Cleaning up: how green loans are evolving

Green loans are gaining traction but some work still needs to be done for them to be clearly definable

Green loans are the new kid on the block when compared with the grown-up green bonds market. Global green bond issuance was $155.5 billion in 2017 up 78% on 2016 numbers according to Reuters. But green loans are about to become a significant feature of the corporate lending market – and the interesting part is that it's not only environmentally-orientated business that will be able to benefit from this type of financing.

Government, consumer sentiment and a sense of corporate and social responsibility on both the lender and borrower sides are all adding to the build-up of momentum. The Paris Agreement placed a marker in aiming to strengthen the global response to climate change by 'making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development'. There is significant market chatter concerning the possibility of a green supporting factor in determining banks' capital requirements. That is, the possibility, mooted by the European Commission, of lower capital charges for green finance.

Until March of this year, the markets didn't have a benchmark for what constituted a green loan. This is in marked contrast to the green bonds market which has, since 2014, looked to the International Capital Markets Association's (ICMA) Green Bond Principles for a voluntary framework to guide green bond classification. The absence of a clear consensus on what a green loan is, meant that the term has been somewhat fluid. It has been used to describe green loans where the use of proceeds is restricted to deployment in green projects; for example, the development of a new wind farm. However, the green loan badge has also been used to describe an alternative financing structure where the loan purposes are not linked to specific environmentally beneficial projects, but the loan nevertheless promotes environmental, social or governance (ESG) objectives, since the borrower is incentivised via an interest margin ratchet to improve its ESG behaviours.

The LMA/APLMA Green Loan Principles introduce a new benchmark

On March 21 2018, the Loan Market Association (LMA), together with the Asia-Pacific Loan Market Association (APLMA), released its Green Loan Principles (GLPs), which aim to create a framework for the green loan market, particularly by establishing the circumstances in which a loan can be labelled green. These closely track the ICMA's Green Bond Principles and share the four core components. These are (in summary):

• Use of proceeds. Proceeds must be deployed to finance or refinance green projects described in the finance documents. The GLPs set out a non-exhaustive list of green projects which include, for example, renewable energy projects, biodiversity conservation and waste water management. 
• Process for project evaluation and selection. The borrower must clearly communicate to its lenders their environmental sustainability objectives, the process by which the project fits the eligibility criteria, any exclusion criteria and process applied to identify and manage environmental issues associated with the project. 
• Management of proceeds. Proceeds should be credited to a dedicated account or appropriately tracked. Borrowers are encouraged to develop internal governance structures for tracking allocation of funds. 
• Reporting. Borrowers should maintain current information on use of proceeds (to be reviewed regularly), including the expected/achieved impact. Qualitative performance indicators and measures and disclosure of underlying methodology is recommended.

Arguably, the most significant of these is the use of proceeds criteria, which effectively aims to align the green loan market with the green bond market. This indicates that the GLPs will not encompass sustainability-linked loans ie loans which finance broader ESG objectives. The indications however, from the LMA, are that social/sustainability loan principles would likely be developed as a phase 2 LMA/APLMA project, as a shadow to the ICMA Social Bond Principles and Sustainability Bond Guidelines.

All borrowers should be able to use financings to incentivise greener behaviour

While, at first glance, the GLPs seem to exclude from the green loans market any entities which don't have eligible green projects for which they have financing (or refinancing) needs, this may not necessarily be the case. It would be unfortunate for the GLPs to be overly narrow, as any incentivisation of greener behaviour should be encouraged. In particular, corporate borrowers who are increasingly motivated to exhibit responsible corporate behaviour are looking to make their general corporate purposes revolving credit facilities consistent with more environmental responsible behaviour – and indeed with wider ESG objectives. What are the alternatives to a green loan facility, which finances pure green projects, which are being explored by corporate lenders and borrowers alike?

A green tranche. This option is entirely consistent with (and anticipated by) the GLPs. Within a general corporate loan facility, a tranche is designated for use only on eligible green projects with proceeds tracked against that project and reported on as per any other green project. This provides flexibility for almost any corporate to take on a green loan. Most corporates have some level of green improvement expenditure within their budgets: for example, installation of more efficient heating or cooling equipment, or switching to electric vehicles. If these expenditures can be separated out from everyday corporate expenditure, then a green tranche of a wider facility is an accessible option.

A greening facility aka sustainability loans. This could be used to describe a facility that motivates a borrower to become greener or more sustainable in behaviour – and penalises backsliding. The facility purposes are not linked to specific green projects, but the loan nevertheless promotes positive environmental action, since the borrower is incentivised via an interest margin ratchet to meet green key performance indicators (KPIs). Equally, if the borrower's KPI behaviours fall below a baseline, it can incur a margin penalty. Performance may be measured either against an independently managed sustainability index or, alternatively, can be a matter for management certification – in either case, often drawing heavily on publicly reported information.

This type of green loan is very attractive to investment grade borrowers which don't operate in a green sector and which don't have specific finance needs for specific green projects, but which are nevertheless incrementally introducing sustainability targets or policies and improving corporate behaviour – for example, eliminating plastics in the staff canteen, installing energy saving lighting in buildings or reducing carbon emissions by upgrading its fleet of delivery vehicles. Large corporates commonly maintain backstop revolving credit facilities which are often largely undrawn. Making such facilities greener or more sustainable in nature enables the borrower to embed greening behaviour into its corporate DNA – without necessarily having any specific green projects which require financing.

A sustainable facility should also potentially be available to borrowers which are already highly green in their activities, but which don't have specific new green projects in need of financing or refinancing. We have seen the market facilitate green loans for this type of borrower by the use of a number of green covenants. For example, a covenant that the value of the borrower's green assets (eg wind turbines, waste recycling infrastructure or sustainable forestry stock) exceeds its green liabilities, that is, the borrowings made under the green loan. We would expect this covenant to be coupled with KPIs testing improvements or backsliding in performance, linked to a two-way margin ratchet.

Documenting green loan facilities

The launch of the GLPs suggests that the key feature of green loan documentation will be terms which bring the loan within that framework. Banks in particular may be motivated to use market discipline to establish clear parameters around what can or cannot be badged as a green loan. If banks are looking to receive advantageous capital treatment for green loans, then those loans need to be clearly definable. There will a high degree of caution amongst supervisory authorities against any delinking of capital requirements from credit risk and therefore financial stability. To overcome that wariness would require a high level of confidence in the integrity of the green loan product – which is what the GLPs are aimed at supporting.

A feature common to this market is that a breach of the green covenants – related to use of proceeds, maintenance of a certain level of green assets or meeting specified green KPIs – is not an event of default. The impact anticipated by the GLPs where the use of proceeds core component is not satisfied, is that the loan can no longer be described as a GLP green loan. For those greening loans linked to broader KPIs, the impact is likely to be a margin penalty.

An area where we have seen market variation in documentation is around reporting and scoring for margin ratchet purposes – particularly for those facilities which are linked to generalised green KPIs rather than specific green projects. Reporting and scoring may be undertaken by borrower management certification – against policies and measures which are reported on publicly – or may be undertaken by an external ESG consultants/research organisations such as Sustainalytics. Use of an external consultant and an external assessment standard (or rating) brings a level of independence which can help to promote product integrity.

External assessment may include an evaluation of the issuer's internal governance, analysis of transparency, sustainability qualityand impact of the loan and, whilst this sounds very personalised and labour intensive, our understanding is that much of the evaluation data is algorithmically processed – lifting information from sources such as annual reports. Ultimately, for cost and practical reasons, even in the case of external assessment, the primary data will come from the company itself, collected at a granular level across the business. With that in mind, selfcertification can be an attractive option where the lenders and borrower have a strong relationship and the borrower has demonstrable internal expertise and gives comprehensive recording and reporting covenants. Reputational enhancement is a relevant driver for this loan product, so it is in neither side's interests to promote a loan as being green without being able to substantiate that. Even where the lenders agree to self-certification on an ongoing basis, our experience is that an external ESG consultant will provide a report on the company's green framework and credentials at the start of the loan.

Once the approach has been finalised, the actual enhancements to the finance documentation are relatively mechanical and can be built into almost any form of documentation. Importantly, this can be done at the time a new facility is put in place or an existing facility can be adapted during its life by amendment). The key areas that we would look at are: 

• the purpose clause and drawdown mechanics for the green/sustainable facility; 
• the interest clause to document adjustments to the margin; 
• information undertakings for ongoing green/ESG reporting obligations necessary to test the committed purpose of the green/sustainable facility and the adjustments to the margin (including the establishing the regime for ongoing external verification or self-certification); and 
• any initial conditions precedent to designating the facility (or converting an existing facility) to a green/sustainable facility.