At first, there were no recognised market standards to help determine what qualifies as a green or sustainability linked loan. While the Green Bond Principles first published by the International Capital Markets Association in January 2014 were a useful indication of the direction being taken in the capital markets, they focussed on bonds rather than loans, and on green use of proceeds rather than sustainability. In the loan markets, the Equator Principles have long been used by financial institutions for managing environmental, social and governance risks in the project finance market, but their application was limited in the wider loan markets.
Without the benefit of recognised market standards there was a risk of diverging approaches being taken on what amounts to a green or sustainability linked loan. At its worst, that risked loans being presented as green or sustainability linked, when in reality they were little different to an ordinary loan, sometimes referred to as “green washing”.
Market standards for green loans were published by recognised industry associations in March 2018, and were followed in March 2019 by sustainability linked loan standards. Green and sustainability linked loans are now recognised products globally.
The drivers for the growth in green and sustainability linked loans are changing. What started as a mostly voluntary approach to addressing climate change risks and the need for businesses to act responsibly is beginning to be overtaken by regulation. In a speech in 2015, the Governor of the Bank of England, Mark Carney, set out how the catastrophic impacts of climate change will be felt beyond the traditional horizons of most banks, investors and financial policy makers, imposing costs on future generations. He warned that once climate change becomes a defining issue for financial stability it may be too late, and noted that risks to financial stability will be minimised if the transition towards a lower-carbon economy begins early and follows a predictable path.
Considerable progress has been made in the years since that speech. In March 2019, Mark Carney spoke of a step change in demand and supply of climate reporting, the push to better climate change risk management and how advances in reporting and risk analysis are paving the way for investors to realise the opportunities in climate-friendly investment.
A raft of national and international initiatives on climate change and corporate governance are starting to change how companies operate. There seems little doubt that in the face of ever increasing pressure, the growth of the green and sustainability linked loan markets is set to continue.
One of the hurdles faced by the green and sustainable finance market generally is the potential for green washing. In October 2018, the UK’s Financial Conduct Authority (the “FCA”) issued a discussion paper on “Climate Change and Green Finance”, which noted that:
“Minimum standards can be helpful for enhancing investor confidence and trust and enabling markets to develop. For example, minimum standards may help ensure investors understand what they are buying and prevent misleading ‘green washing’ of financial products and services. Green washing is marketing that portrays an organisation’s products, activities or policies as producing positive environmental outcomes when this is not the case.”
Minimum standards have been developed for the loan markets. The Loan Market Association (“LMA”), Asia Pacific Loan Market Association (“APLMA”) and the Loan Syndications and Trading Association (“LSTA”) launched their Green Loan Principles with the support of the International Capital Market Association (“ICMA”) in March 2018. The Green Loan Principles are similar in scope to ICMA’s own Green Bond Principles. The initiative began in 2017 at the instigation of the Global Green Finance Council, of which the LMA and ICMA are founder members, and the APLMA, which established a working group in 2016.
A year later, in March 2019, the Sustainability Linked Loan Principles were published by the LMA, APLMA and the LSTA.
Both the Green Loan Principles and the Sustainability Linked Loan Principles are voluntary frameworks, widespread adoption of which would mitigate the risks of green washing in the loan markets.
The Green Loan Principles establish four key criteria:
- use of proceeds;
- the process of green project selection;
- management of proceeds; and
Use of proceeds
The fundamental defining feature of a green loan is that the proceeds are applied for green purposes. The Green Loan Principles include a non-exhaustive list of green projects towards which the proceeds of the loan could be applied, and require that the relevant green project provides clear environmental benefits.
Process of green project selection
Green borrowers are expected to communicate certain key information to their lenders including details of their wider environmental sustainability objectives, the process by which they determine whether their projects are eligible green initiatives and the related eligibility criteria. They are also expected to provide details of any wider green standards to which they seek to conform.
Management of proceeds
The Green Loan Principles provide that the proceeds of a green loan should be credited to a dedicated account, or otherwise tracked by the borrower in an appropriate manner. This requirement is aimed at ensuring transparent use of proceeds for eligible green purposes in order to promote the credibility of green loans. By holding green loan proceeds separately, borrowers can more easily ensure that they are applied towards the purposes for which they are drawn, particularly where the facility may be used for more than one purpose.
This also reduces the risk that proceeds are applied for other purposes and are not available to fund the relevant green project. Where the loan proceeds are to be applied over a period of time, borrowers are likely to prefer a staggered drawdown profile to drawing the whole amount of the loan to hold in a deposit account pending application (since the interest received on that deposit is likely to be less than the interest accruing on the drawn loan).
It is acknowledged in the Green Loan Principles that tracing the use of loan proceeds can be easier with a term loan than a revolving facility because revolving facilities tend to be flexible in the purposes for which they may be drawn. This can be addressed by structuring the facilities into separate tranches to make tracing easier – there are examples of revolving facilities split into tranches for general corporate purposes and for green purposes, for instance.
The borrower of a green loan is required to record the green projects towards which proceeds are applied, together with a description of the project, the amount allocated and the expected impact of the project. Borrowers should renew that information annually and report it to their lenders.
The Green Loan Principles recommend (but do not require) third party oversight, and acknowledge that borrowers can seek guidance and input on their green loan processes in a variety of ways – examples include taking advice from external environmental consultants on their activities and arranging certification against external green assessment standards.
The key distinction between a green loan and a sustainability linked loan is that categorisation as a sustainability linked loan is not conditional on the proceeds being used for a particular purpose. Instead, the defining feature is that the terms of the loan incentivise the borrower to improve its performance against certain pre-determined environmental, social and governance (“ESG”) criteria. In practice this would typically mean that the pricing on the loan is directly linked to the sustainability performance of the borrower.
Summary of the key features of the Green Loan Principles and the Sustainability Linked Loan Principles
Sustainability linked loans
To facilitate and support environmentally and socially sustainable economic activity.
Loan instruments made available exclusively to finance or refinance new or existing “green projects”.
Loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance objectives.
Restrictions on purpose
The fundamental feature is the utilisation of the loan for “green projects”. The Green Loan Principles set out a non-exhaustive list of 10 categories of green projects, including renewable energy, energy efficiency and pollution prevention and control. Loan proceeds should be credited to a dedicated account or otherwise tracked.
No specific requirement for use of proceeds – loan could be for a borrower’s general corporate purposes.
Impact on pricing of borrower performance
There are facilities which have been split into tranches for green purposes and for other purposes where the green tranche attracts lower pricing.
The Sustainability Linked Loan Principles set out a non-exhaustive list of 10 common categories of objectives, including reduced greenhouse gas emissions, reduced water consumption and the amount of renewable energy generated or used by the borrower.
Borrowers should maintain records of the use of green loan proceeds, including a list of the green projects to which the proceeds have been allocated together with a description of the project, amount allocated and the expected impact. External review is recommended but not required.
The need for external review of the borrower’s performance against its predetermined sustainability objectives is decided on a case by case basis. For public companies, public disclosures may be sufficient to verify performance for the purposes of the loan.
According to Bloomberg data, global green and sustainability linked loan volumes exceeded US$99bn in 2018, with sustainability linked loans accounting for US$43.2bn of that (see Figure 1). Global sustainability linked loan activity in particular is clearly on the rise, and the rate of growth is increasing year on year. Projected sustainability linked loan volumes for 2019 exceed US$81bn based on extrapolating from deals announced between 1 January 2019 and 12 June 2019 (see Figure 2).
The Equator Principles were first published in 2003 and incorporate the International Finance Corporation Performance Standards and the World Bank Group’s technical industry guidelines for projects in emerging markets. The Equator Principles are intended to help ensure that project finance transactions are undertaken in a socially responsible way and in accordance with appropriate environmental management practices.
While widely adopted in the project finance sector, the Equator Principles are rarely encountered in ordinary corporate loan transactions. The introduction of the Green Loan Principles may have broader reach into other parts of the loan markets, but they are less established than the Equator Principles.
While the Green Loan Principles do not contemplate the pricing on the loan being linked to green use of proceeds, that linkage has been a feature of some corporate financings. In one example, a revolving credit facility for general corporate purposes was split into two tranches – the first tranche, which was available for general corporate purposes did not benefit from any discount, but the second tranche, which was available only for green purposes had reduced pricing.
"Two-way pricing mechanisms better incentivise performance by providing for a pricing reduction if sustainability criteria are met, and applying a pricing increase where performance declines."
Early financings were structured such that if the borrower satisfied its sustainability criteria, the margin on the loan was reduced. The size of that reduction varied between loans and markets, but might typically be in the range of 0.02% to 0.04% on a general corporate financing. In some markets the discount might be higher – as much as 0.10% to 0.20%.
Where sustainability targets were not met, the margin calculation mechanism on those financings had no penalty for poor performance. Instead the margin reduction was simply not applied.
More recently, two-way pricing mechanisms have been introduced on some deals. Two-way pricing mechanisms better incentivise performance by providing for a pricing reduction if sustainability criteria are met, and applying a pricing increase where performance declines.
The underlying objective of incentivising borrowers to make improvements to their sustainability profile is probably more likely to be achieved through two-way pricing mechanisms, but it is possible that they could be viewed in a less positive way – after all, they result in lenders making greater returns on loans from borrowers who are not meeting sustainability targets.
There are examples of alternative structures being considered, which could mitigate that concern. One idea replaces increases in pricing with a requirement to make additional payments into a separate bank account should sustainability targets not be met. Those amounts could then be reinvested into improving the sustainability profile of the borrower.
"As the market becomes more sophisticated, rating methodologies are becoming more tailored."
The Sustainability Linked Loan Principles state that the need for external review of the borrower’s ESG performance is to be negotiated and agreed on a transaction by transaction basis. Where information relating to sustainability performance targets is not publicly available or otherwise accompanied by an audit or assurance statement, the Sustainability Linked Loan Principles recommend that external review of those targets is sought. Even where data is publicly disclosed, independent external review may be desirable. The majority of deals signed to date require external review rather than relying on self-reporting. This is in some ways similar to the requirement for an independent environmental and social consultant under the Equator Principles.
A number of factors influence whether third party oversight is required by lenders. At a general level, the integrity of the product is promoted by credible independent review. In many cases, self-reporting is not feasible because borrowers do not have the internal expertise to perform the role themselves. Larger corporates, which may have the necessary internal expertise to self-report, are encouraged by the Sustainability Linked Loan Principles to thoroughly document that expertise and their internal processes.
One reason borrowers might prefer to self-report is to avoid incurring an increased cost burden. It is worth bearing in mind the wider trend toward companies assessing and reporting on their ESG performance for other purposes, so to the extent information is already being gathered, it may be possible to repurpose it for a lower incremental cost.
A less obvious concern is the potential for external ESG rating providers to change their methodologies unilaterally. There are many entities in the market that research and rate corporate sustainability, although reporting in the loans market is concentrated on a smaller group of providers.
Each of the ESG rating agencies considers various data points to arrive at their respective ratings. Their rating methodologies are not only varied from each other, but evolve over time. In part that reflects shifts in perception towards particular risk factors – what is considered green or sustainable today may be less so tomorrow. For example, the production of electric vehicles might in some cases rely on the transport and use of raw materials that are extracted using polluting methods or perhaps involving poor employment conditions. Early ESG ratings tended not to differentiate between sectors when assessing the relevance of particular risks, but as the market becomes more sophisticated, rating methodologies are becoming more tailored.
Evolving rating methodologies can also be the result of consolidation in the market. For example, Sustainalitics acquired ESG Analytics in 2015. Vigeo Eiris was formed in 2015 by the merger of Vigeo and Eiris, both of which were ESG data providers. There are also moves from credit rating agencies into the market – Moody’s acquired a majority stake in Vigeo Eiris in April 2019.
Concerns have been raised about the low correlation between different ESG rating agencies’ assessment of the same company, which contrasts with the strong positive correlation generally seen in the context of credit ratings. This is a challenge for investors seeking a comparative assessment across companies with ratings provided by different sources. It is perhaps less of a problem in the loan markets where a particular ESG rating agency’s rating is being used to demonstrate an improvement in the performance of the borrower over time rather than to compare different borrowers. In time, the industry may well develop a more uniform approach, but to get there will require greater standardisation of the various methodologies used currently.
Changing methodologies could create a potential difficulty for the sustainability linked loans market. It is agreed when the loan is entered into that the pricing will change by reference to whether particular ESG performance targets are hit. If a rating agency changes its calculation methodology for whatever reason during the life of the loan, and that results in changes to a particular corporate’s rating, the pricing on the loan may also change. Whether or not methodology changes are significant enough to have a substantial impact is another question.
It is not uncommon for the facility agreement to include a list of possible rating providers or otherwise contemplate that the rating provider could change over the life of the loan.
The suggested criteria listed in the Sustainability Linked Loan Principles are indicative only – the critical factor is that the criteria chosen are ambitious and meaningful to the borrower’s business.
Market participants are not tied to using only the criteria listed in the Sustainability Linked Loan Principles. Metrics such as target CO2 emissions are common, but there are examples of novel criteria relevant to the borrower’s business, such as the proportion of electric vehicles in an electricity company’s fleet, or improvements in uptake of energy consumption monitoring tools among customers of a utility company. Criteria can be tailored to the business – for instance, the three-year average intensity of CO2 emissions in kilograms per megawatt hour of power produced by an electricity company.
It is common for pricing to be set by reference to the borrower’s overall ESG rating (which is typically expressed on a scale of 0 to 100, although some ESG rating agencies use a scale similar to that of the credit rating agencies). The borrower’s ESG rating is usually assessed annually, and a discount (or increase) to the applicable margin is applied if the ESG rating has moved more than a few points higher or lower than the initial ESG rating at the time the loan was entered into. The threshold for a change to the ESG rating to impact the applicable margin varies, but tends to be in the range of two to five points (on a scale of 0 to 100). The annual changes to the margin are not usually cumulative – the discount (or increase) is applied each year to the originally applicable margin if the ESG rating has moved sufficiently from the initial ESG rating, rather than to an already discounted (or increased) figure.
On transactions where specific ESG criteria are used rather than an overall rating, different discounts (or increases) can be applied for each specific target that is met. The alternative is an all or nothing approach that requires all targets to be met before the pricing changes.
"It is common for pricing to be set by reference to the borrower’s overall ESG rating, typically expressed on a scale of 0 to 100."
There is no single driver for the rise of green and sustainability linked finance. Instead, a raft of national and supranational initiatives are part of a wholesale shift to embed climate change risk and ESG risks at the heart of business strategy.
Adoption of the Equator Principles referred to earlier in this report is voluntary, but many financial institutions use the Equator Principles as a primary tool for managing ESG risks and impacts in the project finance market. The Equator Principles paved the way for other sustainability initiatives in the loan markets.
The UN Principles for Responsible Investment (“UNPRI”) are a longstanding voluntary initiative to incorporate ESG issues into investment practice. The UNPRI focus on, amongst other things, the incorporation of ESG issues into investment analysis and ownership policies and the disclosure of ESG issues.
Recommendations of the Task Force on Climate-related Financial Disclosures and Principles for Responsible Investment
The shift to embed climate and ESG risk factors into corporate decision making gained further traction following the Paris Agreement in 2015. In December 2015, the Financial Stability Board announced the establishment of an industry-led Task Force on Climate-related Financial Disclosures, with the goal of developing voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to lenders, insurers, investors and other stakeholders. In June 2017, the Task Force published its recommendations (the “TCFD Recommendations”), which give guidance on how to disclose clear, comparable and consistent information about the risks and opportunities presented by climate change. The core elements of the TCFD Recommendations concern governance, strategy (including scenario analysis), risk management and metrics and targets, each in relation to climate risk.
The impact of the TCFD Recommendations is significant, with financial institutions increasingly taking note of the TCFD Recommendations in their sustainability disclosures. There is potential for compliance with the TCFD Recommendations to become mandatory (on a comply or explain basis) in the near to medium term.
We have extensive experience advising on green and sustainable loan transactions. We are also at the forefront of legal and regulatory developments on ESG across Europe, Asia and the US, as national and regional regulators drive changes to the banking landscape.
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