The Impact of Environmental, Social, and Governance (ESG) Criteria on Lending Decisions
Environmental, social, and governance (ESG) is a popular term that’s meant to represent the ethical and sustainable impacts that a company’s corporate financial interests have. As is the case with many industries, ESG criteria have become much more common with lending decisions.
The reason that ESG is more widely considered among lenders is because of the demand by investors for sustainability as well as lender efforts to develop sustainable portfolios. The lending implications associated with ESG mainly center around margin ratchets, reporting needs, and documentation.
Margin Ratchets
When looking at the terms of a sustainability-linked loan (SSL), not reaching certain goals means that the interest rate will increase. Reaching the right targets should lead to interest rates dropping. Lenders are using margin ratchets to implement borrower incentives. The standard range for an ESG ratchet is around 5-15 basis points, which is smaller than the 10-50 basis point range that occurs with standard financing.
The borrower can provide their agent with key performance indicators (KPIs) that either meet or exceed the preset targets that were placed in the loan terms. The lender will then receive this documentation and can make decisions based off of it.
Documentation
The sustainability performance that a borrower maintains is measured with sustainability performance targets (SPTs). If a borrower has obtained an SLL loan, they can measure their current progress based on the preset sustainability targets. If the lender agrees with these targets, they are placed into the loan terms.
There are, however, issues pertaining to how this information is reported. Over time, it’s likely that ESG ratings will change to better account for policy updates and market events. At the moment, reliability of these targets is based on the loan documentation.
Reporting Needs
The borrower must provide the lender with regular updates on sustainability information. However, the frequency of these updates is based on the terms put in the loan documentation. Standardization has yet to occur in this regard. Lenders want to receive credible data on a consistent basis.
Industry norms should begin to form as ESG lending activity increases. This is a relatively new framework for lending that requires participation by lenders, borrowers, and service providers alike.
Contact us to find out how we can help you close loans faster with employment verifications and 4506C income verifications.
Have questions? Speak to a Private Eyes expert for more information.