Climate Change And Corporate Credit: Emerging Trends In Sustainable-impact Lending Practices – Environment – Canada Mondaq News AlertsRead More
Impact Investing Forum 2023
London. May 04-05, 2023.
Drivers toward emphasizing ESG in the debt market
Environmental, social and governance (ESG) factors have exploded
into the public discourse in recent years, especially with
increased public awareness regarding the importance of companies
using environmentally sustainable practices to stem climate
change.1 While many ESG initiatives
are focused on social or governance metrics, such as increasing
board diversity, workplace safety and equity programs, much of the
regulatory, shareholder and political attention has been focused on
curbing adverse environmental impacts.
Regulatory influences at all levels of government have amplified
the spotlight on environmental factors, in some cases mandating
that businesses reduce their carbon footprints. Canada adopted the
ambitious emissions reduction targets of the Paris Agreement, set
to be revisited this fall at the upcoming Conference of the Parties
(COP) 26 UN Climate Change Conference in Glasgow. At the national
level, the Supreme Court of Canada recently upheld the
constitutionality of the federal government’s carbon
pricing legislation, with some provinces choosing to implement
their own carbon pollution pricing systems to meet or exceed
federally mandated benchmarks.2
Corporations are facing increasing stakeholder demands for
better environmental reporting and concrete action to reduce their
corporate carbon footprints. At the same time, such pressures are
also increasing on banks and institutional investors. In some
cases, stakeholder groups are successfully pressuring commercial
lenders to divest themselves entirely of companies engaged in
upstream oil and gas production or other industries they perceive
to be insufficiently aligned with the Paris Agreement.3
Increased pressure on companies is also coming from lenders and
institutional investors themselves. On October 15, 2021, the
“Big 6” Canadian Banks – BMO, CIBC, National Bank, RBC,
Scotiabank and TD – announced their pledge to join the Net-Zero
Banking Alliance, an industry-led, UN-convened global group of
banks representing over one-third of global banking assets, which
“are committed to aligning their lending and investment
portfolios with net-zero emissions by 2050.”4 In September, the second largest pension
fund in Canada announced that it intends to divest from its
remaining oil-producing assets.5
Sustainable financing in the debt markets
The confluence of these ESG pressures has increased global
interest in sustainable financing. In some cases, financial
institutions have stopped investing in certain industries
entirely.6 Given the Canadian
economy’s current reliance on natural resources, such binary
stances on climate-oriented investments in fossil fuel production,
mining or other emissions-intensive industries could make it harder
for domestic financial institutions to deploy their capital.
ESG principles have also worked their way into debt instruments
in a more nuanced way. A borrower’s environmental performance
can be reflected in a variety of sustainable financing vehicles,
including project finance loans that incorporate the Equator
Principles, green bonds or sustainability-linked bond issuances in
the public or private debt capital markets, and social loans. All
share a common feature in that coupon or other payment obligations
are directly tied to the borrower’s or issuer’s performance
on a specified ESG-oriented goal.
Arguably the most flexible debt product to have emerged in
response to the ESG imperative is the sustainability-linked loan.
As a result of their flexibility, in our view,
sustainability-linked loans are poised to experience exponential
growth in Canada’s debt markets in the coming years.
Features of sustainability-linked loans
Sustainability-linked loans are defined as “any types of
loan instruments and/or contingent facilities (such as bonding
lines, guarantee lines or letters of credit) which incentivize the
borrower’s achievement of ambitious, predetermined
sustainability performance objectives.”7 These incentives are always tied to the
borrower’s actual performance against predetermined ESG metrics
agreed upon by the borrower and the lender group.
Sustainability-linked loans can be project-specific loans, term
loans or, unlike most other sustainable debt instruments, revolving
credit facilities used for general corporate purposes. To
legitimize and standardize sustainability-linked loans, many of
these loans are negotiated using the framework of the
Sustainability-Linked Loan Principles, most recently updated in
July 2021.8 Sustainability-linked
loans employing these principles contain four key elements:
1. The borrower’s sustainability objectives
To improve its ESG profile over time in a way that makes sense
for its business, the borrower must select a performance target
that is relevant and material to its overall business or future
strategic operating plans. Common environmental targets revolve
around reducing carbon emissions, improving energy efficiency,
generating or consuming renewable energy, conserving water,
sustainable farming, earning a recognized ESG certification or
improving a third-party ESG rating.
Loan markets are relationship-driven. By using
sustainability-linked loans, borrowers and lenders can customize
the structure of a debt instrument’s terms to reflect the
borrower’s business as well as the lender’s own
sustainability objectives. The customizable and bilaterally
negotiated performance target is an attractive feature of
sustainability-linked loans, given that blunter instruments like
third-party ESG ratings have come under scrutiny in recent years
for their biases and lack of standardization.
Whichever sustainability targets parties select, they should be
clearly defined (including a baseline level and calculation
methodology), measurable and ambitious. To meet the
“additionality” requirement of credible climate-oriented
programs, a sustainability-linked loan’s performance target
must represent a meaningful improvement in the borrower’s
current business practices. Targets should also be able to be
benchmarked against the borrower’s historical performance,
against its industry peers or against global or national
2. Loan features
Use of proceeds. A key feature of sustainability-linked
loans is that they permit the borrower to use the proceeds of the
loan for general corporate purposes. Unlike green bonds or green
loans, a borrower’s use of sustainability-linked loan proceeds
is not restricted to eligible green projects. Of course, a borrower
will need to make investments in its business to achieve meaningful
sustainability improvements, but the borrower does not need to
restrict its use of the loan proceeds to such investments.
Financial incentives. Most commonly,
sustainability-linked loans embed a discount to interest rates
payable by the borrower upon achievement of its predetermined
sustainability targets. Discount rates are case-specific and vary
based on the difficulty the borrower faces in achieving its
sustainability targets. They are always bilaterally negotiated.
Importantly, a borrower’s failure to achieve its sustainability
goals is not an event of default and does not entitle the lenders
to accelerate the loan, enforce against any collateral or trigger
cross-defaults to other debt products.
The borrower under a sustainability-linked loan must be prepared
to report regularly (at least once per year) on its actual
performance against the agreed-upon targets. Where the company has
public disclosure obligations, a public corporate social
responsibility reporting practice or other regulatory requirements
for public reporting, the public may also access the borrower’s
performance data. However, one of the benefits of
sustainability-linked loans compared to other ESG-oriented debt
products is that they permit borrowers to maintain a high degree of
confidentiality around their commercially sensitive practices and
share only the results of their actual performance against their
4. Review or third-party verification
To extend a sustainability-linked loan’s credibility, where
a borrower does not offer public reporting on its sustainability
performance, experts strongly recommend that borrowers engage in an
annual independent review of their progress. Independent
third-party review and verification of a borrower’s performance
can be conducted by qualified service providers; depending on the
nature of the sustainability target, they may be auditors,
environmental consultants or ratings agencies.
Regulatory and corporate commitments to net-zero operations or
lower carbon impacts mean that environmental considerations will
play a meaningful role in corporate decision-making going forward.
Given the large proportion of companies that access debt
instruments to sustain and grow their operations, debt instruments
like bonds and loan facilities are poised to play an important role
in holding lenders and borrowers to their sustainability targets by
providing borrowers with a carrot, a stick, or both.
The general consensus among experts is that the debt market can
expect to see a growing volume and proportion of
sustainability-linked loans. According to a Bloomberg report,
ESG-linked loans in Canada may reach $20 billion by the end of 2021
and have already increased three-fold since 2020.9 Many blue-chip Canadian companies are
committing their sizeable general corporate debt facilities to
sustainability-linked loans. Some experts predict the $3-trillion
ESG debt market could swell to $11 trillion by 2025.10 Crystallization of the Net-Zero Banking
Alliance will further incentivize banks to invest their loan
capital in sustainability-linked loans.
Flexibility and creative structuring
Sustainability-linked loans are still a nascent debt product.
Time, experience and market forces will encourage borrowers and
lenders to structure their loan terms in increasingly flexible and
creative ways. For instance, sustainability-linked loans
historically reward borrowers achieving their predetermined
sustainability targets with reduced pricing margins. Canadian bond
markets have already inverted the incentive to require borrowers
who fall short of their targets to pay increased interest
margins, mandatory donations or other financial penalties, and
sustainability-linked loans will increasingly follow suit.
Sustainability-linked loans are accessible to a wide range of
companies, even those traditionally viewed as not environmentally
friendly. New entrants to the ESG-oriented loan market will drive
creative structuring to meet the needs of these borrowers while
holding them to credible sustainability targets.
Sustainability-linked loans also offer borrowers flexibility to
combine different ESG-oriented goals into one loan product.
Further, a multi-tranche loan product obtained by a company with
several ESG initiatives could assign different sustainability
performance targets to different tranches of debt offered by a
common lender syndicate.
Sustainability-linked loan principles may also seep into
corporate loans for smaller companies or loan sizes generally
considered by lenders to be far too small for a typical capital
market issuance (e.g., green bonds). To date, the
sustainability-linked loan market is primarily limited to
investment-grade credit and blue-chip public issuers.
Increased regulation and more stringent targets and
So far, the markets for sustainability-oriented credit have
evolved on a self-regulated and voluntary basis. While
sustainability-linked loans put less onerous disclosure and
reporting obligations on borrowers than green bonds do, we expect
that more disclosure and standardization is on the horizon for
sustainability-linked loans as increased regulation around
environmental targets adds further rigour to the market over time.
In particular, as legislators enshrine certain carbon mitigation
strategies into law, the “additionality” factor will
require sustainability-linked loan targets to become increasingly
ambitious to be eligible for pricing discounts in the loan
The financial institutions providing these loan products may
themselves come under regulation or accede to voluntary standards.
In addition to the Net-Zero Banking Alliance and other voluntary
cross-border sustainable lending and investment initiatives, the
Office of the Superintendent of Financial Institutions, an
independent federal agency responsible for supervising certain
financial institutions in Canada, began consulting on
climate-related risks with federally regulated financial
institutions and pension funds in January 2021. This process will
likely guide governmental development of regulations and oversight
related to climate change on institutions in Canada.
While the flexibility sustainability-linked loans offer is a
defining benefit over other sustainability-oriented debt products,
transparency, reporting and standardization are important to
building a credible sustainable–impact financing
market and to preventing the reduction of sustainability-linked
loans to mere marketing tools. As a result, we can expect that
sustainability-linked loan-related reporting will standardize over
time and require borrowers to increase their sustainability-linked
In conclusion, there is a strong and growing impetus for lenders
and other capital providers to direct their funds to borrowers in
industries that are prioritizing ambitious, credible sustainability
practices and away from borrowers whose business operations and
future plans are not aligned with emissions reduction and other
environmental goals. Sustainability-linked loans are likely to play
a rising role in ESG-oriented debt products, which in turn are
likely to become an increasingly attractive segment of the public
and private debt markets.
1. IPCC, Climate Change 2021:
The Physical Science Basis. Contribution of Working Group I to
Assessment Report of the Intergovernmental Panel on
Climate Change. Cambridge University Press. In Press.
2. Government of Canada,
“Carbon pollution pricing systems across Canada”, online:
3. Kalyeena Makortoff,
“Shareholders push HSBC to cut exposure to fossil fuels”,
The Guardian (10 January 2021), online: (theguardian.com/environment/2021/jan/10/shareholders-push-hsbc-to-cut-exposure-to-fossil-fuels).
4. BMO Financial Group, “Six
of Canada’s Largest Banks Join United Nations-convened Net-Zero
Banking Alliance”, Canada Newswire (15 October 2021),
5. Jeffrey Jones, “Quebec
pension giant Caisse to exit remaining oil-producing assets,
setting up $10-billion green fund”, The Globe and
Mail (28 September 2021), online: (theglobeandmail.com/business/industry-news/energy-and-resources/article-caisse-jettisoning-oil-producing-assets-setting-up-10-billion-green/).
6. Matthieu Protard, “French
lender Banque Postale commits to exit oil and gas by 2030″,
Reuters (14 October 2021), online: (reuters.com/business/sustainable-business/french-lender-banque-postale-commits-exit-oil-gas-by-2030-2021-10-14/).
7. Loan Syndications &
Trading Association, Sustainability Linked Loan Principles, online:
(SLLP) at 2.
9. Esteban Duarte,
“ESG-Linked Loans Grow in Canada as Regulator Takes on
Climate”, Bloomberg (25 May 2021), online: (bloomberg.com/news/articles/2021-05-25/esg-linked-loans-grow-in-canada-as-regulator-takes-on-climate).
10. Bloomberg Intelligence,
“Game on! ESG debt issuance passes $3 trillion with record
speed”, Bloomberg (21 June 2021), online: (bloomberg.com/professional/blog/game-on-esg-debt-issuance-passes-3-trillion-with-record-speed/).
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.