Leveraging ESG for better financing: the ESG ratchet in lending agreements

Securing favourable financing terms is a priority for any private equity manager looking to optimise returns. Over the last few years, lenders have introduced the ESG ratchet, or sustainability-linked margin ratchet, into credit agreements. It adjusts the interest margin according to the borrower's performance against agreed sustainability targets, creating a financial incentive to meet or beat them. In this article we explain how the ESG ratchet works, why lenders use it and how to position portfolio companies to benefit.

Not sure where to start with the underlying measurements? Read our step-by-step guide to Scope 3 emissions.

What is the ESG ratchet?

In a conventional loan, the interest rate is built from a reference rate, such as SOFR, SONIA or Euribor, plus a margin that reflects credit risk. The ESG ratchet adds another dimension: the borrower commits to specific ESG key performance indicators (KPIs) with sustainability performance targets (SPTs), and whether those targets are met changes the margin. Typically:

• Downward ratchet: meeting or exceeding targets reduces the margin.
• Upward ratchet: missing targets increases it. Two-way ratchets exist but downward-only structures remain the most common.

The adjustment is usually modest. Law firm commentary on mid-market deals puts the range at roughly 2.5 to 15 basis points on the margin, so the value lies as much in the discipline the structure imposes, and in the signal it sends to lenders and LPs, as in the discount itself.

Why lenders use ESG ratchets

• Their own obligations: banks face climate and sustainability disclosure requirements and want greener loan books.
• Risk management: borrowers with weak ESG performance are more exposed to regulation, litigation and reputational damage.
• Differentiation: sustainability-linked products help lenders stand out in a market that increasingly asks for them.

The rules of the game: the Sustainability-Linked Loan Principles

Sustainability-linked loans follow the Sustainability-Linked Loan Principles published by the loan market associations (LMA, APLMA and LSTA), most recently updated in March 2025. They require KPIs that are material to the borrower's business, assessed from both an impact and a financial perspective, targets that are ambitious beyond business as usual and beyond what regulation already requires, and independent external verification of performance against each target. A ratchet that does not meet these standards invites accusations of greenwashing rather than better terms.

Common ESG ratchet KPIs

KPIs vary by sector but often include:

• Greenhouse gas emissions: absolute or intensity reductions across Scope 1 and 2, and increasingly Scope 3.
• Diversity and inclusion: board composition or management representation.
• Health and safety: incident rates or lost-time injuries.
• Resource efficiency: water savings, waste reduction or renewable energy share.

Whatever the KPI, the borrower needs data it can defend. Our guide to modernising ESG data management in portfolio companies covers the infrastructure side.

Structuring the ESG ratchet in private equity deals

The GP usually leads financing negotiations for acquisitions and add-ons. Consider the following steps:

• Define the right metrics: work with lenders to choose KPIs aligned with the company's material ESG issues, following our guide to ESG materiality for portfolio companies.
• Set ambitious but achievable targets: overly aggressive targets risk penalty margins, while easy ones will not pass lender or verifier scrutiny.
• Agree the verification mechanism: an independent reviewer and a recognised methodology, such as the GHG Protocol for emissions, confirm whether targets are met.
• Plan the reporting cadence: some agreements require annual testing, others more frequent updates. Make sure the data collection process can keep up.

An illustration: emissions intensity in manufacturing

Picture a manufacturing company in the automotive supply chain that negotiates an ESG ratchet tied to emissions per unit produced. Investment in energy-efficient machinery, better production planning and a switch to renewable electricity brings its intensity below the agreed threshold, and the margin steps down at the next testing date. The saving on interest is real but modest; the bigger gains are the operational savings that delivered the reduction and the evidence the company can now show its next lender and its investors.

Overcoming hurdles

• Data credibility: lenders and verifiers expect standardised, auditable metrics, which is hard to deliver from spreadsheets.
• Flexibility versus accountability: allow realistic timelines for improvements while keeping reporting transparent.
• Reputational exposure: missing a target does not just cost basis points; it can undermine the company's ESG narrative.

Looking ahead: more ESG-linked instruments

The same logic is spreading to sustainability-linked bonds and other instruments with performance-based terms. For a forward-looking view of how ESG financing will evolve, see our five-year outlook for ESG in private equity.

Best practice

• Prepare early: if an ESG-linked loan is on the horizon, refine KPIs and data tracking well before negotiations.
• Engage the whole business: leadership and operations teams must own the improvement plan, because they are the ones who will hit or miss the targets.
• Get independent assurance: verification is required under the principles and adds credibility with every stakeholder.
• Communicate success: a lower margin earned through sustainability progress is a powerful story for LPs.

The ESG ratchet gives companies a tangible financial reward for measurable sustainability performance. As more lenders adopt it, private equity managers have a clear opportunity to secure better terms and drive ESG improvements across their portfolios. The precondition is emissions data that a verifier will sign off on, which is where Manglai's carbon footprint software comes in.