The Race Towards Green Finance Continues – Green Loans and Sustainability-Linked Loans
Despite the continuing challenges of the global pandemic, the green finance revolution is in full swing in the UK.
On 3 June 2021, the Governor of the Bank of England, Andrew Bailey, published a speech on tackling climate change. Mr Bailey set out three main focus points for banks and financial institutions over the coming years: firstly, the need to improve the understanding of climate-related financial risks across the financial system; secondly, the development and embedding of climate risk management in regulated financial firms; and thirdly, how the Bank of England itself can achieve best practice through its operations as a centralised financial institution. Hoping to lead by example, the Bank is committed to reducing emissions from its physical operations so it will become net-zero by 2050 at the latest.
This speech is encouraging, as it pushes green finance ever closer to the top of financial institutions’ agendas. So, what kind of products have started to emerge in the financial markets to achieve these ambitious but necessary targets? Two increasingly popular initiatives are ‘green loans’ and ‘sustainability-linked loans’, which are already offered by the likes of financial giants such as Lloyds and Barclays. While the two loans differ in their mechanisms, they both aim to tackle the broader issue of climate change at their core.
While ‘green loan’ is often used as a blanket term to describe any type of lending with sustainability in mind, it is more accurately described as a type of loan where the proceeds are required to be used for a specific ‘green’ project or purpose. Unlike a sustainability-linked loan, there is no pricing adjustment mechanism in a green loan.
To qualify as a green loan, a loan must comply with the four components of the Loan Syndications and Trading Association (LSTA) Green Loan Principles (GLP), last updated in February 2021:
- Use of proceeds – green loan proceeds must be used to finance or refinance an eligible green project which has clear environmental benefits. What constitutes a ‘green project’ is highly subjective at present in the absence of any standardisation, but indicative categories set out in the GLP include (among others) energy efficiency, pollution prevention, renewable energy and clean transportation.
- Process for project evaluation and selection – the borrower of a green loan must communicate its environmental sustainability objectives, how the project fits within the GLP, and the related eligibility criteria to lenders.
- Management of proceeds – all proceeds of green loans are required to be advanced into a separate account of the borrower. This promotes transparency of how the proceeds are applied and creates integrity of the green loan product.
- Reporting – borrowers are required to keep up to date information on the use of green loan proceeds and make this information available to lenders. Reports should include details of all the green projects to which the proceeds of the loan have been applied, including a brief description of and the amounts applied to each.
The GLP also recommend that borrowers obtain an external review of their green loans, though they do not include guidance on when such a review is appropriate. Since the loan market is relationship-driven, lenders are often very knowledgeable about their borrowers’ activities, and self-certification by the borrower, rather than an external review, will suffice.
Perhaps more flexible than green loans, and as a result increasingly popular, are sustainability-linked loans. According to the Sustainability Linked Loan Principles (SLLP), a set of voluntary guidelines issued by the Loan Market Association in May 2021, these products incentivise borrowers to achieve “ambitious, predetermined sustainability performance objectives” on a deal-by-deal basis. If a borrower successfully improves its sustainability profile against agreed criteria during the life of a sustainability-linked loan, it will benefit from a pricing adjustment: typically, the margin on the loan will decrease. Likewise, the margin may increase if the borrower fails to meet its targets. Unlike green loans, these loans do not carry a use of proceeds requirement and many are granted for general corporate purposes.
The SLLP base sustainability-linked loans around four core components:
- Relationship to the borrower’s overall sustainability strategy – a borrower must clearly set out its sustainability targets to lenders. It should also reference any certifications or external standards to which it is aiming to conform.
- Target setting – the sustainability targets against which the borrower’s performance is measured should be negotiated between the lender and the borrower for each transaction. The targets should be ambitious and meaningful to the borrower’s business, based on recent performance levels, and should remain relevant throughout the life of the loan. Achievement of the targets will result in a reduction of the borrower’s margin.
- Reporting – as with green loans, borrowers should make and keep readily available and up to date information regarding their sustainability targets, and are also encouraged to publically report this information.
- Review – requirements for the borrower’s performance against sustainability targets to be reviewed or verified will be negotiated and agreed between the borrower and lender for each transaction.
In June 2021, the SLLP were revised and expanded to the following five key components:
- Selection of Key Performance Indicators (KPIs) that are material, measurable, and can be bench marked.
- Calibration of Sustainability Performance Targets (SPTs) in relation to each KPI.
- Loan characteristics that link sustainability with an economic outcome.
- Reporting progress against SPTs.
- Verification of the borrower's sustainability performance.
Next steps for the financial markets?
These two loan products are hopefully a positive sign of things to come in the green finance world. Notably, as the green loan and sustainability-linked loan markets are still rapidly developing, there is currently no market standard drafting for incorporating the respective GLP or SLLP into facility agreements. This lack of standardisation is also due to the wide variety of projects which may qualify as ‘green’. However, as time goes on and more businesses make use of green finance, it is likely that a precedent will emerge and the market will begin to settle on clearer criteria.
For now at least, green finance continues to pave the way for more sustainable business, big or small, and provides an effective means for companies to meet and excel in their ongoing corporate social responsibility duties.
Get in touch
If you have any questions about this article or would like to know more about green finance, please do not hesitate to contact Sean Halliwell.
This article was created by Tom Revitt.