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04 May 2022

An opening for sustainability-linked debt in project finance?

Corporate borrowers and lenders have responded enthusiastically to the concept of sustainability-linked lending. Jennifer Charles and Ryan Ayrton, London-based partners at Watson Farley & Williams, discuss the application of sustainability-linked debt principles to project finance.

Jennifer Charles

Ryan Ayrton

The levels of activity in the sustainability-linked loan and bond (SLL/SLB) markets are reaching staggering heights and there’s no sign of that growth stalling. Financial products with clearly identified sustainability targets offer obvious benefits to investors looking for ways of demonstrating and measuring their ESG activities.

The project finance dilemma

The SLL/SLB market is effectively open to all industries, in stark contrast to the green loan and bond markets. So there may be an opportunity for other participants in financial markets outside of substantial corporates to access this expanding pool of liquidity. Could the most rigidly-controlled borrowers – project finance special purpose vehicles (SPVs) - join the sustainability revolution?

How can project finance sponsors access the SLL/SLB market, and how can debt arrangers make that market a reliable pool of capital for those sponsors?

First, two definitions. For ease, let’s reduce a SLL/SLB to:

  • a tangible financial consequence (positive or negative) resulting from the achievement (or not) of specific, pre-defined and ambitious ESG targets for the development of the relevant operating business, which are measured, tested and reported against specific and pre-defined parameters,

and project finance to:

  • an insolvency-remote SPV with debt sized against modelled, predicted cash-flows from an asset, which may or may not physically exist at the point the financing is available.

If those definitions are accurate, then the essential tenets of a SLL/SLB are at odds with the fundamental principles of a project financing, because of the need for adaptation and investment on the one hand and specific contractual terms and regulated cash flows on the other. Even in a highly liquid, borrower-friendly market there are certain characteristics which continue to define a project finance credit.

Of particular note are these key tensions:

  • Operational data vs Clean balance sheet

In order for a borrower to improve its performance, it must by definition already be performing. Historic data will be used to set targets and serve as benchmarks. By contrast a project SPV begins life as a shell – deliberately isolated from its shareholders, with no operations beyond the concessions, permits and contractual rights that are required for it to raise debt and carry out its specific purpose.

  • Investment vs Controlled budgets

As anyone administering a project-financed construction process will confirm, applying cash according to contractual requirements can be burdensome. Waterfalls, exacting construction budgets, mandatory prepayments, contract regulation, blocked accounts, distribution conditions and reserves don’t leave a lot of wiggle room for ambitious initiatives. By contrast, lenders on a SLL/SLB for a listed conglomerate (which is likely not operating under such constraints) positively want to see new plans, large investments and capital deployed to non-essential but sustainable ends.

  • Corporate credit vs Coverage ratios

Whereas lenders to investment grade entities can assess the credit quality of their issuers, using either metrics generated by that borrower’s financial statements or external assessments, project finance lenders have (comparably) little to work with. Debt service coverage ratios are their best tool. Mechanisms which may make the debt more expensive for a project finance borrower will likely encounter some hesitancy and requirements for additional sensitivity analysis (see below).

How could a project finance loan be sustainability-linked?

Despite the hurdles above, it is possible, with a dash of contractual creativity, to introduce a sustainability linked programme to a project finance documentation suite.

Sponsors may wish to consider the following:

  • KPIs

Instead of an operational status quo, the baseline for the KPIs can be derived from the extensive and detailed project construction plan – whether that is the due diligence, the environmental reporting, the construction contracts, supply contracts, contract counterparties or the adopted technology. Formulating KPIs based on the impact of a project on the local community or the environment could use these assessments as the starting point for improvement.

  • Financial model

Arrangers will need to update their models and sensitivity analysis to ensure that a project can absorb the impact of any pricing adjustment and its impact on the ratios. A lenders’ base case will inevitably assume the negative adjustment for the debt tenor. Sponsors may therefore see a slight impact on debt sizing but on any project where gearing is not stretched to the maximum this may be an acceptable compromise.

  • Pre-negotiated flexibility

If the project company needs to enter into contracts or make adjustments to meet its KPIs then this flexibility can be built into the covenant package upfront. Even without carte blanche to re-work project documents, eligibility baskets, thresholds and objective criteria can be included to give some breathing space to a project’s operator.

  • Delayed effectiveness

There is no reason that any pricing adjustment needs to take place until the operational phase of the project, even if it is based on achievements during the construction period. A bespoke financial adjustment that aligns to a project’s construction programme and anticipated revenue schedule may be more fitting for a project than an annual adjustment based on operational data.

  • Alternative consequences

Finally, there is no reason that SLL/SLBs need to have a margin ratchet. There are many other mechanisms in a complex project finance network which could provide genuine consequence. This could be ratio adjustments, softening of distribution conditions, releases from blocked accounts, changes to mandatory prepayment thresholds and so on.

The complexity and tangibility of project finance could be its strength in this context, because it offers so many areas for adjustment and opportunity. Indeed, we have seen some SPV borrowers start to adopt SLL/SLB terms in certain narrow product areas where the KPIs could be set appropriately. It remains to be seen whether this trend will continue, particularly in the renewables space , where sponsors and lenders may consider their project already sufficiently green and sustainable. Whatever the take-up, we expect the SLL/SLB concepts will be liable to be applied creatively in more structured financings.


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