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 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.