Essential Contractual Considerations in Sustainability linked Loans

Introduction

Over the years, financial institutions have focused on credit creation for purposes of ensuring sustainable economic growth and social stability. The environmental aspect was never a key factor in lending until recently where we have seen a growing consciousness on the need to focus on environmental sustainability occasioned by the adverse impacts of climate change being experienced globally. These loans are therefore structured to incentivize borrowers to achieve predefined sustainability targets aligning financial incentives with environmental, social and governance (ESG) goals.

Kenya has taken measures towards promoting sustainable finance with the Central Bank of Kenya (the “CBK”) leading in these initiatives. CBK has taken certain initiatives towards incorporating green financing in the banking sector including:

1. The issuance of the CBK Guidance on Climate Related Risk Management in October 2021. This aims at enabling banks to assess and mitigate climate related risks on their financial operations. Banks are therefore expected to integrate the climate related risks and opportunities into their business operations, structures and governance;

• The release of the draft Kenya Green Finance Taxonomy (KGFT) for public consultation in April 2024. The KGFT is aimed at providing guidance to financial institutions in determining which activities/projects promote environmental sustainability. It sets out the criteria for determining which activities can qualify as “green” projects in the various sectors; and

• The release of the draft Climate Risk Disclosure Framework for public commentary in September 2024. On releasing the Risk Disclosure Framework, CBK indicated that it is part of its reforms aimed at greening the banking sector. The Risk Disclosure Framework focuses on providing standards on how banks access, manage and report climate related risks in line with the international best practices in sustainable finance.

There are now high societal and global expectations for financial institutions to participate in sustainability linked finance in a bid to address the global sustainability challenges and in return benefit from the new revenue streams. Further, inclusion of ESG factors in lending can help banks to identify certain risks which may not be apparent when measured using the conventional criteria.

Kenyan banks are now warming up to sustainability linked financing and their commitment can be noted through their Commitment Statement encompassed in the Kenya Bankers Association-Sustainable Finance Principles and Guidelines (KBA Sustainable Principles) which reads in part… “We the Kenya Bankers Association and representatives of the Kenyan Banking Industry, believe that in order to have long term business success, there is a need to recognize our environmental and social responsibilities while simultaneously meeting our economic responsibilities and financial objectives.” Further, the members of KBA committed to: corporate sustainability, setting up a working group (Sustainable Finance Initiative) and to develop internal capacity.

However, entering into sustainability linked loans requires careful consideration of contractual terms to ensure clarity, enforceability, and alignment with sustainability objectives. In the circumstances therefore, the inclusion of ESG factors into loan agreements and other finance documentation has thus become increasingly important in corporate financing especially in cases of sustainability-linked loans. The ESG related provisions are aimed at encouraging borrowers to meet certain pre-determined sustainability goals.

• Essential Contractual Considerations in Sustainability linked Loans

In order to achieve sustainability goals, it is important that the documentation including facility agreements in sustainability linked loans (the “Finance Documents”) take into account the key elements of sustainability linked loans in order to align with international best practices. Accordingly, this article explores essential contractual considerations in sustainability linked loans documentation:

• ESG Metrics and Indicators

Two of the key components of sustainability linked loans are:

1. Selection of Key Performance Indicators (KPIs)– KPIs are the specific goals that the borrower wishes to achieve towards meeting their sustainability goals. Sustainability Linked Loans Principles (SLLPs) recommend that the KPIs should be material to the borrowers’ business, measurable and capable of being benchmarked against the global standards. The KGFT provides guidelines that are helpful in developing KPIs for each sector in the economy which align with the national sustainability goals.

• Calibration of the Sustainability Performance Targets (SPTs)- SPTs are the set targets that the borrower commits to achieve for each KPI and they are aimed at determining whether the borrower is on track towards achieving its sustainability goals. SLLPs recommend that STPs should be ambitious and set in good faith and remain relevant throughout the term of the loan.

The ability to accurately measure sustainability is crucial to achieving sustainability development goals. Therefore, the Finance Documents should: i) clearly provide a list of indicators (physical manifestation of attainment of sustainability) and clearly defined metrics that quantify the achievement of sustainability goals; ii) define the baseline for the SPTs, the target and the calibrations; and iii) for the SPTs to be based on international standards or the standards set out under the Kenyan laws or CBK guidelines such as the KGFT. This will not only ensure their effectiveness but also reduce the risk of potential disputes over the performance assessments caused by uncertainty on whether the borrower has fulfilled their contractual obligations.

• Interest Rates Adjustments

ESG clauses often tie financial terms, like interest rates or loan conditions, to the borrower’s achievement of specific Sustainability Performance Targets (SPTs) that cover various ESG areas. Borrowers who meet these targets may receive favorable loan terms, such as a lower interest rates while those failing to meet ESG targets attract penalties and the same may amount to material default of loan obligations.

The clause on interest adjustments should therefore provide for the events that would trigger the interest rate to be adjusted upwards or downwards and the applicable margins.

• Reporting and Reviews

The Finance Documents should provide periodic assessment and review of the set metrics in order to track progress or achievement of the sustainability goals. Further, the contract should clearly:

1. set out the guidelines and principles on the reporting standards to be used by the borrower. Although there are no universally acceptable ESG Metrics, the Global Reporting Initiative- Framework for Sustainability Reporting Standards are the most widely used and internationally recognized standards for ESG reporting globally.

• provide the requirement for independent third-party verification requirement for assessing the borrower’s compliance with its SPTs. The lender may provide for specific institutions or bodies or minimum qualifications for the third-party verifier in order to ensure credibility of the independent report.

• Covenants

The covenants of the parties should be clearly stipulated and linked to the KPIs and SPTs to enable meeting of the ESG lending objectives. Further, the covenants may be modelled around the worldly recognized ESG frameworks such us the KGFT draft guidelines, the Equator Principles, the SLLPs, KBA-Sustainable Principles, IFC Sustainability Principles etc. as this will ensure compliance with recognized sustainability standards. The covenants may include requirements for provision of sustainability compliance certificate for purposes of confirming the borrower has met its SPTs, requirements for reporting and verification.

Incorporating ESG covenants into loan agreements introduces the possibility of default if these covenants are breached.

• Warranty and Indemnity clauses

ESG warranties often take the form of a confirmation that the borrower has complied with the relevant ESG policies and standards and that there have been no adverse ESG-related issues that have arisen during a specified period of time. Such clauses may capture ESG goals of the lender, risks revealed during due diligence and other matters that come to light between the signing of the facility agreement and disbursement of the facility.

Indemnity clauses are also vital to protect parties from incurring legal and financial liabilities from actions caused by the other party. This is important in such a case, for example in instances where the lenders may be tied into ESG regulatory breaches caused by borrowers due to their financing.

• Events of Default and Sustainability Breach

The Finance Documents should clearly differentiate between events of default and sustainability event/breach and stipulate which events would result in default and those that will result in a sustainability breach and the penalties/remedial actions required. For instance, failure by the borrower to meet its SPTs may not amount to an event of default but rather a sustainability breach which triggers adjustment of the interest rates or other remedial actions to be agreed on between the borrower and the lender or declassification in the event the borrower fails to remedy the breach.

Further, sustainability events may also include events which make it impossible for the borrower to meet its SPTs and KPIs e.g changes in the law or industry standards.

• Sustainability Amendment Event and Declassification

The Finance Documents may also take into account which sustainability event/breaches make it necessary for certain adjustments to be made in the contract in order to ensure that the sustainability goals are still achievable. The contract should clearly stipulate the process and requirements for amendments to be effected.

Declassification, is whereby the loan ceases to be classified as a sustainability linked loan due to breach by the borrower of its covenants. The contract should include a declassification clause which sets out what events would trigger declassification and the consequences for declassification. Once a loan is declassified it ceases to be a sustainability linked loan and the benefits of interest rate adjustments cease to apply. It is important for borrowers to ensure that a grace period is provided for remedying a breach prior to declassification taking effect.

• Conclusion

Sustainability-linked loans present a unique opportunity for businesses not only in Kenya but also globally to demonstrate their commitment to sustainability while accessing affordable financing. By carefully considering and incorporating essential contractual provisions, lenders can establish a framework that promotes transparency, accountability, and continuous improvement in sustainability performance. Collaborative partnerships between lenders, borrowers, and sustainability experts are key to driving positive impact and achieving long-term sustainability goals through sustainability-linked loans.

SOURCES:

ESG Subcommittee of the IBA Arbitration Committee, “Report on use of ESG contractual obligations and related disputes” (2023) accessed at:  https://www.ibanet.org/document?id=report-on-use-of-ESG-contractual-obligations

Isaiah Mungai Kamau and Mary Mwai, “ESG Lending: Towards Sustainability Linked Finance” accessed at:

https://www.linkedin.com/pulse/esg-lending-towards  sustainability/?trackingId=iryve%2BmQSeeDBhYc%2BKJveA%3D%3D

Isaiah Mungai Kamau and Nalianya Ian Smith, “The regulatory framework behind ESG Lending in Kenya” accessed at:

https://www.linkedin.com/pulse/regulatory-framework-behind-esg-lending/?trackingId=sxjeIgQbRieLLdqX2YnFPQ%3D%3D

Guide_to_Sustainability_Linked_Loan_Terms_August_2023_0.pdf

Sustainability Linked Loan Principles developed by the Loan Market Association (LMA), Asia Pacific Loan Market Association (APLMA) and Loan Syndication and Trading Association (LSTA)

Draft Kenya Green Finance Taxonomy, March 2024

Kenya Bankers Association-Sustainable Finance Principles and Guidelines