initial pricing. Since the transactions are different, it becomes difficult to distinguish the price of credit risk. The same goes for private placements.
Add to this the fact that we find it surprising to reward a company for keeping its commitments. Let’s bet today that in the short term, the bonus system will naturally disappear as ESG becomes the norm, leaving only a penalty.
Who benefits from the mechanism?
In a mechanism where the borrower who fails to meet its CSR objectives is penalized with an additional margin, the question of how the malus is allocated is central. Currently, the malus is allocated to the lenders in almost all transactions. The banks consider this situation to be legitimate and are even happy to claim it! For example, ING recently explained its position in these terms: ” As a credible sustainability strategy aligns increasingly with credit risk, discounts and premiums are part of a bank’s business model and we would be reluctant for them to go to charity”.
Our analysis of the subject is completely opposite. Given the philosophy of sustainable finance and the onerous costs of ESG compliance, failure to meet targets should not be exploited by lending institutions with no transparency for borrowers. The mechanism must redirect the malus to specific projects related to the energy transition or social impact managed by the company or institutions working to offset the non-completion of the sustainability targets.
Our advice to corporates
- Be a driving force in the structuring of financing
Despite the existence of guidelines (Principles) established by international organizations such as the International Capital Market Association or the Loan Market Association, practices related to the implementation of a sustainability-linked loan remain disparate from one lender to another. As banks seek to impose their own standards, it is essential to maintain control over the process of structuring the financing (nature of the KPIs used, trajectory of the targets, etc.) so that it takes into account the DNA, business model, and CSR strategy of the company. The best approach to achieve this is to surround yourself with one or two lenders who share your convictions, so that they can then convince the other participants in the syndicate.
- Negotiate a loan at the right price
If the borrower cannot avoid the inclusion of a bonus mechanism, he or she must ensure that the financial terms offered are not artificially inflated by banks anxious to cover the potential cost of disbursing the bonus later on.
- Introduce a progressive malus grid
Whether the issuer fails to meet its ESG targets by a small margin or by a large margin, the penalty will be the same, as the malus will be applied in a uniform manner. In order to make the issuer more accountable, and in order to stay in line with the “Principles”, we could consider introducing different malus thresholds.
- Making the use of the malus conditional
Last but not least, we recommend that corporates include a system for earmarking the funds corresponding to the possible excess margin or coupon in the financing documentation. Thus, this malus envelope could only be used to finance projects that contribute to compensating for all or part of the consequences of not achieving the objectives defined when the sustainability-linked loan or bond was set up.
*ING, Position paper – The credibility of the sustainability linked loans and bond markets, 2021