Sustainable finance is a rapidly developing market. Until recently the market for sustainable finance was made up primarily of bonds (and, to a lesser extent, term loans) funding "green" projects. Now sustainable lending increasingly provides flexible solutions to borrowers who wish to incorporate environmental, social or governance targets into their funding.
There are many reasons why lenders and borrowers may want to be active in the market. Reputation is a key driver at the moment but further impetus will be provided if regulatory changes are enacted with the aim of supporting sustainable finance. Certain borrowers may be required to disclose information on sustainability issues as part of their annual non-financial reporting obligations.
There are currently no "market standard" provisions for sustainable loans. The documentation continues to develop as the market evolves. That said, many agreements feature a mix of the following:
•incorporating a sustainable project into the purpose clause
•a requirement to hold a minimum level of sustainable assets, and
•a margin ratchet which reflects the borrower’s compliance with defined sustainability criteria.
"Sustainable" or "impact" finance are current buzzwords, but their genesis lies in green finance which has been a hot topic for a number of years. Green bonds were the first form of green financing; created to fund projects with positive environmental or climate benefits, the first green bond was issued in 2007. Following rapid growth in the market, ICMA published the first iteration of its Green Bond Principles in January 2014. The green bond market has grown by 80% each year over the past five years and continues to grow; there are estimates that (self-labelled) global green bond issuance in 2018 will total US$250bn.
In comparison to the green bond market, the green loan market is relatively new. Sainsbury’s is credited with entering into the first green loan in July 2014, and since then the green loan market has grown, with Thomson Reuters reporting that the total volume of green loans in Europe amounted to approximately EUR19bn by March 2018. The LMA issued its Green Loan Principles (based on the Green Bond Principles) in March 2018 and many borrowers, especially those whose business impact the environment, are now considering green loans as part of their funding mix.
In this note, we look at some of the drivers behind the loan market’s recent uptick in sustainable lending, and look at how the principles behind sustainable lending are applied in practice and in documentation.
What is sustainable finance?
Although the original focus of the green finance market was to use bonds, and later, term loans, to fund environmentally beneficial projects, the market is widening as it develops. It now includes more flexible ways of providing financing, for example, providing revolving credit facilities or supply chain finance. In addition, the focus has shifted from solely environmental matters to the broader concept of sustainability, which also includes social and governance factors.
The global political drive for sustainable development is likely to influence the focus and growth of the market. The issue has gathered momentum over the past decade, culminating in the Sustainability Goals of the UN Conference on Sustainable Development and the Paris Climate Agreement. The EU has been particularly active in this area. For example, in March 2018, the European Commission published its action plan on developing an EU-wide strategy to support sustainable finance. The proposals include, among others, the establishment of a classification and labelling system for sustainable finance products, and an investigation into whether sustainability could be incorporated into the prudential requirements of banks, insurance companies and pension funds.
The concept of sustainability comprises a wide range of policy aims and concerns and, at a broader level, similar principles could be linked to a variety of social purposes: ICMA’s Social Bond Principles talk about funding for the purposes of affordable infrastructure, affordable housing, and projects designed to help marginalised populations such as those living below the poverty line.
Why are lenders and borrowers interested in sustainable lending?
Sustainable business (and therefore sustainable lending) is high on the agenda of many borrowers for a number of reasons including:
•Reputation and public pressure: we have seen in recent years how important a company’s reputation can be, and how a perception of lacking social responsibility or behaving in an unfair way (even though perfectly legal) can cause damage. Public opinion is generally in favour of environmental concerns, so there is a "halo effect" for a company being able to promote its green credentials or demonstrate its commitment to sustainable practices.
•Shareholder and regulatory pressure: even if a company can deal with (or ignore) issues of public reputation, it cannot afford to ignore its shareholders or regulators. This trend can be seen across Europe, for instance, as certain large companies must disclose a broad range of sustainability factors as part of their annual reporting obligations. The Financial Stability Board’s Task Force on Climate-related Financial Disclosures is also providing a strong regulatory push towards understanding sustainability risk. Shareholders, particularly pension funds and similar collective investment schemes, are increasingly activist and expect companies in which they invest to show that they are responsible citizens. Making green loans (in the case of lenders) or taking them (in the case of borrowers) is one way of demonstrating this.
•Alternative pools of capital: although sustainable bonds can call on capital such as ethical funds, which choose to invest only in debt meeting their ethical or sustainability criteria, it is unlikely in the current market that sustainable loans would have a similar advantage. Any individual loan will be funded in the usual way from a bank’s own resources or from a mix of funding sources. However, as the market grows and develops, it will be increasingly possible to package sustainable loans into asset-backed wholesale financings (such as securitisations) to tap ethical funding sources and interestingly, one bank has already issued green bonds with the aim of using the proceeds for green lending. If the LMA Green Loan Principles are widely accepted (as we expect they will be), they will help the development of the sustainable funding market by creating consistency across the sustainable lending market and by making it easier for investors to assess the sustainable credentials of the relevant capital market instrument.
•Flexibility and accessibility: the rise of the green loan market has been particularly welcomed by some (particularly smaller) borrowers who are unable to access the green bond market. However, despite flexibility generally being considered to be an advantage of the loans market compared to bonds, until recently there has been no green funding other than drawn debt, which does not suit the needs of all borrowers. Now that structures have been developed around sustainable RCFs, green supply chain financing and asset finance, sustainable finance may be a viable option for more borrowers.
•Credit profile: many lenders believe that a company operating on a sustainable basis is likely to have better governance and better management. There is also the advantage of external investigation: sustainable debt often requires the borrower’s operations to be audited or certified by third party sustainability experts. As part of that certification process, the experts will ensure that the corporate governance and internal working practices of the borrower meet certain standards. These factors it is argued, may mean that a company taking on green debt should also manage its risks better in general, making it a better credit risk – and justifying the lower pricing which often accompanies meeting agreed sustainability criteria.
•Capital requirements: currently there is no regulatory advantage to green loans, but this may change. At the end of last year, the EU Commission announced that it is considering lowering capital requirements for sustainable finance and the investigation of this "green supporting factor" forms part of the EU’s action plan on sustainable finance. The idea has met with mixed reactions. While it would undoubtedly boost sustainable lending and align broader economic incentives with the political imperative for sustainability, there are concerns that it may lead to weaknesses in the banking system if capital advantages for sustainable lending are so significant that they dilute usual credit metrics.
How does it work?
There is currently no market standard form of sustainable finance loan. So far, sustainable provisions have been incorporated in credit agreements in a number of ways and we expect further changes as the market continues to develop. We have seen the following approaches in documentation:
•Purpose: the purpose clause requires that the loan proceeds should be applied to a purpose which meets the LMA’s Green Loan Principles. This is similar to the approach taken by most green bonds, and has the advantage of simplicity. However, although this is suitable for a drawn asset such as a bond or a term loan, it is unsuitable for a revolving facility, or other financing solutions such as supply chain finance, where it is hard to monitor how any particular advance is applied.
•Margin adjustments: the margin is subject to a ratchet, presented like a ratings grid but based on sustainability criteria rather than creditworthiness. In most green loans to date, the margin adjustments have been binary (i.e. if targets are met then the margin is reduced, if not then the margin is higher), but we are starting to see grids based on various factors such as environment, health & safety record, suppliers, customers and staff, where the margin varies on a scale depending on the company’s performance against a range of criteria. The level of margin adjustment is not always huge – in some transactions it is only a few basis points, but in others (particularly more recent deals) the margin can vary much more.
•Level of green assets: the borrower is required to ensure that the value of its investment in green assets is never less than the amount of its green debt (perhaps with an additional buffer built in). This approach attempts to achieve the benefits of the "purpose" approach set out above, but acknowledges that it will not always be possible for a company to show that a loan has been applied directly for a green purpose.
•Third party validation: although the LMA’s Green Loan Principles theoretically allow borrowers to self-certify compliance with sustainability criteria, compliance with sustainability criteria generally relies on certification or verification by third party experts, either to test the green-ness of particular assets or investments or to give a second opinion on the company’s certification of performance against green criteria. A key issue for developing this market is building confidence in third party verification by ensuring that the standards are appropriate and that they are consistently applied across transactions.
•Enforcement of sustainable representation and covenants: although green loan facilities contain representations or covenants relating to green performance, approaches differ on how (and whether) these are enforced. At the most borrower-friendly level, failure to continue meeting green criteria may merely have a pricing impact, meaning that the green margin reverts to a (higher) non-green margin. If covenants and representations are tested on each drawdown, the borrower may only be allowed to draw new funds if it meets the green criteria, but outstanding debt is not affected. At the other end of the scale (where lenders want to enforce compliance more strictly) green covenants and representations may be tested as other covenants, compliance with relevant ratios may be tested in the same way as financial covenants, and failure to meet those criteria may trigger defaults, giving lenders the usual acceleration rights.
The sustainable loan market looks set to continue its rapid development, particularly if capital allocation rules change to favour loans meeting sustainability criteria.