A holistic approach to environmental, social and governance (ESG) linked funding can unlock additional funding benefits for businesses. 

Understanding the various elements in the ESG umbrella and the interplay between them and determining the right funding instrument and type of funding arrangement, amongst others, are key to this and can require specialist insight from several advisors. 

ESG-linked financing 

“ESG” is an umbrella term encompassing three broad spheres – environmental aspects, social causes and governance issues. These three are often considered mutually exclusive, but this is frequently not the case and they can each be much broader than they first appear. 

Businesses tend to focus on the environmental aspects, as these are the easiest to identify and quantify, but the social and governance aspects can be equally important levers when negotiating funding arrangements. The interplay between these aspects is key to unlocking value in funding arrangements.  

Forms of funding 

In the South African market, two types of ESG-linked funding are generally made available to corporate borrowers – sustainable financing and the use of proceeds financing, also sometimes known as green loans or social loans. 

There are a few high-level risks and benefits of each, and when they might be suitable for a business.  

Sustainable financing 

• This type of funding allows borrowers to measure their performance against a set of predetermined key performance indicators (KPIs). 
• Depending on the level of performance achieved against these KPIs, the borrower can obtain a financial benefit, such as a margin reduction or access to additional funding. 
• A failure to perform against one or more KPIs can sometimes also result in a margin ratchet. 
• Depending on the number of KPIs and level of performance with individual KPIs and as a whole, the margin ratchet or reduction may be structured on a tiered basis. 

Sustainable financing typically takes the form of a loan instrument, rather than a bond, commercial paper or other securities. It is typically a better fit for larger corporates who already have: 

• Their own corporate social responsibility programmes geared towards one or more ESG objectives. 
• The relevant information and verification systems and relationships in place. 
• The requisite financial resources to implement these.  

Funders may be willing to accept pre-existing KPIs, or they may wish to set their own KPI targets or verify that the proposed targets are sufficiently ambitious. In the United Kingdom (UK) and European markets, there appears to be an emerging trend of requiring more aggressive KPI targets, both upfront and year-on-year, to avoid allegations of greenwashing. The basis for these allegations within the funding space specifically seems to be that the funders’ intervention has not caused the “good behaviour” for which both these corporates and funders are being rewarded through financial incentives. 

A similar trend for more aggressive KPI targets in the future may be seen in the South African market, and perhaps more punitive margin ratchets and structuring. 

Risks and benefits 

The benefits of a sustainable financing arrangement are that a borrower can: 

• Save on its interest costs (and often in circumstances where it is already complying or aligning with its own internal objectives). 
• Potentially access additional funding that it may otherwise not be eligible to access. 

The risks are that: 

• Failure to comply could result in an increased interest cost. 
• If the KPI targets are not set at appropriate levels, one could potentially face allegations of greenwashing. 

Use of proceeds financing (green loans) 

• The use of proceeds financing focuses on the purpose against which the proceeds are applied. 
• It can be either a loan or a similar instrument, or a security, such as bonds, notes or other commercial paper. 
• This type of funding is appropriate where it is possible to link the purpose to which the funding will be applied to an ESG-linked cause. 
• The purpose could take various forms, such as a once-off expenditure like the installation of a solar-powered system; a multi-stage project, such as the construction of a greenfields development or a brownfields expansion; or even a longer-term, ongoing initiative such as a housing or education development programme. 

This type of funding can be more accessible for a broader range of borrowers or issuers, ranging from governments, project companies and big corporates to smaller enterprises looking to fund an ESG-linked purpose. 

It is a key requirement for the borrower or issuer to disclose how the proceeds are applied for this type of funding. This may include a report on initial expenditure and subsequent reporting on the actual and anticipated impact of the funded initiative.  

Risks and benefits 

There are similar risks and benefits for this type of funding – a potential margin ratchet for non-compliance, on the one hand, and a margin reduction and/or access to additional funding on the other. 

Greenwashing also remains a risk if, for example, the purpose to which the loan proceeds are applied does not actually benefit or even indirectly support an initiative that actively harms the relevant cause.  

Issue: Which type of ESG-linked funding is best suited for a project? 

Solution: An understanding of all spheres of ESG can unlock value in funding arrangements. 

Full thanks and acknowledgement go to https://www.webberwentzel.com/ for the information in this article. Originally written by Natasha Pather, partner at Webber.