Sustainable lending: what is it and which forms can it take?
In the context of COP-26 targets and with the UK Government issuing £16 billion in green bonds in 2021, the sustainable lending area is one proving to live up to the expectation of massive fiscal growth, making the topic one worth revisiting.
The Loan Market Association (LMA) has released three concurrent types of sustainable lending. These seek to create voluntary high-level market standards and guidelines for use across the market.
1. Green Loan Principles
For a loan to be determined ‘green’, the utilisation of funds must exclusively provide clear environmental benefits, including addressing climate change, natural resource depletion, loss of biodiversity and air, water and soil pollution.
The core components of the Green Loan Principles are
- (1) Use of Proceeds;
- (2) Process for Project Evaluation and Selection;
- (3) Management of Proceeds; and
- (4) Reporting.
Green proceeds must be applied to a dedicated account and tracked to maintain transparency and allocation of funds towards green projects. The borrower should clearly communicate its environmental sustainability objectives, the criteria by which its projects fit within the eligible categories and any related lending criteria set by the lenders. It is also crucial to identify any exclusion criteria which a lender is not prepared to fund, such as vehicles powered through fossil fuel, weapons or tobacco, gaming industry.
3. Sustainability Linked Loan ('SLL') Principles
An SLL can be used for any purpose but differs from a typical loan as it gives incentives to the Borrower to achieve their sustainability performance targets, commonly in the form of a reduction in interest rate. Sustainability performance targets may include an organisation’s greenhouse gas emissions, use of renewable energy or recycled materials.
Sustainability Linked Loans are more common than Green Loans due to their core difference: the proceeds of an SLL can be used for any financing (typically working capital/ general corporate purposes), whereas Green Loans must be utilised in a way that provides environmental benefits.
The key components of the SLL Principles are:
- (1) Relationship to Borrower’s Overall CSR Strategy;
- (2) Target Setting;
- (3) Reporting; and
- (4) Review.
Importantly, there is now a strong push towards mandatory third party verification for SLL’s, under which borrowers should obtain independent and external verification of their performance level against sustainability performance targets for each key performance indicator. Whether this is required or if a borrower’s internal expertise is sufficient will be determined on a case by case basis.
The Future of Sustainable Lending
Sustainable lending market trends remain positive: according to the LSTA, global green and sustainability-linked lending in 2021 totalled $681 billion, increasing by 275% from 2020. The uncertainty which may determine the future fate of the market relates to the need to report and review the relevant standards: will the cost of hiring a third party adviser or monitoring body disincentive lenders and borrowers from taking part in the LMA Principles?
Future regulation and clarification, particularly in relation to the pre-mentioned verification, is highly likely. Going forward, lenders, borrowers and legal advisors should continue to stay up-to-date with relevant information for all three provisions to ascertain whether sustainable finance market will continue to grow, or if external reporting will present a cap on the potential of sustainable lending as we know it.
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