Sustainable Finance: The rise of green loans and sustainability linked lending (2024)

Green loans

The Equator Principles were firstpublished in 2003 and incorporatethe International Finance CorporationPerformance Standards and the WorldBank Group’s technical industry guidelinesfor projects in emerging markets. TheEquator Principles are intended to helpensure that project finance transactionsare undertaken in a socially responsibleway and in accordance with appropriateenvironmental management practices.

While widely adopted in the projectfinance sector, the Equator Principles arerarely encountered in ordinary corporateloan transactions. The introduction of theGreen Loan Principles may have broaderreach into other parts of the loan markets,but they are less established than theEquator Principles.

While the Green Loan Principles do notcontemplate the pricing on the loanbeing linked to green use of proceeds,that linkage has been a feature of somecorporate financings. In one example,a revolving credit facility for generalcorporate purposes was split into twotranches – the first tranche, which wasavailable for general corporate purposesdid not benefit from any discount, but thesecond tranche, which was available onlyfor green purposes had reduced pricing.

"Two-way pricing mechanisms better incentiviseperformance by providing for a pricing reductionif sustainability criteria are met, and applying apricing increase where performance declines."

One-way or two-way pricing

Early financings were structured such thatif the borrower satisfied its sustainabilitycriteria, the margin on the loan wasreduced. The size of that reduction variedbetween loans and markets, but mighttypically be in the range of 0.02% to0.04% on a general corporate financing.In some markets the discount might behigher – as much as 0.10% to 0.20%.

Where sustainability targets were notmet, the margin calculation mechanismon those financings had no penalty forpoor performance. Instead the marginreduction was simply not applied.

More recently, two-way pricingmechanisms have been introduced onsome deals. Two-way pricing mechanismsbetter incentivise performance by providingfor a pricing reduction if sustainabilitycriteria are met, and applying a pricingincrease where performance declines.

The underlying objective of incentivisingborrowers to make improvements to theirsustainability profile is probably more likelyto be achieved through two-way pricingmechanisms, but it is possible that theycould be viewed in a less positive way– after all, they result in lenders makinggreater returns on loans from borrowerswho are not meeting sustainability targets.

There are examples of alternativestructures being considered, which couldmitigate that concern. One idea replacesincreases in pricing with a requirement tomake additional payments into a separatebank account should sustainability targetsnot be met. Those amounts could then bereinvested into improving the sustainabilityprofile of the borrower.

"As the market becomes moresophisticated, rating methodologies arebecoming more tailored."

Third party oversight

The Sustainability Linked Loan Principlesstate that the need for external review ofthe borrower’s ESG performance is to benegotiated and agreed on a transactionby transaction basis. Where informationrelating to sustainability performancetargets is not publicly available orotherwise accompanied by an audit orassurance statement, the SustainabilityLinked Loan Principles recommend thatexternal review of those targets is sought.Even where data is publicly disclosed,independent external review may bedesirable. The majority of deals signed todate require external review rather thanrelying on self-reporting. This is in someways similar to the requirement for anindependent environmental and socialconsultant under the Equator Principles.

A number of factors influence whether third party oversight is required by lenders. At a general level, the integrity of the product is promoted by credible independent review. In many cases, self-reporting is not feasible because borrowers do not have the internal expertise to perform the role themselves. Larger corporates, which may have the necessary internal expertise to self-report, are encouraged by the Sustainability Linked Loan Principles to thoroughly document that expertise and their internal processes.

One reason borrowers might prefer to self-report is to avoid incurring an increased cost burden. It is worth bearing in mind the wider trend toward companies assessing and reporting on their ESG performance for other purposes, so to the extent information is already being gathered, it may be possible to repurpose it for a lower incremental cost.

Methodology changes

A less obvious concern is the potentialfor external ESG rating providers tochange their methodologies unilaterally.There are many entities in the marketthat research and rate corporatesustainability, although reporting in theloans market is concentrated on a smallergroup of providers.

Each of the ESG rating agenciesconsiders various data points to arriveat their respective ratings. Their ratingmethodologies are not only varied fromeach other, but evolve over time. In partthat reflects shifts in perception towardsparticular risk factors – what is consideredgreen or sustainable today may be less sotomorrow. For example, the production ofelectric vehicles might in some cases relyon the transport and use of raw materialsthat are extracted using polluting methodsor perhaps involving poor employmentconditions. Early ESG ratings tended notto differentiate between sectors whenassessing the relevance of particularrisks, but as the market becomes moresophisticated, rating methodologies arebecoming more tailored.

Evolving rating methodologies can also bethe result of consolidation in the market.For example, Sustainalytics acquired ESGAnalytics in 2015. Vigeo Eiris was formedin 2015 by the merger of Vigeo and Eiris,both of which were ESG data providers.There are also moves from credit ratingagencies into the market – Moody’sacquired a majority stake in Vigeo Eiris inApril 2019.

Concerns have been raised aboutthe low correlation between differentESG rating agencies’ assessment ofthe same company, which contrastswith the strong positive correlationgenerally seen in the context of creditratings. This is a challenge for investorsseeking a comparative assessmentacross companies with ratings providedby different sources. It is perhapsless of a problem in the loan marketswhere a particular ESG rating agency’srating is being used to demonstrate animprovement in the performance ofthe borrower over time rather than tocompare different borrowers. In time, theindustry may well develop a more uniformapproach, but to get there will requiregreater standardisation of the variousmethodologies used currently.

Changing methodologies could create apotential difficulty for the sustainabilitylinked loans market. It is agreed when theloan is entered into that the pricing willchange by reference to whether particularESG performance targets are hit. If arating agency changes its calculationmethodology for whatever reason duringthe life of the loan, and that results inchanges to a particular corporate’s rating,the pricing on the loan may also change.Whether or not methodology changes aresignificant enough to have a substantialimpact is another question.

It is not uncommon for the facilityagreement to include a list of possiblerating providers or otherwise contemplatethat the rating provider could change overthe life of the loan.

Sustainability criteria

The suggested criteria listed in theSustainability Linked Loan Principles areindicative only – the critical factor is thatthe criteria chosen are ambitious andmeaningful to the borrower’s business.

Market participants are not tied to usingonly the criteria listed in the SustainabilityLinked Loan Principles. Metrics suchas targetCO₂emissions are common,but there are examples of novel criteriarelevant to the borrower’s business, suchas the proportion of electric vehiclesin an electricity company’s fleet, orimprovements in uptake of energyconsumption monitoring tools amongcustomers of a utility company. Criteriacan be tailored to the business – forinstance, the three-year average intensityofCO₂emissions in kilograms permegawatt hour of power produced by anelectricity company.

It is common for pricing to be set byreference to the borrower’s overall ESGrating (which is typically expressed ona scale of 0 to 100, although some ESGrating agencies use a scale similar tothat of the credit rating agencies). Theborrower’s ESG rating is usually assessedannually, and a discount (or increase)to the applicable margin is applied if theESG rating has moved more than a fewpoints higher or lower than the initial ESGrating at the time the loan was enteredinto. The threshold for a change to theESG rating to impact the applicable marginvaries, but tends to be in the range of twoto five points (on a scale of 0 to 100).The annual changes to the margin arenot usually cumulative – the discount(or increase) is applied each year to theoriginally applicable margin if the ESGrating has moved sufficiently from theinitial ESG rating, rather than to an alreadydiscounted (or increased) figure.

On transactions where specific ESGcriteria are used rather than an overallrating, different discounts (or increases)can be applied for each specific targetthat is met. The alternative is an all ornothing approach that requires all targetsto be met before the pricing changes.

"It is common for pricing to be set by referenceto the borrower’s overall ESG rating, typicallyexpressed on a scale of 0 to 100."