Green Loans

Key policy makers are pushing to transform the global economy from carbon-dependency and from a use and abuse approach, to sustainable and responsible alternatives. What are Green Loans?  What issues should lenders and borrowers focus on? What trends do we expect to develop?

What is Green Finance?

There isn't a single descriptor for every type of green finance; any financing which incentivises or promotes environmentally responsible behaviour can potentially be considered "green". Nor is sustainable finance new; the Equator Principles, initiated in 2003, provide a voluntary framework for responsible environmental and social risk management in project finance transactions. 

"Green bonds" have been in issue for the past decade; sovereign and supranational issuers (such as the World Bank and EIB) have led the way, but the asset class has accelerated via major corporate issuances (for example by Toyota and Apple).  The key characteristic of a green bond is that its proceeds will be invested in approved green projects, for example low-carbon or sustainability-focussed ventures.  The ICMA Green Bond Principles 2017 alongside their Sustainability Bond Guidelines provide voluntary guidelines for issuers and investors to help promote the integrity of this asset class.

Green and socially responsible investment funds with sustainability-orientated investment criteria are also part of the picture.  That moniker could indicate that target investments must have sustainability objectives as their key purpose (for example a wind farm), or it might mean that targets (whilst potentially from any sector) must have environmentally sound corporate policies and behaviours.  Certain sectors may be excluded altogether (e.g. petro-chemical) or alternatively fund managers may have sector flexibility, but be required to invest in companies with positive environmental, social and governance (ESG) behaviours.  So we see both "dark green" and "light green" investment strategies.

"Green loans" are the newest entrant to the market.  They have the potential to operate in the same space as green bonds (where the use of proceeds is restricted via "green covenants"), but green loans may also be used to describe a new, alternative financing structure where the loan purposes are not linked to specific sustainability projects, but the loan nevertheless promotes ESG objectives, since the borrower is incentivised via an interest margin ratchet to improve its ESG behaviours.  Positive behaviour can be measured against an independently managed sustainability index or, alternatively, can be a matter for management certification.  This type of green loan is therefore attractive to investment grade borrowers with revolving credit facilities which are typically largely undrawn.  The green loan enables the borrower to embed sustainability-linked behaviour into its corporate DNA – without necessarily having any specific green projects which require financing.   

What are the key talking points for borrowers and lenders?

Reputation.  Investors are committing funds to green finance because environmental and social corporate behaviour is now a key influencer in consumer and governmental behaviour.  Consumers are migrating to businesses with sustainability agendas, and governments are inclined to incentivise and reward social consciousness.  An enhanced (or diminished) reputation in this area can impact the bottom line.

Integrity – the dangers of greenwashing.  If an asset class sells itself as "green", then green it should be.  The risk is that the criteria adopted for testing compliance with green covenants is not sufficiently rigorous, or that green covenants are inadequately monitored, or that the process is simply not transparent.  Tightly defined financing purposes, clear disclosure and behaviour covenants and disciplined monitoring set the credibility standard for financings based on green covenants.  Green loans that are linked to more generalised positive ESG behaviour have yet to settle on agreed standards.  

On 21 March 2018, the Loan Market Association released its "Green Loan Principles", which aim to create a framework for the green loan market, particularly by establishing the circumstances in which a loan can be considered "green".  The most significant of these is the  "Use of Proceeds" criteria, which effectively aims to align the green loan market with the direction of the green bond market, but doesn't acknowledge the potential positive ESG impacts which can arise from responsibly managed green loans which are linked to generalised ESG behaviours, but which don't have specific green purposes.

Independent benchmarking.  ESG data collection and analytics is now a major operation for information providers such as Sustainalytics and Thomson Reuters.  Benchmarking reduces transaction costs associated with monitoring green covenants and enhances credibility; it has also helped to kick-start the breed of green loans that are not coupled to green projects/green covenants.  However, ESG scoring can only assess relative performance (since there is no "absolute" ESG standard), and like-for-like comparisons can be difficult.  Furthermore, data is gathered and processed both algorithmically and by humans – and in both cases is susceptible to the reliability of the sources.  In addition, different benchmark providers attach different weightings to different factors; whilst any credible outfit will be transparent as to those weightings and to their scoring methodology, the reality is that it is hard to accurately score (for example) corporate governance.  Furthermore, it can be hard for bankers to get to grips with, and assess, the methodology.  Where banks and corporate borrowers have strong relationships, bankers are asking themselves whether management certification of ESG behaviours could be an acceptable alternative to an independent ESG score. 

Pricing.  ESG enhancements, and their impact on a borrower's bottom line, are difficult to price.  A borrower scoring well wouldn't traditionally see that factor resulting in a reduction in its financing costs.  However, the newer incarnation of green loans gives borrowers a small enhancement (single figure bps) – and, as reputation is key to this area, that is positive both for lenders (to be seen to reward borrowers who improve their ESG behaviour) as well as borrowers (who are seen to be driving improvements in their own corporate behaviour through their financing terms).

Supervisory impact¹.  The European Commission has stated its intent to bring sustainability risks into the mandate given to financial supervisory authorities.  More significantly, they have indicated a willingness to consider lowering capital charges for green finance.  That could be a game-changer in terms of accelerating growth – but there's a lot of work to be done first in terms of clarifying what assets would qualify for favourable treatment. 

What will drive the growth of green loans?  

Real estate finance is a natural fit for green loans.  For loans with a green purpose covenant, a real estate asset which is designed or modified to have a low environmental impact is a more valuable collateral asset.  The additional reporting that may be associated with green covenants can give lenders a better insight into a borrower's business and therefore drive more competitive pricing.

The SME market is an important space for green loans.  Whilst that borrower class may have limited access to the bond markets, the bond markets certainly enjoy access to SME assets.  Appetite for Green CDOs will help to fuel a healthy SME green loan market.

Advantageous capital treatment for banks making green loans would be a significant stimulus.  That would be a big step for the regulator and to get to that point there would need to be conviction that any capital easing wouldn't negatively impact financial stability, as well as real confidence in the integrity of the product.  For example, lenders may be entitled to accelerate facilities if loans are not used for eligible purposes – but there is no obligation for them to do so.  The dangers of greenwashing will weigh heavily on the regulators – and there is a question mark over how they will view new categories of green loans, where the purpose of the financing is decoupled from specific green objectives.  Green bonds are clearly at the forefront of the regulators' thinking – but  loan products shouldn't be too far behind.

Product integrity. Process transparency. Player reputation. These are the factors that are important to the success of this market. They are factors that have threatened the Banking sector and its products in the recent past. Going forward, green loans should be whiter than white.

1.  See EC Final report of the High-Level Expert Group on Sustainable Finance and EC Action Plan: Financing Sustainable Growth.