Sustainability-linked loans and bonds

Green, social and sustainability bonds and green loans are use-of-proceeds instruments: the money must fund eligible projects. Sustainability-linked instruments flip this. The borrower can use the money for general purposes, but commits to company-wide targets, and the cost of the finance moves with performance.

This makes sustainability-linked finance useful for companies that do not have a large pipeline of separately identifiable green assets — for example a manufacturer cutting emissions intensity, a bank growing its lending to women-owned businesses, or a utility raising its renewable share.

Both the Sustainability-Linked Loan Principles (published by the LMA, LSTA and APLMA) and ICMA's Sustainability-Linked Bond Principles are built around the same five components. Lenders and investors in developed markets will expect a deal to follow them.

• Selection of KPIs: material to the borrower's core business, measurable and benchmarkable.
• Calibration of sustainability performance targets (SPTs): ambitious beyond business as usual, with a baseline and a timeline.
• Financial characteristics: how the margin or coupon changes if targets are met or missed.
• Reporting: regular, public or lender-facing updates on KPI performance.
• Verification: independent external review of performance against each target.

In a loan, the margin usually steps down when targets are met and may step up when they are missed — a two-way ratchet, commonly worth a few basis points. In a bond, the usual structure is a coupon step-up if the issuer misses its target at a set observation date.

The money involved is modest. The real value is signalling, access to a wider lender or investor base, and a disciplined way to manage the company's transition plan. Borrowers should not expect pricing alone to pay for the cost of measurement and verification.

Most criticism of sustainability-linked finance comes from weak targets. Lenders and reviewers look for:

• KPIs that cover the borrower's most material impact, not a peripheral metric.
• Targets aligned with a recognised pathway (for example a science-based emissions target) or clearly ahead of the company's past trend.
• Audited baselines, especially for Scope 1 and 2 emissions.
• A second-party opinion before signing and annual verification afterwards.

Start with a sustainability-linked loan from a relationship bank before attempting a bond: it is smaller, private and lets you build a track record on reporting. Development finance institutions such as IFC, FMO and regional development banks have anchored early sustainability-linked deals in markets where local banks have little experience, and can help design KPIs.

Data is usually the bottleneck. If you cannot measure the KPI reliably today, invest in that first — a missed or restated baseline costs more credibility than a modest target.

Deals in developing countries often need extra work on KPI baselines, verification capacity and local regulation. Co-lending with a development finance institution, or using a development-bank guarantee on part of the facility, can bring the risk into your appetite while keeping the deal aligned with the market principles your investors expect.

Use the database to identify development finance institutions, commercial banks and funds active in the borrower's country and sector before structuring the syndicate.

Sustainability-linked loans are arranged by the borrower's relationship bank, usually acting as sustainability coordinator alongside a syndicate. In developing countries the realistic arrangers fall into three groups. Check each institution's profile on our database for the countries and sectors it currently covers.

• Pan-African and regional commercial banks with sustainable-finance desks, which arrange loans for corporates in their home markets.
• International banks with emerging-market lending teams, typically for larger corporates and syndicated facilities.
• Development finance institutions such as IFC, FMO and regional development banks, which anchor or co-lend on early deals and help design KPIs where local experience is thin.

Choose a green bond or green loan when you have specific, identifiable green assets to fund — a solar plant, an efficient building, a water system — and can track where the money goes. Choose a sustainability-linked loan when the money is for general corporate purposes but you can commit to measurable company-wide targets.

Bonds need a public listing, a rating or investor roadshow and a larger size, so they suit established issuers. A sustainability-linked loan is private, can be smaller and is usually the first step for a company building a sustainability-finance track record.

• Use of money — green bond: ring-fenced to eligible projects. SLL: general purposes.
• What is promised — green bond: how proceeds are spent. SLL: hitting performance targets.
• Pricing link — green bond: usually none. SLL: margin moves with target performance.
• Typical first step — green bond: established issuers. SLL: companies with a relationship bank.