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The rise of green and sustainability linked loan financing8 November 2019

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The Green Bond Principles (“GBPs”) were introduced in 2014 and were subsequently followed by the Green Loan Principles (“GLPs”) in 2018. Both the GBPs and GLPs provide recognised market standards and share the aim of facilitating and supporting environmentally sustainable economic activity. While the introduction of these principles was undoubtedly a positive first step, arising out of the ‘use of proceeds’ requirement in which loan proceeds have to be used for specific sustainable projects, they have not been inclusive enough to attract the wider green market. With OECD estimates of US$6.9tn a year being required in order to meet 2030 climate and development objectives under the Paris Agreement, there is a need for extending ways to provide green finance. Enter the Sustainability Linked Loan Principles (“SLLPs”).

Corporates, not Projects

Those who work in project finance, particularly in renewable energy, have long viewed the four core components of the GLPs as standard terms of project finance facility agreements. The four core components are: (1) a green use of proceeds; (2) communicating the sustainability objectives and the selection of green projects to its lender(s); (3) management of proceeds in dedicated accounts and (4) detailed reporting requirements to its lender(s).

While many renewable energy projects satisfy the criteria of the GLPs, the GBPs and GLPs do not actually focus on the project financing market, but have been designed to boost, stimulate and provide a framework for, the corporate lending market.

The principles are undoubtedly growing in significance in the corporate market, with the aggregate volume of green loans increasing by 20% and 23% from 2016 to 2017 and 2017 to 2018 respectively.

"Unlike the ‘use of proceeds’ requirement, sustainability linked loans (“SLLs”) are linked to the overall sustainability profile of the borrower "

Will Sustainability Linked Loan Principles be a game changer?

Despite the rising volume of green loans in recent years, a key building block for scaling up the green corporate lending market was missing. While sustainable financing already existed, the publication of the SLLPs in March 2019 has provided legitimacy through a common set of principles and fresh impetus to this market.

Unlike the ‘use of proceeds’ requirement, sustainability linked loans (“SLLs”) are linked to the overall sustainability profile of the borrower by measuring the latter’s performance against pre-determined sustainability performance targets (“SPTs”). This new approach opens the door to a wider pool of borrowers seeking funding for sectors as diverse as energy efficiency, water consumption, affordable housing and the circular economy. The growth in SLLs has been significant; as of June 2019 the volume of SLLs surpassed the US$40bn lent worldwide in 2018; an exponential increase on the US$5bn lent in 2017.

The core component of the SLLPs are:

Relationship to borrower’s Overall Corporate Social Responsibility (CSR) strategy

The borrower must communicate how their sustainability objectives (as set out in their CSR strategy) align with the proposed SPTs.

Target setting – Measuring the sustainability of the borrower

A fundamental attribute of SLLs is the development of SPTs. The borrower and lender must negotiate and set ambitious and meaningful SPTs tied to sustainable improvement. The reason SPTs carry so much importance is that the borrower’s performance is measured against these SPTs and further linked to the terms of the loan through a margin ratchet mechanism. This financial incentive is discussed further below.

Reporting

As there are financial consequences in meeting, or not meeting, the SPTs, reporting is an essential element of SLLs. Borrowers must make and keep information relating to their SPTs readily available, and such information is to be provided to lenders at least once a year.

Review

The review and verification process of whether or not the borrower is in compliance with the SPTs is decided on a transaction by transaction basis and can be done internally or externally. Where information is not made publicly available, external review will almost always be required for verification and assurance. For publicly traded companies, public disclosures may be enough to meet lender requirements. If internal reviews are to be agreed by the lender, the borrower will have to demonstrate that its internal expertise is sufficiently qualified, and independent, to validate its performance against their SPTs.

"...the key drivers are the benefits that both lenders and borrowers can gain from the SLLPs that are not evident in the GLPs."

What makes the SLLPs so appealing?

The core components of the SLLPs place an additional burden on the borrower compared to a vanilla corporate financing. So why are they gaining so much popularity? The reason for the uptake is not just because of the wider remit of the SLLPs compared with GLPs, rather the key drivers are the benefits that both lenders and borrowers can gain from the SLLPs that are not evident in the GLPs.

For the borrowers, they achieve:

  • Cheaper debt – provided the SPTs are met, the margin on the loan will be reduced resulting in cheaper cost of capital. Early financings only included one-way pricing (margin reductions), while some two-way pricing is now coming into the market. This would result in margin increases if SPTs are not met. While this two-way pricing carrot and stick approach is potentially detrimental to borrowers, it also increases the incentives for achieving the SPTs. As the market continues to evolve, alternative structures are emerging. For example, additional payments being required if SPTs are not met, which will be used specifically for helping achieve those SPTs.
  • Cheaper operations – the use of debt for improving the sustainability profile of the borrowers may result in secondary financial benefits such as lower operating costs.
  • Reputational impacts – the need to demonstrate an awareness of climate change impacts and a genuine commitment to sustainable development are moving beyond simple ‘green washing’ and failure to do so can have a significant impact on a company’s reputation. SLLPs offer companies the means to prove ‘additionality’ (demonstrating climate change mitigation and adaptation) by requiring ambitious and measurable SPTs. This will help companies better communicate their sustainability strategy to all stakeholders.
  • Regulations – in addition to reputational concerns, a growing body of regulation around environmental disclosure standards and obligations is beginning to focus minds on boards across all levels and sectors of the economy. By participating in SLLs not only will developing regulation and requirements be easier to meet, but a competitive advantage will be achieved through developing corporate resources and capabilities relating to sustainability.

From the lenders’ perspective, equally powerful benefits can be seen:

  • Sustainable lending – increasing the amount of sustainable and green lending is becoming of greater importance to banking institutions. While most international banks have moved away from coal, and many have renewable lending targets, the ability to lend more debt through corporate sustainable lending is appealing.
  • Credit risk – a recent benchmarking exercise by a leading consultancy into environmental, social and governance (ESG) metrics found that, contrary to the commonly held view that a high level of ESG performance is a burden, those companies who outperformed their industry peers in ESG metrics also outperformed them financially too. Whilst there is no substitute for corporate due diligence, it seems possible that an improvement in ESG performance via SLLs could also have a beneficial impact on the level of credit risk they represent.
 

SLLPs

GLPs

Guiding principleTo facilitate and support environmentally and socially sustainable economic activity and growth.To facilitate and support environmentally sustainable activity.
PurposeThere is no specific requirement for the use of proceeds for the loan. The loan can be for general corporate purposes to improve the borrower’s sustainability profile (done by aligning the loan terms to the borrower’s performance against the relevant sustainability performance targets).

 

The fundamental determinant of a green loan is the utilisation of the loan proceeds for green projects. This requires a specific use of proceeds for the loan.  The GLP provide a non-exhaustive list of categories, such as renewable energy, clean transportation and green buildings.
PricingThe borrowers’ performance against their sustainability performance targets affects the margin of the loan (this can be a one way or two way ratchet mechanism).No pricing considerations or impact is provided in the GLPs.
VerificationGiven the implication of meeting the sustainability performance targets on the margin, the importance of verification is crucial to the SLLPs.  Dependent on the company, private or public, this can be through internal or external means.The borrowers should make and keep up to date information on the use of proceeds.  This reporting requirement is less stringent than the verification needed under the SLLPs.

 

"A win-win situation and Asia is starting to join the sustainability loan boom"

A win-win situation and Asia is starting to join the sustainability loan boom

To date, the majority of green financing (through GBPs, GLPs and SLLPs) has been in the Americas and EMEA.  While there is still a large gap in funding levels, we have seen an increase in both dialogue and action in the Asian market, with Singapore featuring in the top ten countries by aggregate sustainability linked loan volumes since 2017.  This development is encouraging, and given the win-win dynamics, not surprising.

We anticipate that this trend will continue and spread through the Asian region, and with the door being pushed wide open through the SLLPs, we believe that more corporates will realise the attraction of sustainable financing.


Glossary of terms

CSR – Corporate Social Responsibility

ESG – Environmental, Social and Governance GBPs – Green Bond Principles

GLPs – Green Loan Principles

SLLPs – Sustainability Linked Loan Principles

SLLs – Sustainability Linked Loans

SPTs – Sustainability Performance Targets

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