A sustainable hedge that somehow adds risk

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??This week: Royal Golden Eagle Group (RGE), which controls a number of resource-based manufacturing companies, just closed a two-year US$550 million sustainability-linked derivative (SLD) with MUFG Bank. The SLD will be used to partially hedge US$787 million of sustainability-linked loans that RGE vegetable oil processing unit Apical Group took up in November 2022.

Interest rate swaps are fairly common in financing. In RGE’s case, the company pays a fixed rate over two years to MUFG in exchange for an amount that’s pegged to prevailing interest rates. This allows RGE to lock in a fixed rate on floating debt that could otherwise start to cost more in a rising-rate environment.

What’s fairly unusual, at least in Singapore and South-east Asia, is that RGE’s swap has a sustainability-linked structure. These structures reward borrowers that achieve key performance indicators (KPIs) – or penalise those that miss the KPIs. If RGE fails to meet those targets, it will have to pay a higher rate for the swap.

What makes RGE’s move even more unusual is that the SLD is being used to hedge a sustainability-linked loan. Because the loan also has KPIs tied to the same sustainability targets, if RGE misses the targets it could get hit by a “double whammy” of paying more – not just for the loan, but for the swap as well.

RGE had to deal with two risks from the loans: The first was higher interest rates, and the second was missing the KPIs. A simple swap would have allowed RGE to hedge against the first risk, without changing its exposure to the second risk. Instead, RGE decided to also raise its exposure to the second risk. Like, why?

Why, indeed. It’s possible that RGE got a discount from MUFG for the SLD because of the sustainability aspect – in other words MUFG paid a “greenium” that made the SLD cheaper than a vanilla swap for RGE.

It’s also possible that RGE is highly confident of meeting the KPIs, such that it doesn’t view the potential double penalty as a real risk. If this is the case, it might be worth examining whether the KPIs for the SLD are sufficiently ambitious. As the International Swaps and Derivatives Association says: “ESG targets and KPIs are crucial to the effectiveness of an SLD and should not be too weak or easy to meet. Weak targets and KPIs could lead to claims of greenwashing.”

The answers given by RGE and MUFG seem to suggest that the apparent financial masochism is ultimately an investment in reputation, which seems reasonable. For RGE – whose businesses include pulp and paper, palm oil, and energy resources development – sustainability credentials have material implications on its ability to access capital and customers. Entering into an SLD now could make it easier to tap the structure again in the future, when there might be a greater need. Someone at RGE presumably saw the extra risk as a worthwhile price.

It’s worth asking, however, if there are more impactful ways to burnish that reputation. RGE might have more at stake from not meeting its KPIs, but the improvements derived from those KPIs haven’t changed. If RGE is going to take on more risk, it might have been more meaningful to raise its KPI targets even if it kept the underperformance penalty the same. At least the world could become a slightly better place for all that trouble.

?? Top ESG reads:

1. Green players hope that Singapore’s coming Budget will offer support for SMEs and for the development of blended finance.
2. If you know of individuals or businesses who have made an impact in sustainability, nominations are open for the inaugural Sustainability Impact Awards by BT and UOB.
3. Oil and gas players are investing in agriculture in South-east Asia because they need to secure green feedstock for biorefineries.
4. Don’t be too quick to write off coal. Indonesia’s set for record coal exports in 2023.
5. A wave of interest in decarbonising Vietnam, which is also highly dependent on coal, is coming up against the pursuit of growth.

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