Green and sustainable loans: a short explanation
Lending markets have responded to the increase in ESG investing – investments that focus on or care about environmental, social and governance criteria – by establishing certain principles for participants to engage with sustainability-related lending principles (the “SLLP”) and Green Lending Principles (the “GLP”). Although both of these products may fall under ESG as an umbrella term, it should be kept in mind that they are different products.
GLPs and SLLPs were published by the LMA, APLMA and LTSA in 2018 and 2019 respectively. As the products developed, subsequent guidance outlining the potential applications of GLPs in the context of real estate finance was published in 2020. More recently, with the rapid increase in the number of sustainability-related loans, LMA, APLMA and LTSA took time. to reflect on the increase and have published an update to the SLLPs (see below).
There is currently no standard form documentation for green loans or sustainability-related loans. While each of the GLPs and SLLPS makes suggestions on where the accent should be paid, the absence of any standard market document allows parties to decide whether a loan is compatible with GLPs or SLLPs. The lack of a standard market form can slow the adoption of these types of loans.
GLPs and SLLPs warn of the problem of “green/sustainable laundering” where the green or sustainability characteristics of a loan are exaggerated. The concern here being that such practices will undermine the value of these genuinely green or sustainability-related loans.
Although in many respects, at least in Europe, the introduction of Regulation (EU) 2020/852 of the European Parliament and of the Council of the EU which entered into force on 12 July 2020 (the “taxonomic regulation”)¹ aims to repress, so called “greenwashing”.
Whether investors are getting green loans to complete a green project or a sustainability-linked loan to improve their credentials, the incentives now go beyond just pricing the finance product and are far longer term.
Many borrowers and sponsors have been made aware of ESG, but it has not been a central focus and has often been relegated to the CSR office as something to include in marketing publications². But that is starting to change. In a recent research report prepared by MSCI ESG Research LLC³, the authors noted that research indicated that companies with better managed ESG risks tended to benefit from lower capital costs, suggesting that the market viewed them as less risky.
ESG investing in an efficient or green building, for example, can allow landlords/investors to demand a premium, often referred to as the green premium⁴, which translates into higher rents or asset premiums for sale .
But what if owners/investors don’t invest in sustainable improvements/buildings? Are they likely to experience a brown shed and what would it look like? The theory around the brown shed relates to the fact that the value of any commercial property is determined by the present value of future cash flows, i.e. rental income⁵ minus costs. Anything that impacts the value of those future cash flows will impact the value of the building as a whole.
As “brown” buildings face rising maintenance costs and delayed capital investment to meet more stringent building requirements, they are also facing reduced demand from high-end tenants looking to upgrade. improve their green profile and regular tenants who avoid variable and higher utility costs. Building owners therefore have to reduce their rents to attract tenants⁶ which leads to a drop in the value of the whole property.
Using green loans and sustainably linked loans can help long-term real estate investors achieve their goals in a sustainable way.
WHAT IS A GREEN LOAN?
A green loan is any type of loan granted for the purpose of financing a “green project”. The definition of “green project” is deliberately broad and includes, but is not limited to, projects focusing on renewable energy, energy efficiency, pollution prevention and control, sustainable management of natural resources, conversation about biodiversity, sustainable water management, clean transport or building green buildings.
Whatever the green project, the central principle is that there must be a clear environmental benefit. GLP provides a framework of four central components:
1. Product use
The proceeds of a green loan must be allocated to a green project as mentioned above. In the context of real estate, an example would be for proceeds to be applied to the construction of an environmentally friendly building.
2. Project evaluation and selection process
Borrowers should communicate their sustainability goals to their lenders and show how the green project aligns with such a strategy.
3. Revenue management
Green loan proceeds should be credited to a dedicated bank account or otherwise tracked by the borrower to maintain transparency and promote the integrity of the green loan. As part of maintaining transparency, borrowers are encouraged to establish an internal governance process to track green loan proceeds.
Borrowers are required to provide updates at least annually to their lenders on the use of green loan proceeds. Reporting should use both qualitative and quantitative measures.
WHAT ARE SUSTAINABLY LINKED LENDING PRINCIPLES?
Unlike the green loans discussed above, the use of the product is not the distinguishing feature. A sustainability-linked loan incentivizes a borrower to improve its sustainability profile over the life of the loan. Borrowers benefit from reduced headroom to achieve pre-agreed ESG-related KPIs.
In March 2019, the LMA, APLMA and LTSA launched the SLLPs along with a guidance note. This provided a framework for sustainability-linked lending and was designed to promote product development and integrity. They are based on the following basic components:
• Selection of KPIs;
• Calibration of performance objectives in terms of sustainable development;
• Characteristics of the loan;
• Reports ; and
In May 2021, the LMA, APLMA and LTSA refined and tightened the core components and aligned them with the International Capital Market Association’s Sustainability Bond Principles.