Sustainable Lending – Banking on a Sustainable Future

Environmental, social and governance issues are becoming increasingly important for corporates as they have become more aware that the potential for long term success is dependent on sustainability risks. This is a consequence of regulatory and political factors, but also changing demands from various stakeholders such as investors, consumers and employees.

It is estimated that Europe needs up to €290 billion in additional yearly investment in order to achieve the targets set by the Paris Agreement. While the EU has committed over €1 trillion in public funding for sustainable investments under the European Green Deal, given the scale of the investment gap this will need to be supplemented by private investment. UN Special Envoy for Climate Action and Finance Mark Carney has been particularly vocal about the need for private investment to be channelled towards sustainable purposes, and for banks to protect themselves against climate related risks on their loan books.

Sustainable lending, incorporating green loans and sustainability linked loans, as well as other forms of sustainable finance such as impact investing and green bonds, enables a wide range of borrowers and lenders to incorporate sustainability in their funding models. Accordingly, these types of loans have become increasingly popular in recent years – it is estimated that the global value of green and sustainability linked loans in 2019 was USD$163 billion.

Sustainability Linked Loans and Green Loans

Sustainability-linked loans are any type of loan instruments and/or contingent facilities which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance objectives. By contrast, green loans are any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible green projects.

The rapid development of these types of loans has been supported by the introduction in 2018 of the Sustainability Linked Loan Principles (SLLPs) and the Green Loan Principles (GLPs). Both the SLLPs and the GLPs were updated in July of this year and provide a framework for the implementation of an increasingly important area of finance. These are guidelines only given the wide range of transactions they are designed to accommodate, and do not prescribe specific drafting.

GLPs vs SLLPs

The GLPs adopt a purpose driven approach. The key determinant for this type of loan is how the proceeds of the loan are to be applied. As a result they will not be suitable for loans outside of certain prescribed classes of “green projects” e.g. construction of a renewable energy project or infrastructure for clean energy vehicles.

By contrast, the SLLPs are focused on performance incentives and so are quite flexible in their potential application. The application of the proceeds of the loan is not a determinant for these types of loans and so these are typically used for general corporate purposes. Sustainability linked loans can be used for all types and sizes of financings. They can also be used as part of a wider financing arrangement, for example for the working capital tranche of a facility.

The borrower and its lenders will agree a set of sustainability performance targets (SPTs) that are both ambitious and meaningful, as well as being relevant to that borrower’s CSR strategy. The borrower is incentivised by way of a margin ratchet – if they succeed in meeting their targets they will benefit from reduced pricing. However, if they fail to meet their targets there may also be an increase or penalty.

Both parties should be committed to the actual sustainability goal rather than direct financial gain. Neither the borrower nor their lenders should benefit financially from meeting or falling short of the SPTs and the proceeds of an increase or decrease should be ring fenced and recirculated back to agreed sustainability purposes.

Various global brands are turning to sustainability linked loans to support their sustainable ethos. By way of example plant milk producer Oatly entered into an SEK 1.925 billion sustainability linked loan earlier this year and agreed 4 key SPTs with its lenders – reducing water usage, improving energy efficiency, introduction of electronic vehicles and avoidance of CO2 emissions. However SPTs will be specific to the particular borrower’s business – and could be something as simple as improving the energy efficiency of properties owned or leased by the borrower.

A key focus of both the SLLPs and GLPs is the avoidance of “greenwashing” or “sustainability washing”. For this reason, ongoing reporting and review, often by a specialised third party, is integral to both sets of principles.

Legal, Regulatory and Other Incentives

While the SLLPs and GLPs are not intended to directly facilitate financial gain, there will be other factors that can incentivise borrowers and their lenders to adopt these types of loans.

The European Parliament adopted the Taxonomy Regulation earlier this year which is designed to establish an EU side classification system so that investors and businesses can assess to what degree economic activities are environmentally sustainable. The European Parliament has also adopted the Disclosure Regulation which sets out to ensure that financial market participants consider sustainability risks and impacts, and disclose these to investors.

Regulators such as the European Central Bank (ECB) and the Central Bank of Ireland (CBI) have indicated that this area will become an increasing focus. The ECB have published a consultation where it has indicated that it will require banks to be more transparent in their disclosures related to these issues and that it will require banks to include these factors in their risk assessments, with similar intentions echoed by the CBI as part of their supervisory role.

In addition to increasing regulatory focus on sustainability which banks will in turn also require from their corporate customers, banks and corporates are likely to also come under pressure from investors to adopt more sustainable approaches to their loan books and business models. Banks in particular are coming under pressure to deleverage certain classes of loans such as those relating to fossil fuels from their balance sheets. An example of this is the resolution filed by some of Barclays largest institutional investors requiring them to publish a plan to phase out lending to certain companies that are not aligned with the targets set out under the Paris Agreement.

Finally, increasing consumer demand for sustainable products and brands with a sustainable ethos will also incentivise change in financing arrangements.

While green loans will be suitable for a very particular type of borrower's purposes, sustainability linked loans present opportunities for borrowers and lenders beyond the green sector to introduce sustainability to their financing arrangements. With the wide range of SPTs that can be accommodated under a sustainability linked loan, borrowers will have the opportunity to focus on targets that are both relevant and important for their particular business, so that they can respond to increasing demand from their stakeholders to demonstrate their sustainability profile.