ESG Metrics in Credit Agreements

The genesis of the term ESG, which combines environmental, social, and governance metrics into a popular acronym, is frequently linked to a report published in 2004 titled “Who Cares Wins.”¹ The report, endorsed by a group of 20 financial institutions and commissioned in part by the United Nations, included proposals for financial institutions, investors, and companies to better implement and measure ESG metrics.

Almost 20 years later, a study by Sia Partners of 70 participants from the financial industry in the U.S. and abroad found that 92% of the participants, and 100% of G-SIB and U.S. regional banks, would like regulators to adopt more “standardized or detailed disclosure rules” related to ESG concepts.²

The U.S. market may soon receive guidance related to the environmental component of ESG that many participants have been seeking: the Biden administration has signaled a “whole-of-government effort to tackle the climate crisis,”³ and all eyes are on the SEC for anticipated rulemaking relating to climate-related disclosures⁴.

Until that time, one key motivator for companies to adopt, enhance, and document their ESG policies ahead of governmental regulation requiring it is the demand from their lenders, which is increasingly becoming the rule rather than the exception.  Bloomberg reported in May 2021 that sustainability-linked loans, which are usually revolving loans for which pricing decreases in line with meeting certain sustainability targets (or increases if the targets are missed), were up 292% compared to 2020.⁵  These loans often include a separate pricing grid that kicks in upon notice from the borrower to the agent that a metric has been met (or missed), triggering a change in interest rates and fees.

Lenders are also setting the stage for measuring their borrowers’ ESG key performance indicators (KPIs) in the future by including in credit agreements the ability to amend the agreement to adjust interest rates and fees based on to-be-agreed-upon KPIs.  In such agreements, the agent typically acts as a sustainability coordinator and works with the borrower to determine the KPIs and the adjustments to pricing and fees.

Even for loans that are not specifically labeled as “sustainability linked”, a corporate borrower often can still expect to receive a questionnaire from its lender or lenders asking for detailed information about its ESG metrics, including questions that will be familiar to corporate borrowers completing know-your-customer (or KYC) requests but with the addition of ESG-specific requests such as:

• Existence of ESG policies, audited or unaudited
• Adherence with certain ESG frameworks (most of which are international)
• Energy footprint (including waste, water, fuel)
• Carbon footprint
• HR policies
• Board composition
• Employee health & wellness programs
• Questions related to procurement and supply chain
• Community engagement
• Percentage of revenue attributable to specified industries
• Regular review and updates of programs, including employee education

There has been an uptick in fund lenders providing sustainability policies or targets to their borrowers as well.

While some companies may already voluntarily comply with certain sustainability metrics through Sustainability Accounting Standards Board (SASB) standards⁶, corporate social responsibility (CSR) reports, internal policies, and external promotion of those policies, investors’ appetite for ESG metrics, and commercial lenders’ desire to satisfy that appetite, is leading to a more formalized framework for measuring and reporting ESG metrics.