26 January 2023

Negotiating ESG financing – key areas to address

Sustainability elements are incorporated into almost all new or renegotiated financing arrangements. This change is driven by various factors, such as companies enhancing their sustainability agenda and a growing demand for sustainability from lenders, other stakeholders and society at large. In our previous article on ESG financing, we discussed the variety of available instruments and key considerations for borrowers. Since then, we have seen a substantial uptick in the number of sustainability-linked financing arrangements and an increased level of sophistication in the documentation and verification process. Sustainability-linked financing products are available to a broader group of companies since there are no restrictions on the use of proceeds. Given the rise in sustainability-linked products and developments in the standardisation of documentation, we focus on sustainability-linked solutions in this article.

There are certain key elements to be considered when negotiating sustainability-linked financing instruments, ranging from the selection of KPIs and the requirement of external verification, to declassification options. Although we do see documentation and processes around sustainability-linked products becoming more sophisticated and standardised, they remain tailor-made. We suggest that companies start considering these sustainability elements well before seeking committed financing.

Selection of KPIs and SPTs

Sustainability-linked financing products' pricing is linked to how a company performs on certain selected Key Performance Indicators (KPIs), tested against predetermined sustainability performance targets (SPTs). KPIs may relate to a broad range of environmental, social or governance-related topics, with financing arrangements typically including two to three KPIs. These could, for example, be targets relating to diversity, reduced emissions or fewer workplace incidents. Consequently, all companies could be eligible for sustainability-linked financing products. In practice, we see that environmental and climate-related KPIs are dominant, with a KPI relating to CO2 reduction being used in almost all cases.

When a company considers issuing a sustainability-linked financing product for the first time, it will need to select specific KPIs and set ambitious SPTs. Pursuant to the frameworks created by the Loan Markets Association (LMA) and the International Capital Markets Association (ICMA), KPIs must be measurable and quantifiable in addition to being relevant, core and material to the company's business. KPIs also need to be capable of being benchmarked. SPTs should be ambitious and require more from the company than continuing business as usual. In addition, SPTs should be consistent with the company's overall ESG strategy. Companies could opt to use third-party ESG ratings as a KPI.

Most companies will already have adopted broader sustainability strategies, which they can use to identify relevant KPIs and SPTs and turn these into a sustainability framework. Once developed, the company's sustainability framework can serve multiple sustainability-linked financing products, meaning that the company will only need to invest in developing a sustainability framework once. If a company has not developed an ESG strategy yet, it can draw from various sources when identifying KPIs, such as the ICMA register of KPIs. Companies may also consider looking at KPIs selected by their peers and draw on the experience of legal and debt advisers. If a company is not yet in a position to set KPIs and SPTs, it could discuss with its financing banks the option to enter into a sustainability-linked financing arrangement without specifying the KPIs and SPTs on day one. In such cases, the ESG mechanics will be included in the documentation with the specific KPIs and SPTs to be agreed at a later stage. However, financiers typically prefer KPIs and SPTs being agreed on from the outset, especially as this enables the product to be categorised as sustainability-linked without the risk of implication of greenwashing.

Most sustainability-linked financing documentation will also include provisions catering for an adjustment of KPIs and SPTs. The main purpose is to ensure the KPIs remain relevant and SPTs remain ambitious, but this could also be used if there are changes in the company's business or in the broader economy requiring an adjustment of the KPIs or SPTs. In addition, we have seen most-favoured-nation clauses included in relation to the ESG components of other debt instruments.

External verification

Second Party Opinion Providers (SPO Providers) are regularly involved in loan financing transactions, including debt capital market transactions. SPO Providers play a key role in setting up the sustainability aspects of financing transactions, by performing an external review of the KPIs and SPTs in the documentation phase.

The need to involve external parties, such as SPO Providers, auditors or ESG rating agencies, in the subsequent periodic verification process of sustainability elements of financing transactions can still be a topic for negotiations. Although the market is moving more towards requiring external verification (not least to avoid allegations of greenwashing) not involving specific external verification could still be an option. Not all financiers require external verification as the company could also report on SPTs in a sustainability compliance certificate and its annual statements. This seems especially relevant where the company is able to self-certify compliance with SPTs. Additionally, the company may be able to use its existing verification process where KPIs and SPTs are based on an existing sustainability framework.


Recently, we have seen declassification clauses included in sustainability-linked financing documentation. Declassification clauses have been included in many green finance products to allow financiers to verify the agreed use of proceeds, but they are less common in sustainability-linked finance documentation. Where declassification clauses are included, they specify circumstances in which the financing's sustainability classification will cease to exist.

Generally, declassification is linked to the company failing to report, or misreporting, on its SPTs or circumstances where financiers feel that the KPIs and SPTs no longer qualify as "sustainable elements". Financiers' internal reporting obligation and greenwashing concerns are key drivers for including this type of provision. Without reporting, or accurate reporting, on the SPTs by the company, financiers will be unable to verify the actual impact the company is making and whether or how the sustainability-linked financing adds to their internal targets for allocating capital towards sustainable finance.

When negotiating the inclusion and strictness of these declassification clauses, a key point for companies is to consider the potential disclosure requirements in the case of declassification. If they are not in a position to push back on the inclusion of declassification clauses, companies should at least try to set the bar high for declassification and to include grace periods. It would also be advisable to include the option to reclassify the financing as sustainability-linked.