An overview of Green and Sustainable Lending
Environmental social and governance (ESG) issues play an increasingly important role in all aspects of business with the continued recognition of the role businesses have to play in tackling issues such as the climate emergency and promoting positive change through their activities.
This increased prevalence is not solely driven by regulators but by the wider recognition that a focus on ESG can be fundamental to term long term success and survival of a business and can have a positive impact on the engagement and wellbeing of its employees.
In this article, we provide an overview as to how the lending sector has sought to support their ESG goals and those of their customers through the development of two key products, Green Loans and Sustainability Linked Loans (SLLs) and consider the key features of these.
What are Green Loans and Sustainability Linked Loans?
The key feature of a Green Loan is that the proceeds of the loan are to be applied to finance or re-finance, in whole or in part, certain new and/or existing green projects.
SLLs on the other hand do not focus on the actual purpose of the loan. Instead, they seek to promote sustainability by incentivising the borrower to achieve ambitious sustainability performance targets (SPTs) which are agreed with its lender at the outset. This incentivisation will most commonly take the form of a reduction in the interest rate margin payable by the borrower.
There are no specific restrictions on who can borrow Green Loans and SLLs provided that the relevant loans meet the requirements of being designated as green or sustainability linked. It is possible for a loan to be both a Green Loan and an SLL, although this is rare in the market.
Green and Sustainability washing and the need for minimum standards
There is a risk that borrowers and lenders could use the Green Loan or SLL label to portray their businesses as producing positive environmental or sustainability outcomes when in fact such claims are inaccurate or misleading. This is known as “green washing” and “sustainability washing”.
The risk of green washing or sustainability washing being used to mislead investors and consumers as to the ESG credentials of a loan, a borrower or a lender has driven the need to develop minimum standards which must be adhered to in order for a loan to be properly described as a green or sustainability linked loan so as to maintain investor confidence and the integrity of the green and sustainability linked loan products and to avoid reputational damage for those involved.
In March 2018 the Loan Market Association, together with its counterparts in North America (LSTA) and Asia Pacific (APLMA) issued the Green Loan Principles (GLPs), followed by the Sustainability Linked Loan Principles (SLLPs) in March 2019. These have each been supplemented by guidance on how the GLPs and SLLPs are to be applied in practice, as well as sector-specific guidance on the application of the GLPs in a real estate finance context.
The GLPs and SLLPs, and the related guidance, seek to set out a high-level voluntary framework of market standards and guidelines which can be adopted by lenders when providing these products. The GLPs also refer to and build on the Green Bond Principles with the aim of promoting consistency across the relevant financial markets for Green Loans and green bonds.
The Green Loan Principles
The GLPs focus on four core components for Green Loans, specifically:
- Use of Proceeds – the loan must be used for specific Green Projects which provide clear environmental benefits. The GLPs includes a non-exhaustive list of broad categories of eligibility for Green Projects. Specific Green Projects could include investment in the generation or transmission of renewable energy, the refurbishment of buildings to be more energy-efficient, the development of sustainable or eco-friendly products or infrastructure or projects for the control and prevention of pollution.
- Process for Project Evaluation and Selection – a borrower must clearly communicate its environmental sustainability objectives, the process by which the borrower has determined that its project fits within the eligible categories set out in the GLPs and details of any related eligibility criteria to its lenders. Borrowers are encouraged to frame this information in the context of their overarching objectives, strategy, policy and/or processes relating to environmental sustainability. In addition, where a borrower is seeking to conform to any specific green standards or certifications these should be specified.
- Management of Proceeds – it is a requirement that the proceeds of a green loan be applied to a dedicated account or are otherwise tracked so that there can be no suggestion that the monies were used for anything other than for Green Projects.
- Reporting - the GLP require borrowers to maintain and provide up to date information on the use of proceeds including details of the relevant project’s impact, with qualitative performance indicators and, where feasible, quantitative performance measures. These should be renewed annually although a borrower and lender may agree that reporting is to be more frequent. The GLPs also recommend that borrowers engage external parties where appropriate to review and/or consult on their green loan process and where relevant obtain verification, certification or ratings from relevant third parties in respect of the green loan, its associated framework and the underlying projects. As such, this may be something a lender looks to include in its reporting requirements.
The Sustainability Linked Loan Principles
Like the GLPs, the SLLPs specifies four key components for SSLs, specifically:
- Relationship to Borrower’s Overall Sustainability Strategy – a borrower is required to clearly communicate its sustainability objectives to its lenders by reference to its sustainability strategy and demonstrate how the specific SPTs which are proposed align to this. This should include details of any sustainability standards or certifications which the borrower aims to comply with.
- Target Setting – Suitable SPTs are to be agreed between the borrower and lenders for each transaction. A Sustainability Co-ordinator or Structuring Agent may be appointed to co-ordinate this process amongst a group of lenders (in a similar way to the role of a traditional Arranger). A key requirement is that the SPTs be meaningful in the context of the borrower’s business and ambitious, with a requirement to demonstrate substantial improvement in relation to agreed benchmarks, with targets generally to be based against the businesses recent performance, which would usually be the previous 6 to 12 months). The SPTs can also be aligned to a borrower’s existing internal ESG targets and reporting. The SLLPs includes a non-exhaustive list of common categories of SPTs and the types of things that can be measured.
- Reporting - a borrow of an SLL should keep and make readily available up-to-date information in respect of their SPTs and this should be reported on to lenders at least annually. The SLLPs also state that borrowers should be encouraged, where appropriate to publicly report information relating to their SPTs and include this in their annual reports.
- Review – The SLLPs recommend that external review of SPTs be obtained, particularly where the information relating to the SPTs is not made public or accompanied by a separate audit or assurance statement, although ultimately this is a point for negotiation on transaction by transaction basis. Appropriate external reviewers could include auditors, environmental consultants or relevant ratings agencies. In the absence of external review, it is recommended that borrowers be required to demonstrate and develop appropriate expertise internally to be able to credibly self-certify their compliance.
The benefit for Borrowers
Undoubtedly, Green Loans and SLLs carry an additional administrative and reporting burden for borrowers than would arise under a normal loan agreement. As such, these products work best where a borrower is already preparing or intending to prepare such information in connection with a specific project or as part of its general ESG reporting and strategy. In that case, a borrower can align the terms of their financing with their wider corporate ESG strategy and targets, with the loan providing additional measurable benefits to the borrower, such as lower interest rates and the ability to attract new investors, as well as the more intangible benefits that come from a business embedding an ESG focus within its organisation.
Failure to Comply with Green Loan or SLL specific provisions
Given the additional requirements noted above in terms of things such as the use of loan proceeds, meeting of targets, reporting and third party verification, a borrower should also be mindful of the consequences of breaching any of these provisions, particularly whether this will result in an Event of Default allowing a lender to require repayment of a loan.
In the context of a green loan, given how fundamental it is that the proceeds be used for an approved Green Project, the guidance to the GLPs does specify that a breach of the provisions regarding the use of proceeds should result in the loan ceasing to be considered green (subject to any agreed cure right) and it may be appropriate for such a breach to constitute an event of default.
In relation to SLLs, the relevant guidance suggests that a breach of SPTs should carry economic consequences, such as an increase in the applicable margin, but may not be an event of default on its own.
Generally, the consequences of a breach of the reporting obligations or other provisions is one for negotiation. In some contexts, it may be appropriate simply for a higher margin to apply or for the loan to cease to be regarded as a green loan or SLL, whereas for fundamental breaches, an event of default may be appropriate. There are currently no established market standards and these are generally points to be agreed on a transaction by transaction basis.
Do you need further advice regarding Green and Sustainable Lending?
The Green Loan Principles, The Sustainability Linked Loan Principles and the related guidance and other relevant resources are available through the Loan Market Association’s Sustainable Lending Micro Site.
If you’d like to discuss any of these matters, please contact your usual contact in the Gateley Banking Unit or our expert detailed below.
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