Over the past number of years, there has been a growing emphasis on and push to incorporate Environmental, Social and Governance (“ESG”) principles in lending practices. Conducting business in a sustainable, socially-conscious way may allow lenders to improve their financial performance by mitigating risks many businesses face, such as climate change, and may have the added benefit of attracting more borrowers and/or capital raisers who are increasingly looking for lenders and/or other capital sources who value sustainability.
There are a number of benefits that lenders and borrowers may gain from engaging in ESG-related financing activities, including enhanced reputational benefits, increased consumer trust and loyalty, and enriched relationships with their respective stakeholders. In addition to the foregoing, incorporating ESG related practices and values in lending activities, especially as it pertains to environmental matters, could help encourage (or induce) borrowers into taking measures to reduce their respective carbon footprints, leading to net-zero economies. Moreover, the inclusion of ESG-related KPIs and/or covenants in specific loan transactions may provide lenders with a “safety cushion” on the principal amount being loaned, and allows for borrowers to potentially reap the benefits of discounted margins on their loan payments.
While new ESG-based lending practices may have the benefits of providing prospective borrowers with socially-conscious sources of capital, as well as enhanced reputational benefits, ESG-related lending practices may also pose challenges and risks to prospective borrowers and lenders, including:
- Greenwashing: When financing is dependent on the sustainable purpose of a project, both lenders and borrowers should ensure that any ESG policies and or understandings surrounding any lending agreements are fully understood, and that all information surrounding any ESG-related KPIs is transparent, plainly stated and clearly documented. Parties are at risk of being mislead if they are not properly aware of what types of initiatives/benchmarks are required to be met in order to keep with the ESG-related KPI targets and/or conditions relating to a specific loan or transaction.
- Transaction Costs: Sustainability-based loans give borrowers the benefit of lower prices when KPI targets are met. However, borrowers can also face high transaction costs associated with ESG initiatives and practices, which may in turn counteract the benefit of lower prices. For example, when conducting business with ESG principles, a business may be forced to consider the cost of ESG consultants’ fees, as well the costs of any additional capital required to meet target KPIs. This is an especially important consideration for businesses that are not already well-versed in ESG-related business practices and/or do not have ESG structures and policies in place.
- Lack of Standardization: There is little guidance as to how ESG principles can be incorporated in loan transactions. As a result, different lenders may have entirely different ESG-based practices and/or standards. This may make it confusing and difficult for prospective borrowers to decide on which lenders to develop a relationship with and which practices are best suited for their specific business. In addition, a general lack of regulatory oversight with respect to ESG-related initiatives can create further risks for borrowers.
In an example of lenders incorporating ESG-related practices into lending activities, one Canadian bank has committed hundreds of billions of dollars to sustainable finance activities between 2018 and 2030. Some of its sustainable lending practices include extending credit in the form of: (i) “Green Loans”, which are structured to meet the requirements of the Loan Markets Association’s Green Loan Principles, and are primarily used to allow borrowers to finance environmentally focused business initiatives such as, energy efficient projects, pollution prevention, and production of renewable energy; (ii) “Sustainability-Based Loans”, which incentivize borrowers to reach certain sustainability-based KPI targets, which allow borrowers to receive discounts on loan payments; and (iii) “Sustainable Finance Bonds”, which allow issuers to link their sustainability efforts to their financing strategies. All other major Canadian banks have dedicated similarly large sums towards “sustainable” and “climate related” financing activities.
Overall, ESG-based lending provides new ways for lenders and borrowers to pursue financing in a sustainable and socially-conscious manner. While there are several risks and/or potential pitfalls with ESG-based lending practices, ESG-based lending is here to stay and provides new opportunities, benefits and financial incentives for both borrowers and lenders.