They could be emission reduction or energy-efficiency targets, goals around waste, sustainable sourcing, biodiversity or human rights and employee engagement objectives. Sustainability KPIs that link the cost of corporate borrowing to sustainable achievement shot to fame in 2017 after Dutch conglomerate Philips signed a Revolving Credit Facility with 16 banks that linked the interest rate to improvements in the company’s sustainability performance tagged to KPIs.
More recently, COP26 and GFANZ [Glasgow Financial Alliance for Net Zero] pledges to clean up and decarbonise bank loan books is accelerating the adoption of KPIs, increasingly supported by important new policy frameworks. EU taxonomy rules are being rolled out, classifying what is and isn’t sustainable and ending subjective sustainability claims. Elsewhere, the ISSB [International Sustainability Standards Board] is preparing new sustainability standards to guide international accounting while in the US, SEC rules on climate disclosures will introduce mandatory non-financial disclosure from corporates.
Treasury, along with the sustainability team, is actively involved when it comes to discussing which sustainability KPIs and targets to embed in debt instruments that can be used (unlike green or social bonds or loans) for any type of corporate purpose. “Treasury is convinced this is something they want to be involved in,” says Agnes Gourc, Head of Sustainable Capital Markets at BNP Paribas who advises treasury teams on integrating KPIs into their borrowing in a bespoke and iterative new process.
What is material to one business may be less relevant to another: fuel efficiency is significant in the airline industry while clothing groups have most work to do around labour rights. Good starting points to ensure KPIs are relevant and material to the overall business and its future operations include frameworks like the LMA Principles, ICMA’s Sustainability-Linked Bond principles and SASB materiality metrics, which highlight the material issues for 77 industries.
Companies will typically develop internal KPIs which they benchmark to external methodologies, explains Gourc, who highlights a step-by-step procedure that doesn’t happen overnight. It takes time determining if a KPI is material, especially when it’s attached to other companies’ (for example, suppliers and customers) sustainability efforts like Scope 3 emission targets.
Elsewhere, embedding KPIs in a deal with a tight turnaround like acquisition finance risks weak, rushed targets. In deals where time, not sustainability, is the primary driver, syndicates might not have time to undertake proper due diligence to ensure that KPIs are sufficiently robust and material says Gemma Lawrence-Pardew, Head of Sustainability, Director – Legal at the Loan Market Association (LMA).
As for a single, most important KPI? Perhaps one of the most important, and increasingly prevalent, KPIs is one that links director performance to achieving sustainability targets, says Caroline May, Partner and Head of Sustainability, Europe, Middle East and Asia at Norton Rose Fulbright. “We expect that reaching ESG targets and objectives will increasingly become part of a board or director’s KPIs,” she predicts.
Treasury Today interviewees observe that banks, not corporates, are driving most KPI uptake. “Banks have been given targets internally and are engaging with corporates through relationship teams,” says Nick Merritt, a Partner at Norton Rose Fulbright. When companies go into new rounds of funding, they are increasingly asked to introduce sustainability KPIs, while relationship teams are targeting new industries for the first time. For example, last year Norwegian tanker operator Oddfjell SE became the first shipping group to issue a sustainability linked bond tied to reducing carbon emissions.
Merritt believes that banks increasingly linking access to finance to climate KPIs heralds a future whereby lenders will exit the companies in their loan book that have not outlined their targets to net zero. In the medium term, he predicts KPIs may harden into genuine covenants that aren’t just price-linked. Instead, corporates which fail to meet them may be subject to mandatory pre-pays or defaults, and banks will likely exit the relationship. “The non-sustainable company of tomorrow risks being shunned by investors, employees and customers and need to shift their focus from stockholders to stakeholders,” he says. “Non-sustainable companies will see capital constrained.”
Loans v debt
In a loan, the interest rate will go up or down according to whether the company reaches its KPIs. In contrast, bond issuance tends not to have a step up, or premium facility: companies only get penalised if they miss their target but if they improve, there is no reward. In another distinction, KPIs embedded into loans tend to be tested annually while KPIs pegged to bond pricing are set for the life of the bond, with every detail published at inception and rarely revisited.
Treasury teams should also bear in mind the different levels of engagement on KPIs attached to either bank finance or bonds. Corporates issuing debt will communicate with their investors about the KPIs primarily during roadshows, and for some via annual engagement thereafter. Banks, on the other hand, regularly discuss companies’ ability to meet targets with conversations focused on “next steps” or target materiality and progress, says Gourc. “We look at KPIs as an engagement tool with the company. Ambitious KPIs require significant corporate transformation, requiring detailed planning and support.”
A number of challenges strew the path ahead. Fear of failure is increasingly crimping robust and ambitious KPIs as corporates, wary of the attention sustainable finance attracts from the broader syndicated and investor market, set deliberately weak goals they can comfortably achieve. “We are trying to educate people not to fear failure,” says Lawrence-Pardew.
It’s a message echoed by others who distinguish between the importance of market scrutiny of KPIs to prevent greenwashing on one hand, and the damaging outing of companies that haven’t met targets on the other. Many corporates may feel trapped in a transparency paradox, explains Merritt. “The more they disclose, the more stones are potentially thrown, yet peers that don’t disclose or set ambitious KPIs may not be subject to the same scrutiny.”
The solution? Market education that identifying and hitting KPIs is an iterative process. Sustainable KPIs set today will be different from those set in the future and old transactions will be refinanced with new KPIs reflective of the energy transition gathering pace. Shared benchmarks and market standards allow for comparison and transparency, but sustainable finance is flexible and depends on understanding companies’ own individual journey because there isn’t a one size fits all when it comes to transition. “Ongoing and significant corporate improvement is the right track,” says Gourc who says few companies are reached where they need to be. New products are also supporting corporate progress. The commercial paper and repo markets are exploring KPIs, and the derivative market is also expanding, driven by the fact KPIs don’t have to be linked to specific projects like social or green bonds.
More robust KPIs will also emerge as efforts to stop greenwashing step up. The LMA is stamping down on declassification, whereby corporates remove the sustainability label of their loan if they don’t reach the KPIs in what Lawrence-Pardew describes as one of the biggest threats to the credibility of the sustainable loan market. “There are examples of ground-breaking transactions that have received lots of publicity but never hit their KPIs. The corporate will then declassify the loan without any public announcement.”
The LMA is also flagging risks in new products. Like so-called sleeping sustainability loans whereby corporate borrowers originate traditional loans that contain dormant sustainability KPIs that can be switched on at a later stage, imply sustainability is not at the heart of the transaction. “This is a growing trend; particularly in the US, and one that needs to be treated with caution,” says Lawrence-Pardew.
In another trend, litigation is also on the rise. The non-profit monitoring group CDP recently reported “a steady increase” in the number of companies at risk of litigation because their green promises don’t match reality on the ground. The trend is most visible in the US, but now European corporates have come under fire, being sued by environmental groups for greenwashing and deceptive marketing. “The risk of scrutiny from NGOs is leading to client demand to better understand governance and reporting structures for ESG issues to ensure that they are not at risk of allegations of greenwashing and challenge from stakeholders, NGOs, investors and their own employees,” says May, signposting a stronger and more robust market ahead as companies come under increased scrutiny from stakeholders.
The biggest and most enduring challenge attached to identifying and meeting robust KPIs and preventing greenwashing is access to data. Banks are encouraging corporates to set KPIs and put sustainability targets into traditional corporate loans in a top down approach, but their existing corporate loan books lack the meaningful sustainability data needed to help set and police targets. “Information needs to be digitised and accessible on an industrial scale to enable banks to measure things like waste, water consumption and GHG emissions to create meaningful targets,” says Merritt. It gets even more complex measuring KPIs around social and governance criteria, and impact.
Despite the challenges, Treasury Today interviewees note that drawing up KPIs is a big step. Interest, homework, and discussions are vital and meaningful precursors in a long process. “As a company, you should decide when you are ready to do this type of transaction,” concludes Gourc. “Sometimes we recommend to clients to further develop their sustainable plans ahead of launching a sustainable finance transaction – and not to worry if it is for the next funding exercise.”