Sustainability-linked loans’ targets increasingly sophisticated, science-based

SUSTAINABILITY-LINKED debt in Singapore increasingly incorporates targets that are more sophisticated and science-based, in line with the growing number of net-zero commitments, industry players told The Business Times.

While details of specific loan transactions are confidential, observers and market participants say that sustainability-linked loans (SLLs) here are increasingly factoring in such targets – with their uptake showing that corporates are also cognisant of the financial benefits of improving their sustainability practices over time.

SLLs and sustainability-linked bonds vary the interest that borrowers must pay depending on the borrowers’ performance against key performance indicators (KPIs).

Sustainable Fitch said that there have been roughly 87 SLLs issued in South-east Asia since 2017, with about 60 issued in Singapore, based on Environmental Finance (EF) data.

From 2018 to 2021, more than S$39.8 billion of SLLs and green loans have been issued in Singapore, based on Monetary Authority of Singapore data.

Melissa Cheok, associate director at Sustainable Fitch, reckoned that most of the regional SLLs are borrowed by companies in the real estate, agriculture, energy and logistic sectors, based on market data and her own observations.

KPIs have largely been tied to green buildings and energy efficiency, and to direct and energy-related greenhouse gas (GHG) production – also known as Scope 1 and 2 emissions. However, indirect emissions from the supply chain – or Scope 3 – have started to emerge.

“We’ve seen some mention of Scope 3 more recently, as well,” Cheok said. “Some are also tied to sustainable sourcing of materials and also water use.”

Within the region, Singapore remains the clear leader in the SLL segment – accounting for 63 per cent of cumulative Asean SLL issuance volumes – according to the Climate Bonds Initiative’s (CBI) 2022 Asean Sustainable Finance State of the Market report. 

Fiona Gray, banking partner at Linklaters in Singapore, said the market has evolved considerably and parties are discussing and incorporating increasingly sophisticated terms into their documentation, particularly around margin ratchet mechanics and sustainability performance targets (SPTs). 

“For example, parties are discussing margin ratchet applying in a ‘two-way’ manner where, besides the discount to the margin applying where there is an improvement in performance, a premium could be added to the margin where performance declines,” she said.

Dior Lin, also a Singapore partner at Linklaters, said parties are also discussing dynamic rather than static SPTs. These require that borrowers continue to make additional improvements in order to keep receiving margin discounts, as opposed to simply hitting a one-time target.

“The selection of more specific KPIs unique to the sector in which the borrower operates is also part of the evolution of this product, which previously relied on generic ESG-related scores published by a third-party ESG rating agency to measure performance,” Lin said, referring to environmental, social and governance factors.

“It is for each lender in a transaction to determine whether the KPIs and SPTs are meaningful and ambitious, and, in any event, should not be less ambitious than any publicly announced targets.”

DBS, which began structuring SLLs in 2018, had its first loan that referenced science-based targets in 2019. Yulanda Chung, head of sustainability for the institutional banking group at DBS, said the bank works with clients to structure financing solutions that reference science-based targets where feasible.

These targets include a reduction in GHG emissions in the midterm, as well as commitments to net-zero targets in the long term.

“In setting targets, we reference several (science-informed) frameworks and principles in line with industry best practices,” Chung said.

“For example, we refer to the latest version of the ICMA (International Capital Market Association) handbook on transition finance and sustainability-linked loan principles, where having science-based targets would be considered core and relevant.”

Currently, about half of the bank’s sustainable finance deals transacted between 2018 and 2022 are SLLs. “Our recommendation of science-based targets is informed by clients’ readiness to embark on their decarbonisation road map,” Chung said, adding that different sectors are at different points along the journey to net zero.

“Science-based targets often extend farther into the future and emission reduction may not come at a linear pace. Therefore, they may not be the most appropriate for loans of shorter tenors,” she said.

“In such cases, we recommend the use of ESG performance indicators, whichever are the most material to the sectors of our clients.”

UOB said that, as part of its SLL requirements, borrowers are required to seek a Second Party Opinion (SPO) to assess that the KPIs selected are material, relevant and ambitious. The bank will avail SLLs to clients who have obtained a favourable SPO on the targets.

Lim Lay Wah, group head of UOB’s sector solutions and global financial institutions groups said that while the bank takes reference from science-based pathways whenever possible, it also eschews a one-size-fits-all approach: “Our focus is on supporting our clients within the context of their operating environment while ensuring an SPO-approved ‘ambitious’ target.”

OCBC recently announced the OCBC 1.5 degree Celsius Loan. A sustainability-linked loan product, it aims to get corporates to set and work towards science-based emissions targets.

Companies that meet or exceed their targets will get a reduced interest rate on their loans.

Mike Ng, head of the sustainability office for global wholesale banking at OCBC, said: “Many of our clients are committing to decarbonise their business activities, and we see an increasing number of them committing to targets endorsed by the Science Based Targets initiative.

“We believe that the time is right to introduce this new financing solution aligned to the 1.5 deg C scenario, as a concrete step to incentivise and partner with our clients to work towards their net-zero goals.”

While details of SLL transactions are generally not revealed to the public due to confidentiality concerns, Sustainable Fitch believes there will soon be greater clarity as to the science-based targets being incorporated into SLLs here, and even what these targets are.

“Various stakeholders are increasingly pushing for transparency from both borrowers and lenders,” Cheok said. “The uptake of this instrument which links borrowing costs to agreed sustainability targets and sustainability performance shows that companies are growing more aware of the financial benefits of improving their sustainability practices over time.”

CBI believes the “time is ripe” for regional regulators to introduce requirements for mandatory transition plans, with no South-east Asian economy having done so yet.

“Policymakers in the region should implement mandatory transition plan disclosure, and can use what has been done in other regions as a base in developing rules for the disclosure – perhaps even through a regional standard, which would bring much needed consistency between countries,” said Zalina Shamsudin, head of Asia-Pacific programmes at CBI.