In the same week the Trump administration formally notified the United Nations that the United States is withdrawing from the Paris climate agreement, luxury goods group Prada announced it had inked its first sustainability linked loan agreement with Crédit Agricole. Prada joins a growing number of companies around the world in sectors ranging from chemicals to industrials to food and agriculture to real estate who have tapped into a growing market for "green capital."

According to Bloomberg, the market for sustainable debt products reached $247 billion in 2018. $36.4 billion of that debt comprised sustainability linked loans. And market analysts expect that number to grow considerably in the foreseeable future.

A sustainability linked loan is a type of financing that aligns the borrower's performance on sustainability matters with the cost of borrowing. These loans are straightforward to structure from a legal point of view, and the credit agreement will look like most others used in customary lending transactions, with the key difference being the inclusion of clear targets by which the coupons can be ratcheted up if the sustainability goals are not met. During negotiations, the borrower develops a set of sustainability performance targets (SPTs) that relate to its own sustainability agenda against which it and its lenders agree the borrower's performance will be evaluated. Very simply, if the borrower achieves its SPTs, then the interest rate on the loan is cheaper. If the borrower's performance against the SPTs falls short, then the interest rate on the loan is higher.

Sustainability linked loans are similar to "green loans"—another form of financing that focuses on the borrower's environmental, social and governance (ESG) initiatives. One of the key differences, however, between the two forms of financing is that proceeds of green loans must be used to finance "green" projects whereas sustainability linked loans may be—and generally are—used to fund the borrowers ordinary course corporate finance and working capital needs.

How did a market for sustainability linked loans develop in the first place? Actions by the United Nations, the European Union, the World Bank have played an important role as financial institutions have voluntarily adopted the standards and practices promulgated by these influential organizations. In 2003, the Equator Principles, which incorporate the International Finance Corporation Performance Standards and the World Bank Group's technical industry guidelines for projects in emerging markets, help ensure that project finance transactions are undertaken in a socially and environmentally responsible way, helped to pave the way for more recent developments leading up to, and following, the Paris Agreement. The United Nations Principles for Responsible Investment, which encourage lenders to incorporate responsible ESG practices into their investment decisions have been adopted by many financial institutions. And finally, coming out of the 2015 Paris Agreement, the Task Force on Climate-Related Financial Disclosures, a sub-group of the Financial Stability Board, adopted a set of recommendations that are increasingly influential among financial institutions on how they should disclose information regarding the risks and opportunities presented by climate change.

The pressure on businesses to operate more sustainably is not just coming from within the organization. For lenders and borrowers alike, public pressure—from shareholders, ESG focused investors and limited partners, consumers and the public generally—has played a role. Today, no financial institution or company wants to be perceived as lacking in its CSR agenda. Sustainability linked loans offer a way for both lenders and borrowers to build their CSR credibility—while being rewarded for actually building more sustainable business practices. There is also a level of flexibility sustainability linked loans offer that green lending does not, a characteristic that makes sustainability linked loans more enticing to small and medium sized businesses. The proceeds of sustainability linked loans need not be applied to a "green" project, which for some businesses, is a non-starter because they do not have the scale or wherewithal to devote such capital resources to a standalone green project. And the benefits may not be reaped solely by the planet and its inhabitants. There is anecdotal evidence that businesses who operate on a sustainable business actually have better governance and management generally, which as a lender is important to the overall credit risk assessment of a particular borrower.

As the market for green finance has grown, some regulators and lenders have expressed concerns about the risk of "greenwashing." Greenwashing occurs when an organization markets a financial product as boosting sustainable, more environmentally friendly business practices when, in fact, that is not the case. To address issues of greenwashing and in order to provide a concrete (but voluntary) framework for the burgeoning sustainability linked loan market, in March of this year, the Loan Market Association, the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association released a set of Sustainability Linked Loan Principles (SLLP).

The SLLP center around four core criteria. Principle 1 urges the borrower of a sustainability linked loan to clearly communicate to lenders the relationship between the borrower's own sustainability objectives (as set out in its broader CSR strategy) and how those objectives align with the proposed SPTs. Principle 2 focuses on target setting and encourages borrowers to set SPTs that are ambitious and meaningful to the borrower's business. In some cases, as a condition precedent to lending, lenders may require borrowers to provide lenders with a third-party opinion as to the appropriateness of the borrower's specific SPTs. As examples, the SLLP identifies SPTs that range from consuming water to improving energy efficiency rating of buildings owned by the borrower to increasing recycling and the use of recycled materials. Principle 3 focuses on the importance of transparency in the nascent market, encouraging borrowers to make and keep readily available, up-to-date information relating to the borrower's specific SPTs—either publicly or by providing them confidentially to lenders. Finally, principle 4 focuses on review of the borrower's actual performance against the SPTs, encouraging external performance review by an independent third party, in particular for private-company borrowers who are not required by securities laws and rules of a particular stock exchange to disclose publicly a range of financial and other performance data on a regular basis.

Disclosure and third-party oversight are common themes in the SLLP. Meet a relative newcomer to the cast of characters involved in a corporate financing: the ESG rating agency. For sustainability linked loans, a handful of third-party providers have emerged as key ESG rating agencies. Sustainalytics and Viego Eiris (in which the ratings agency, Moody's, acquired a majority stake in April of this year) are two frequently seen. In brief, an ESG rating agency is named in the loan documentation as the third party that will assess the borrower's performance against its SPTs. As noted above, the margin on the loan will change by reference to whether particular SPTs are attained. As of today, no common set of criteria for measuring performance have been adopted (and none are mandated by the SLLP). Typically, the ESG rating agency will determine the borrower's overall ESG rating (expressed on a scale of 0 to 100, although some ESG rating agencies differ and use a scale akin to that of a credit rating agency). The loan documentation typically requires the borrower's ESG rating to be assessed annually and evidence thereof to be provided to the lenders. Movements in the ESG rating higher or lower than the initial ESG rating at the time the loan was entered into will determine any changes in pricing of the loan. The annual changes to the loan pricing usually reset each year to the originally applicable margin—changes are not usually on a cumulative basis.

Even though the U.S. policy on climate change seems in limbo at this moment, business is not standing still to see where policymakers ultimately land. In a world where more corporate leaders are explicitly recognizing duties to all stakeholders—not solely shareholders—companies can now be rewarded by their lenders for placing a financial bet on their ability to achieve their sustainability goals. If the growth trends in this very, very young market are any indication of what is to come, the sustainability linked loan will become a common tool that corporates and their lenders use to deliver on their ESG strategies. Their banks will reward them; that much is negotiated into the term of the loan itself. But whether their shareholders—and the growing voice of "other" stakeholders—will do so remains to be seen.

Paul Humphreys is a corporate and M&A partner, and Timothy Wilkins is global partner for client sustainability, at Freshfields Bruckhaus Deringer.