The climate change-related reporting requirements lenders are increasingly subject to and an appreciation of the need to ensure the assets they lend against do not become “stranded” due to the impacts of climate change, together with reputational drivers and increasing demand from borrowers, mean lenders are using ESG criteria in their lending decisions. Most lenders have now invested heavily in ESG lending teams and many have dedicated ESG ambassadors across their business. ESG is now right at the centre of lenders’ business planning.
Across the market lenders have set themselves tough targets on ESG, both as to the amount and proportion of their lending books and in terms of their own ESG targets. As time moves forward, ESG will only become more and more important and critical for all lenders.
Beyond regulatory drivers, lenders are embracing the ESG agenda for a number of other reasons too, including:
‘Green’ finance is a term referring to a loan or a bond that is marketed or drafted specifically as being environmentally-friendly. It either entails proceeds being used to fund green projects or the income stream being generated by green assets. Green finance products are subject to substantial requirements on an ongoing basis – there are ongoing reporting requirements and costs to obtain accreditation.
There is currently no single, agreed definition of what constitutes sustainable finance in the market. However, sustainable finance has recently been defined in the bond market as incorporating climate, green and social finance while also adding wider considerations concerning the longer-term economic sustainability of the organisations that are being funded.
The concept of ‘green loans’ is a subset of green finance. In the UK, the Loan Market Association (LMA) published its green loan principles in December 2018. These were based on the green bond principles previously in place for bond issues. The vast majority of loans documented in the UK are based on the LMA suggested forms.
Broadly the LMA’s green loan principles cover four main areas.
The fundamental determinant of a green loan is the use of the loan proceeds for green projects, including other related and supporting expenditures such as R&D, which should be appropriately described in the finance documents and, if applicable, marketing materials. All designated green projects should provide clear environmental benefits, which will be assessed, and where feasible, quantified, measured and reported by the borrower. Where funds are to be used, in whole or part, for refinancing, it is recommended that borrowers provide an estimate of the share of financing versus refinancing. Where appropriate, they should also clarify which investments or project portfolios may be refinanced, and, to the extent relevant, the expected look-back period for refinanced green projects.
A green loan may take the form of one or more tranches of a loan facility. In such cases, the green tranche(s) must be clearly designated, with proceeds of the green tranche(s) credited to a separate account or tracked by the borrower in an appropriate manner. The non-exhaustive list of green projects is intended to capture the most usual types of projects supported, and expected to be supported, by the green loan market. However, it is recognised that definitions of green and green projects may vary depending on sector and geography.
The borrower of a green loan should clearly communicate to its lenders its environmental sustainability objectives, the process by which the borrower determines how its projects fit within the eligible categories set out in the LMA’s green loan principles and the related eligibility criteria, including, if applicable, exclusion criteria or any other process applied to identify and manage potentially material environmental risks associated with the proposed projects.
Borrowers are encouraged to position this information within the context of their overarching objectives, strategy, policy and/or processes relating to environmental sustainability. Borrowers are also encouraged to disclose any green standards or certifications to which they are seeking to conform.
Borrowers are encouraged to establish an internal governance process through which they can track the allocation of funds towards green projects.
Borrowers should collate and keep readily available up to date information on the use of proceeds to be renewed annually until fully drawn, and as necessary thereafter in the event of material developments. This should include a list of the green projects to which the green loan proceeds have been allocated and a brief description of the projects and the amounts allocated and their expected impact.
Where confidentiality agreements, competition considerations, or a large number of underlying projects limit the amount of detail that can be made available, the green loan principles recommend that information is presented in generic terms or on an aggregated project portfolio basis. Information need only be provided to those institutions participating in the loan.
Transparency is of particular value in communicating the expected impact of projects. The green loan principles recommend the use of qualitative performance indicators and, where feasible, quantitative performance measures. Examples might include energy capacity, electricity generation, greenhouse gas emissions reduced or avoided, for instance. There should also be disclosure of the key underlying methodology and/or assumptions used in the quantitative determination.
The LMA’s green loan principles are intentionally high-level in detail to provide flexibility. An indicative, though not exhaustive, list of green projects set out in the LMA’s green loan includes:
There has a significant focus on the issue of green, social and sustainability – i.e. green and social – bonds in 2020 and 2021. There are two types of sustainability bonds.
Issuers issue bonds and commit to using the proceeds of the issuance for green and/or social purposes usually as specified in a sustainability financing framework. The sustainability financing framework usually reflects the guidance of the International Capital Market Association’s green bond principles, social bond principles and/or sustainability bond guidelines. They therefore describe the use of proceeds, the process for evaluation and selection, the management of proceeds and reporting in similar manner as under the LMA’s green loan principles.
Many sustainability financing frameworks do not just cater for use of bond proceeds, but also contemplate the application of any loan proceeds. In the bond market, bond issuers typically obtain a second party opinion which analyses how sustainable the eligible projects in the sustainability financing framework are and their compliance with the ICMA guidance. Accordingly, a second party opinion helps strengthen the credibility of the bond and, in turn, helps to gain the confidence of potential investors. Sustainability bonds do not typically have penalties for failure to use the proceeds in accordance with the sustainability financing framework, such as an event of default, but any such failure may have an impact on the issuer’s reputation.
In the summer of 2020, sustainability-linked bonds were introduced through the ICMA sustainability-linked bond principles. There is no requirement to use the proceeds for sustainable purposes, but the terms and conditions of the bonds incentivise the bond issuer’s achievement of sustainability objectives in or across its business. For example, a coupon ratchet may result in reduced interest coupons as certain key performance indicators are met.
Sustainability-linked bonds may be more relevant for businesses that do not have an identifiable sustainable project on which to apply proceeds over time, but are themselves looking to transition to be more sustainable.
There are many reasons why a business might choose to issue a sustainability bond. These include: