ESG & Sustainability Insights

New principles will help the social loan market develop

9 minute read time

The growing significance of organisations’ environmental, social and governance (ESG) credibility is increasingly determining how they operate, invest and grow. In recent years, this has seen the expanding provision of financing and funding to support initiatives with specific ESG goals.

In April 2021, the Loan Market Association (LMA) published its Social Loan Principles (SLP), providing an independent framework and setting out how the loan market can facilitate and support economic activity which mitigates social issues and challenges or supports improved social outcomes.

Developed by a working party comprised of representatives from leading financial institutions and legal firms active in the global loan market, the SLP were created to promote the development of the emerging social loan product and ensure their integrity, consistency and transparency.

Hannah Vanstone, legal associate at the LMA, says: “There’s been plenty of focus on the ‘E’ in ESG, with the emergence of green loans to fund specifically green projects; and, in relation to sustainability linked loans, we’ve seen a lot of the targets set around environmental key performance indicators. But there is also a growing focus on social issues and outcomes among companies and lenders. We therefore spoke to our members about the need for SLP to mirror the Social Bond Principles (SBP) that were already in the market.”

The sharpened focus on social – the ‘S’ in ESG – came in the wake of the outbreak of Covid-19 in 2020. There was a spike in activity around ‘pandemic loans’ to mitigate the adverse outcomes of lockdown, which broadly fell under the social loans banner.

Vanstone says: “But more generally, speaking to our members there are many potential uses for these types of products. Social loans have a huge potential to fund vital social projects such as affordable housing, building hospitals and increasing accessibility to healthcare. It is a product that potentially has an extensive reach, and we hope the social loan market will continue to grow and develop with the support of the Social Loan Principles.”

Establishing consistency across social

The International Capital Market Association (ICMA) developed the SBP in 2020 for the fixed-income market. The new SLP build on those principles for the loan market, setting out a clear framework, helping market participants to understand the characteristics of a social loan, based on providing guidance around four core components also reflected in the SBP. These are: use of proceeds; process for project evaluation and selection; management of proceeds; and reporting.

Bradley Davidson, ESG lead at RBS International, says: “The SLP and SBP really are an extension of one another, and both will refer back to the other one. That’s important because you may have financial institutions raising debt through a social bond and then wanting to issue that as social lending. That consistency is important to ensure that flow-through of funding reaches the causes it was intended for, and that investors or purchasers of bonds expect it to go to.”

While the principles are voluntary, banks, for the most part, are keen to support them. Davidson says: “Ultimately, all the principles set out consistency and transparency. I think the reason we’ve seen considerable uptake of the principles, whether that is social, green or sustainability, is because all market participants, and especially banks, want to avoid the risk of ‘greenwashing’ or ‘bluewashing’ (social washing). It’s about avoiding that risk, but also providing the transparency that investors and consumers are asking for.”

“The key point is to set appropriate targets when a loan is put in place, then monitoring and reporting functions are the ones to watch. With time, the markets will likely feed back as to whether the principles are working in practice” Julia Keppe, senior counsel, Walkers, Jersey

As banks face continuing pressure to adopt ESG strategies, they will also be asked which voluntary frameworks they’re aligning to. In most cases, it will simply be more efficient to align to an external framework rather than creating proprietary methods and principles.

The market’s need and desire to standardise and provide some framework and guidelines are primarily accepted. However, the flip side to this is that with the market evolving as quickly as it is, players will require some flexibility not to deter new participants or ‘punish’ those trying to get it right. Also, so that such guidelines accommodate the different potential uses of a social loan; from sanitation to, for example, access to justice.

Julia Keppe, senior counsel, Walkers (Jersey), says: “From an offshore law perspective, we deal with the full spectrum of market participants working on transactions and agreements often governed by English law, and the feedback we have is generally positive. The voluntary guidelines generally appear to be perceived as providing a borrower with the encouragement to adopt a social loan product and also provide some level of assurance for lenders who have, at the very least, somewhere to look for guidance and the relevant considerations.

“The four principles are certainly a good start and provide some much-needed clarity around social loans. In particular, they set out what a social loan is and provide a non-exhaustive list of social projects, which helps both borrowers and lenders get it right and avoid mislabelling products.”

However, while the principles make a lot of common sense, businesses will need to make the four components work in practice. Keppe says: “The next steps are for companies to map their purpose and strategy against the core components and ensure they are meeting their requirements. As more businesses/funds do so, they will undoubtedly look for more clarification on the practical application of these principles to their deals.

“The key point is to set appropriate targets when a loan is put in place, then monitoring and reporting functions are the ones to watch. With time, the markets will likely feed back as to whether the principles are working in practice.” 

There is a broad opinion in the market that the latest SLP represents progress. Keppe adds: “With the GLPs (Green Loan Principles) and the Sustainability Linked Loan Principles (SLLP), this is another key milestone in the development of the green and sustainable finance market. There is likely more to be done, and time will tell how they work in practice, but the framework and guidance is a big step and, so far at least, is useful in practice.”

SLP could support long-term ESG transition

Davidson says that there is an upfront cost to implementing ESG financing versus traditional financing. It involves both effort and time, and there is a price to bringing in the third-party verification. 

“But where the customer will retrieve that cost is when you start to look at the cost of capital over a long-term horizon.” Being able to provide evidence that financing is going specifically towards ESG-progressive activities will benefit the customer. 

“If you look at the cost of capital, equity and investment from the investor pooled funds, we know there is an ESG preference right now. We have mounting data that says that funds adopting ESG strategies are performing better than their traditional peers.”

Evidencing progress towards ESG will allow you to maintain the current cost of capital or even reduce it by reflecting the diminished or lower ESG risk that you hold as a counterparty. Davidson says that won’t happen overnight, but it will happen over time.

What’s next for the European social market?

Earlier this summer, the European Commission published an open consultation to assess a draft report on EU Social Taxonomy; the first step in creating a framework for investors to consider investments that promote social benefit.

The social pillar subgroup has identified key differences between the social and environmental taxonomies: 

  • A social taxonomy must distinguish between inherent benefits, such as job creation, and added social benefits such as improved access to quality healthcare. This should encourage a wider assessment of activity that aims to prevent unintended consequences resulting from a narrow view of social benefits.
  • It must build upon international authoritative standards, like the International Bill of Human Rights, rather than being based only on science.
  • A social taxonomy must look at the economic entity for social aspects that reach beyond economic activity; for example tax transparency. 
  • There will be challenges in developing meaningful quantitative criteria within a social taxonomy.

Although it may take some time to reach a final draft, a social taxonomy should provide clear signals across the market and create a common language for market participants to assess social development.