A guide to sustainable finance

What is sustainable finance?

Sustainable finance is a form of debt financing for investments that exhibit a very high correlation between the financial return of those investments and their sustainability practices or outcomes, resulting in benefits for borrowers, investors and the lenders who lend to them.

This sustainable financing framework:

  • promotes market-driven solutions;
  • encourages positive environmental, social and governance (ESG) the results ;
  • facilitates the development, use and evolution of alternative and complementary types of flexible debt financing.

As sustainable finance markets have developed, this framework has been given additional structure through the creation of market practices and principles focused on incentivizing and rewarding sustainable behaviors and conducts of all borrowers. .

What are the benefits of sustainable financing?

The benefits of sustainable financing for borrowers include:

  1. Meet current (or future) stakeholder requirements: including investors, shareholders, contractual counterparties and employees.
  2. Access to Capital: For “brown” borrowers, some lenders or investors may require a green or sustainable lending product to lend.
  3. Reducing exposure: of companies to climate-related systemic risk.
  4. Positive press/marketing: allowing borrowers to make announcements such as “we are transforming our business to be greener/sustainable”.
  5. Financial incentive: margin advantage / penalty for achieving / not achieving objectives.

The benefits of sustainable financing for lenders include:

The five advantages for lenders

  1. Meet current (or future) stakeholder requirements: including investors, shareholders, contractual counterparties and employees.
  2. Build customer loyalty: Lenders retain the ability to continue to do business with “branded” customers on a “green” or sustainable basis.
  3. Reduce exposure: of the loan portfolio to climate-related systemic risk.
  4. Positive press/marketing: e.g. statements such as “$X billion of our loan portfolio is green/sustainable”
  5. Satisfy regulators and governments: who are expanding their focus on integrating sustainability into a lender’s investment information and decision-making processes.

There are clear overlaps between the benefits to borrowers and lenders of sustainable finance, which supports one of the fundamental tenets of this form of finance that it is much closer to a “win-win” outcome than other forms of financing.

What are the two distinct approaches to sustainable finance frameworks in lending markets?

Sustainable finance has two distinct finance frameworks, although there are overlaps between the characteristics of each:

Green finance

What is green finance?

Green finance is the financing of public and private green projects or investments (including preparation and investment costs) in:

  • environmental goods and services (such as water management or the protection of biodiversity and natural landscapes);
  • prevention, minimization and compensation of environmental and climate damage (such as energy efficiency or dams).
  • the financing of public policies (including operating costs) that encourage the implementation of environmental projects and initiatives and the mitigation or adaptation of environmental damage (for example, feed-in tariffs for renewable energy) ; and
  • components of the financial system that specifically address green investments, such as financial instruments for green investments and structured green investment funds, including their specific legal, economic and institutional framework conditions.

There are several forms of green financing, such as project financing or green bonds. Project financing is a means of forming a consortium of investors, lenders and other participants to finance, without recourse or with limited recourse, large-scale infrastructure projects. A green bond is a fixed income debt instrument and, like any other bond, offers a financial return. However, its uniqueness compared to so-called vanilla bonds is that they are issued for the specific purpose of financing new or existing sustainable projects or other beneficial uses for the natural environment.

A product use approach is at the heart of green finance. For example, bonds and loans cannot be labeled “green” unless the proceeds are used to fund a green goal or project.

Green loans are aligned with the Loan Market Association’s Green Loan Principles (see below).

Sustainability Linked Loans

Sustainability-linked loans can be used by borrowers for general corporate purposes, rather than exclusively for green projects. Rather than being “activity-based”, as is the case with green loans, sustainability-linked loans are based on investments that change behaviors or practices with the intended outcome that financial inventions of a project or investment and its sustainability outcomes are aligned.

A central feature of sustainability-linked loans are mechanisms in loan documents for a margin reduction to be applied to the cost of debt for a successful project (which delivers the expected financial and sustainable results) or a margin increase to be applied. to the cost of debt for an unsuccessful project.

Loan Market Association (LMA) Principles Applied to Green and Sustainability-Related Lending

LMA Green Loan Principles

The Loan Market Association issues a set of four fundamental principles which apply to all green loans made in markets governed by English law:

  • Revenue utilization instrument: activity-based, with funds used exclusively to finance or refinance new and/or existing “green projects” that deliver clear environmental benefits.
  • Project evaluation and selection process: A borrower must communicate to its lenders how its green objectives meet the eligibility criteria for green projects.
  • Product management: Green loan proceeds should be clearly designated in a specific tranche and, once drawn, specifically tracked to maintain product transparency and integrity.
  • Reports: Provided to lenders annually and including reports on qualitative and quantitative indicators (eg renewable energy production).

The LMA Green Lending Principles strongly recommend an external review of green lending against the LMA Principles:

  • Consultants: A borrower can seek advice from recognized experts.
  • Verification: A borrower can have their green loan verified by qualified parties such as independent ESG rating providers.
  • Certification: A borrower can have their green loan certified against an external assessment standard.
  • Rating: A borrower can have their green loan rated by qualified third parties.

The LMA principles contemplate self-certification of the Borrower when it has “demonstrated or developed internal expertise”. Such expertise must be “fully documented”, including policies and procedures.

The Asia Pacific Loan Market Association, among others, has supported the LMA’s Green Lending Principles for green loans made in the Asia-Pacific market.

LMA Sustainability Linked Lending Principles

The LMA has also set out four fundamental principles which apply to all sustainability-related lending in markets governed by English law:

  • Relation to borrower’s overall strategy: A borrower should disclose how a sustainability-linked loan will incentivize the achievement of predetermined sustainability-related performance targets, in line with its overall ESG strategy.
  • Target setting: Appropriate “ambitious” and “meaningful” targets are negotiated, with loan conditions aligned with the borrower’s performance against their targets. External review of the adequacy of the targets recommended as a precondition for funding.
  • Reporting: Provided to lenders annually, but also encouraged to report publicly to improve transparency.
  • Review: The need for an external review is a negotiated point, but particularly recommended when a borrower’s sustainability performance is not made public.

There is no drafting of market standards for sustainability lending provisions, but key themes are emerging and industry standards are developing.

Developing approaches when documenting green and sustainability loans

For attorneys writing loan documents based on sustainable finance, there are some general principles that should be considered and implemented in the finance document suite:

  • Purpose vs Behavior: Remember the distinction between green loans (purpose) and sustainability loans (behaviour) and structure the loan accordingly for the business and asset in question.
  • Can you use both? nothing prevents a borrower and their lenders from incorporating both green lending (eg Capex facility) and sustainability linked lending (eg term loans to refinance existing debt) provided that the LMA principles for both structures can be adapted.
  • Lender reluctance: It is possible to slice facilities so that some tranches are green or sustainability-related for lenders willing to participate, while others are not.
  • Follow the leader: it is also possible that one (or more) lender(s) will be appointed as a “sustainability coordinator” to advise on the structuring of sustainability or green provisions in the financing documents and communicate these characteristics to other lenders (initial or syndication). Each lender must always be satisfied with the relevant provisions even if such a role is assumed and a sustainability coordinator must make it clear that he has no responsibility or obligation towards any other party.

When drafting a durable linked loan document, there are additional drafting considerations:

  • Relation to borrower’s overall ESG strategy: A borrower should communicate how an SLL will encourage the achievement of predetermined sustainability-related performance targets, in line with its overall ESG strategy.
  • Target setting: Appropriate “ambitious” and “meaningful” targets are negotiated, with loan conditions aligned with the borrower’s performance against their targets. External review of the suitability of the recommended objectives as PCs for funding.
  • Reporting: Provided to lenders annually, but also encouraged to report publicly to improve transparency
  • Review: The need for an external review is a negotiated point, but particularly recommended when a borrower’s sustainability performance is not made public.

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