Demand for sustainability-linked loans is surging and banks are competing to offer this new form of finance in South Africa, which is driving legal firms like Webber Wentzel to innovate in the loan terms and agreements that they are drafting for clients, say Webber Wentzel partners Khurshid Fazel and Karen Couzyn.

A sustainability-linked loan or a sustainability-linked debt security, collectively referred to as SLLs, is different from a green bond or other sustainability use of proceeds debt securities.

An SLL could be used for any purpose, such as to make an acquisition, but the interest rate applicable is informed by the achievement of certain targets by the borrower on environmental, social and governance key indicators, the partners explain.

“Sustainability use of proceeds debt securities are advanced to finance one or more green, sustainable and social project. A green bond, for example, is specifically loaned to fund a green activity, such as building a solar plant. A green bond, like any other sustainability use of proceeds or sustainability-linked debt security, can be listed on the JSE Sustainability segment and is, thus, available for investment by a group of financiers, including pension funds and asset managers.”

There are usually four performance indicators in a sustainability-linked loan – three are related to the environment and one is related to social factors, Fazel and Couzyn point out.

“The environmental goals are generally quite standard, namely improving the lender’s carbon footprint, waste and water management.

The social element is, however, usually unique and is specifically tailored to the environment in which the borrower operates. For example, a sustainability-linked loan to a hospital might depend on achieving a specified level of patient satisfaction.

“These will not all be absolute goals. They could also be incremental, such as when a borrower commits to reduce their carbon footprint during the term of the loan, or even beyond the maturity of the loan, in which case yearly targets would be set during the term of the loan and their achievement would be independently verified. Whether the borrower achieves or misses its targets will influence the interest rate,” they explain.

One of the reasons that banks are able to offer SLLs at favourable interest rates is related to their back-to-back funding. Entities such as the World Bank and the International Finance Corporation will provide funding to banks for onward lending at a concessional interest rate, on condition that those funds are only lent to achieve sustainability objectives.

Using this form of finance improves the funding costs of commercial banks and they can offer better rates to their customers, Fazel and Couzyn note.

“SLLs are becoming very popular in South Africa. Sustainability-linked bonds did not fulfil the requirement of market participants for a predictable interest rate, but, on SLLs, the lender is able to take a more flexible long-term view. Over the past couple of months, we have seen several sustainability-linked instruments, issued by, for example, Redefine, Rand Water, Mediclinic and various other real estate and retail companies. We expect this trend will continue, following global trends,” they say.

“Webber Wentzel’s banking and finance lawyers have advised on several sustainability loans and bonds. This is a challenging field, because there are no previous agreements to provide a template and we are having to solve various issues along the way, creating intellectual property in the process. To date, we have handled a couple of iterations of these loans, which has enabled us to anticipate problematic areas and make improvements.”

An area where government could play a role in promoting sustainability-linked financing would be in providing more tax incentives. Currently, there are some tax incentives for companies to become more environmentally and socially responsible, but they generally achieve their objectives through penalties. Positive incentivisation is far more effective in encouraging correct behaviour, Fazel and Couzyn say.

“One of the discussion points at COP26 is around sustainable finance and mobilising public and private finance flows at scale for mitigation and adaptation. A key question to ask is how is this funding issue playing out within the South African context and what are the issues that are cropping up in the space?”

Real estate investment trust Fortress REIT has issued an interesting instrument, which has features of both a green bond and a sustainability linked bond. This is the first listed corporate five-year sustainability-linked note in South Africa, and the first where there is both a margin step down and a margin step up. The company’s cost of funding will be determined by pre-agreed performance objectives linked to its renewable energy projects and additional solar photovoltaic installation targets, the partners note.

Further, commercial property development financing company TUHF, advised by Webber Wentzel, launched the first social impact bonds in South Africa. The bonds were issued by Urban Ubomi 1, as asset-backed structure administered by TUHF and listed on the JSE Sustainability segment.