Businesses, investors and banks are getting serious about ESG. David Prosser looks at a facility that will see NatWest reduce the interest charged to a recycling business for meeting sustainability targets centred on the circular economy and social value.
In a world where every organisation is under growing pressure to improve its environmental, social and governance (ESG) performance, lenders and borrowers alike believe ESG-linked credit can be a valuable tool for incentivising good practice. A new facility agreed between NatWest and its customer Recycling Lives extends that idea further into the debt market.
Under the agreement, NatWest will provide more than £40m of financing to Recycling Lives, at an interest rate dependent on the business’s ability to hit two specific ESG targets in the years ahead (see Here’s the Deal, below). The greater the good social and environmental impact Recycling Lives achieves, the less interest it will pay. It is the first time NatWest has built ESG criteria into an asset-backed finance facility for a customer, although such arrangements have become common with other types of loans.
Andrew Hodgson, executive chairman of Recycling Lives, says the business was keen to explore this concept from the moment it began discussions on refinancing its credit arrangements last year. “We didn’t do this just to save a bit of money on the debt – we were much more interested in an arrangement that aligned with our values,” he explains. “We’re a unique organisation and it’s really important that all our stakeholders buy into the idea that we’re ultimately here to improve lives.”
Recycling Lives works with its customers from industries in sectors such as automotive, manufacturing, construction, retail and utilities, using technology to manage their waste so significantly more of it can be recycled and reused, rather than dumped in landfill sites. The company is focused on social value, with initiatives ranging from employing ex-offenders to help them rehabilitate to programmes in local communities across the UK. It also works alongside its sister organisation, Recycling Lives Charity, which supports the homeless, redistributes food to vulnerable groups and works to reduce reoffending.
Andy Barraclough, head of regional asset-based lending (ABL) at NatWest, says this profile meant the company was a natural fit for a loan with an ESG ratchet. While other companies exploring asset-based finance have expressed interest in the idea, few have had a sufficiently mature understanding of how to set and work towards detailed sustainability performance targets (SPTs). “The SPTs do need to be clear and ambitious, rather than something the company is already doing,” Barraclough says. “Recycling Lives had well-developed KPIs to put in front of us.”
Moving behaviour
Nevertheless, Jane Hartley, a director at EY, which advised Recycling Lives on the transaction, believes ESG ratchets are going to become much more common across the whole debt market. It’s an arrangement that is attractive for all parties, she argues: “Lenders are under pressure to increase their ESG activities and companies with stronger sustainability credentials are regarded as more creditworthy. Borrowers get access to lower-cost funding, but also an opportunity to make a public statement about what they stand for and believe in.”
Investors are also appreciative of these arrangements. Private equity funds such as Three Hills Capital Partners, which has backed Recycling Lives, is keen to establish its own credentials. Three Hills, like Recycling Lives itself, has actually secured B Corp status, an independent certification of its strong social and environmental performance. But there is also a financial imperative.
“It’s possible that a portfolio company’s strong ESG performance will enhance its value at the point of exit,” says Hartley. “ESG-linked funding can be important evidence of that performance.”
Still, given that ESG ratchets offer value to so many different parties, it is important that these arrangements are structured with integrity. As regulators begin to crack down on greenwashing – and scrutiny more widely also increases – there is potential for reputational damage if the SPTs are too soft (see Perils of greenwashing, below).
In the case of Recycling Lives, the company spent time thinking about what would be challenging for its management. “We did a piece of work last year with Boston Consulting Group, mapping out a materiality matrix of the most important KPIs for us in terms of delivering core purpose and financial stability,” says Hodgson. “We felt we had an independently verified model.”
Moreover, that independent verification is needed on an ongoing basis; codes of best practice developed by groups such as the Loan Markets Association require both parties to have progress against their SPTs monitored by a third party – typically an auditor or a specialist ESG consultant. “The first thing we look at is whether the targets are material and robust,” says Gustavo Brianza, head of debt and ESG advisory at NatWest, about lenders’ approach to this area.
This isn’t simply a question of mitigating any potential reputational risk. In practice, lenders feel able to offer reduced pricing through ESG ratchets because they regard businesses with stronger sustainability as better credit risks. They are, for example, less likely to face regulatory sanctions for environmental failures, or suffer loss of value due to a reputational problem; they’re less likely to get caught up in a damaging event; and they attract more support from the growing number of customers, employees, investors and stakeholders focused on ESG issues.
However, if ESG ratchets are offered to businesses on the basis of superficial SPTs, this advantage may be illusory. Lenders may be offering cheaper finance to borrowers who are actually no more sustainable than peers who have higher- priced conventional credit arrangements.
This may become more of an issue over time. Right now, the value of most ESG ratchets tends to be relatively small – shaving basis points, rather than whole percentage points, off the cost of finance. However, Chris Lowe, partner in EY’s corporate finance debt advisory team, thinks this could change over time: “We may well see margins increase because lenders are becoming increasingly competitive in this market,” he argues.
One question for lenders to consider is what should happen to any value left in the ESG ratchet in the event that the borrower falls short of its SPTs. In the Recycling Lives deal, NatWest will pay any interest rebate not claimed by the company to its charity, but Brianza says it is likely to be “more normal that the lender would retain the rebate”.
Room for development
As for borrowers, they may – if they wish – commit to deploying any savings they earn in a particular way, as Recycling Lives has done. More commonly, however, there are no such requirements or commitments.
Still, this is an evolving field. Indeed, Recycling Lives’ Hodgson says the discussions he held with lenders suggested that some banks are only just beginning to recognise the importance of this market. “Different banks are definitely at different stages,” he notes. “We’re a leader in the ESG space and we often felt we were ahead of where the banks had got to.”
However, the advance of ESG ratchets into the asset-based finance sector suggests this situation is changing rapidly. “There’s nothing that’s inherently more complicated about building sustainability criteria into asset-based finance,” says NatWest’s Barraclough. “We’ve certainly got the appetite to do more of these transactions.”
ICAEW’s guideline to ESG can be found here.
Here’s the deal
In February 2023, Recycling Lives secured a £40.3m asset-backed financing facility from NatWest for refinancing and working capital purposes, plus an additional £10m of capital from Lombard, NatWest’s asset finance business. The latter support will help fund the company’s investment in new equipment.
The pricing of the main NatWest facility will ultimately depend on Recycling Lives’ ESG performance.
Assuming that the business hits two sustainability performance targets (SPTs), it will qualify for a rebate of interest, effectively reducing the interest rate payable on the debt by up to around 20 basis points.
The first of these SPTs is centred on the circular economy, with Recycling Lives expected to deliver a reduction in the amount of waste from its activities that needs to be diverted to landfill. The second SPT reflects Recycling Lives’ mission to create social value, with the business’s social programmes tasked to deliver in this area. Both targets are structured on a sliding scale, paying a more generous interest rebate if the company outperforms.
Recycling Lives has pledged to use any rebate secured to further enhance its ESG processes or to support the charity that it runs. If the business falls short of its targets, NatWest will pay the rebate direct to the charity – although this is unusual, it says.