As the world faces pressing environmental challenges, the need for sustainable practices has become more apparent than ever. In response, financial institutions and borrowers are increasingly turning to innovative financing options that promote environmental and social responsibility. Two such solutions that have gained significant traction are sustainability-linked loans (SLLs) and green loans. These instruments not only provide capital for businesses but also incentivise them to adopt and achieve sustainable targets.
In this article, we explore the key aspects of green loans and SLLs and examine the efforts being made to standardise drafting of finance documents, which is considered key to promote these types of products.
Understanding Green Loans
Green loans are specifically designated for financing projects that have positive environmental or climate-related impacts. These projects often focus on renewable energy, energy efficiency, pollution prevention, sustainable land use and other environmentally beneficial initiatives.
The Loan Market Association (LMA) has developed a set of principles, known as the Green Loan Principals (GLPs) to facilitate and support environmentally sustainable projects. The GLPs work as a voluntary framework for green loans which guide market participants and help them achieve a more standard approach to green lending. The latest update of the GLPs published in February 2023, made significant improvements in clarifying the scope of green loans and making them more robust and accessible to a bigger pool of market participants.
The GLPs specify the following as the four core components for any green loan:
1. Use of Proceeds: green loans should outline how the borrowed funds are allocated to specific green projects. The GLPs provide a helpful high-level list of categories of eligible green projects. The list is obviously indicative only and parties may agree to categorise their loans as “green” as long as they have clear environmental objectives that can be assessed and quantified.
2. Project Evaluation and Selection: borrowers must disclose the selection process for identifying green projects. This ensures that projects meet the predefined sustainability criteria. The GLPs also encourage borrowers to explain how their projects align with official or market-based taxonomies and which green standards or certifications were used when identifying their projects.
3. Management of Proceeds: green loans should have clear tracking and reporting mechanisms to ensure that the green loan proceeds are allocated solely to sustainable projects. This can be for example by creating a separate “green tranche” with proceeds flowing into a separate bank account.
4. Reporting: regular reporting on the environmental impact of the financed project is essential as this serves to verify that the loan proceeds are being used exclusively for sustainable projects and it also enable stakeholders to monitor and evaluate the overall effectiveness of the green finance activities. Reporting can take different forms depending on each lender’s requirements however, in general, borrowers are expected to submit an annual report describing their green project and specifying the impact expected or achieved so far.
While various lenders and financial institutions have independently developed their own green loan principals, the GLPs have emerged as the widely accepted standard within the market. The GLPs are well regarded for their comprehensive framework, clear guidelines and emphasis on transparency and accountability.
Understanding Sustainability-Linked Loans
Unlike green loans, SLLs seek to encourage companies to improve their overall sustainability performance, irrespective of the specific use of loan proceeds. SLLs are tied to the borrower's achievement of predetermined sustainability performance targets (SPTs) which are assessed against predetermined key performance indicators (KPIs). The financial terms of the loan, such as interest rates, may be adjusted based on the borrower's ability to meet these sustainability goals.
The LMA has also developed a set of principles for SLLs known as the sustainability linked loan principals (SLLPs), which were first published in 2019 with the latest update made in February 2023. By tying the loan terms to the borrower's sustainability performance, SLLPs offer a more holistic approach and makes those loans available to a bigger pool of participants that operate in different sectors such as infrastructure, real estate, manufacturing or services, as long as the core components of the SLLPs are met.
The SLLPs specify the following as the five core components for any SLL:
1. Selection of Key Performance indicators (KPIs): borrowers and lenders agree on specific KPIs related to the borrower's sustainability initiatives. According to the LMA, those KPIs should be relevant, core and material to the borrower’s business, they should be measurable and able to be benchmarked. Selected KPIs should also have well defined parameters and a recognised calculation methodology to be able to gauge the borrower’s performance against selected KPIs.
2. Selection of Sustainability Performance Targets: The defining characteristic of SLLs is the inclusion of SPTs. Like KPIs, SPTs must be relevant to the borrower's business activities and remain sufficiently ambitious throughout the life of the loan to drive meaningful change. SPTs should be quantifiable, time-bound and directly linked to the borrower’s environmental or social KPIs. In its latest update, the LMA has strengthened the language around setting the SPTs whereby borrowers will not only have to go beyond business as usual, but their SPTs will also have to go beyond targets required by regulation or by law.
3. Loan Characteristics: Unlike traditional loans, sustainability linked loans have the unique feature of adjusting the cost of borrowing based on the borrower sustainability performance. If the borrower meets or exceeds the predefined SPTs, the loan terms may be adjusted favourably, such as reducing the margin, extending the loan tenure or relaxing certain financial covenants. Conversely, failure to meet the SPTs may lead to increased borrowing costs.
4. Reporting: Borrowers are required to provide regular updates on their progress toward meeting their sustainability targets. This could be done on an annual basis or when certain SPTs are met or on agreed reporting dates, by submitting a compliance certificate to the lenders or their sustainability coordinator accompanied in most cases by a report from external reviewers. These periodic assessments enable stakeholders to assess the efficacy of their sustainability initiatives and provide empirical evidence of the tangible impact resulting from the loan.
5. Verification: Third-party verification is usually employed to ensure the accuracy and credibility of the reported data. Verification is usually only optional pre-signing however, the SLLPs have made it compulsory post-signing. The verification report should be provided by an independent practitioner describing the level and type of verification conducted as well as the procedure and standards employed to assess conformance.
The efforts being made by the LMA and other stakeholders in this field are playing a vital role in shaping the sustainable finance space and are undoubtedly a move in the right direction. Obviously, there remains a lot of work to be done, but as market participants start getting familiar with SLLs, we could see a move towards strengthening the SLLPs to make them more comprehensive and ambitious.
Risks and Opportunities: Assessing the Green and Sustainability Linked Loan Markets
Are we there yet?
In a recent letter published by the Financial Conduct Authority (FCA), the FCA revealed some concerning weaknesses in the sustainability linked loan market. The letter highlighted the lack of ambition and commitment exhibited by some market participants, which is largely rooted in the setting of KPIs and SPTs and the increasing risk of conflict of interest.
The FCA noted that in some cases, banks and financial institutions have accepted weak targets that drive little or no meaningful change in their borrowers’ businesses and with little impunity in case those targets are not met, such as by stepping up the margin by around 2.5 basis points. The FCA's scrutiny has further exposed a looming risk of conflicts of interest, whereby certain banks, driven by a desire to meet environmental, social and governance (ESG) financing targets or to preserve their relationship with their clients, may be incentivised to prioritise their own additional remuneration and interests, which in turn increases the risk of greenwashing.
The FCA, in fact, does not directly regulate this part of the market and market participants are usually directed by a set of frameworks, guidelines and best practices issued by regulatory bodies and industry experts.
This state of affairs underscores the imperative for regulatory oversight and stringent reforms within the sustainability linked loan market to ensure its alignment with the overarching objectives of sustainable finance and responsible investment practices.
The road ahead
While the road ahead might still be long, there is important work being undertaken by stakeholders.
On 9 October 2023 the UK’s Transition Plan Taskforce (TPT) (launched by HM Treasury in April 2022), published its final “Disclosure Framework” which provides good practice recommendations to help companies set high quality, consistent and comparable transition plan disclosures.
The TPT Disclosure Framework is meant to contain a set of recommendations for companies to follow and it is expected that those recommendations become mandatory in the coming years and more detailed.
The TPT Disclosure Framework will be beneficial for the sustainability loan market as it offers good guidance for market participants and helps them design credible and ambitious SPTs and KPIs.
In addition to the work on the regulatory side, there are also initiatives to standardise the drafting of green and sustainability linked loans. This will undoubtedly be a challenging task given that the market is constantly evolving, and the different approaches being taken by stakeholders in tackling ESG issues, with some being more ambitious than others.
Clearly, model provisions will only serve as a starting point for negotiations between the parties, as they are generally based on a set of assumptions that do not necessarily apply to each loan. They are also based on common standards or practices in the sustainable finance market, although such practices are still fast evolving. However, having model provisions will surely make SLLs and green loans more accessible and will pave the way for new entrants.
Among the notable initiatives in this space is the work being done by the International Capital Markets Association (ICMA), the LMA and the Chancery Lane Project. The LMA has recently published its model form provisions for SLLs to be used in their senior multicurrency term and revolving facilities agreement for leveraged acquisition finance transactions, although the wording could also be adapted for use with their other recommended forms.
The standard drafting provisions are based on the SLLPs and they are intentionally left broad to allow parties negotiate the specific terms of each transaction, such as the purpose of the loan, the target level, the times for testing and verification and the consequences for non-compliance.
As the industry gets more familiar with this type of product, standard provisions will probably evolve to become more stringent and ambitious. For example, by improving reporting mechanisms and tightening controls around sustainability undertakings while at the same time offering more incentives for borrowers that achieve ambitious sustainable goals.
Closing Remarks
At the moment, firms are not showing much appetite for green or sustainability linked loans, especially in the mid-cap and SME segment, this is possibly due to the lack of trust and knowledge of this market. By weighing the risks and costs for obtaining such products, borrowers consider that they are exposing themselves to increased scrutiny from their lenders and they are subjecting themselves to additional costs for negotiating those loans and for complying with the agreed targets and benchmarks in exchange for small savings on margins.
The key to promoting sustainable and green loans is to build trust and credibility within the sustainable finance ecosystem. This may be achieved by taking an industry led action to increase transparency in the market, providing a comprehensive regulatory framework with proper oversight and providing strong incentives for stakeholders to participate.
