The term ‘green loan’ has become increasingly omnipresent in economic and market discourse. What is a ‘green loan’ and what distinguishes it from your typical ‘loan’?
Traditionally, a ‘loan’ is identifiable as such if the instrument in question satisfies three basic financial and legal criteria, namely that the instrument prescribes a specific purpose for which the funds advanced may be utilised; the instrument is for a specific term, upon the lapse of which the funds advanced must be repaid; and, lastly, the instrument attributes a financial cost to the whole affair, typically by way of charging interest, whether fixed, variable, or a combination of the two. Naturally, whilst these criteria describe a typical plain vanilla loan, it is possible to structure a more complex loan, with more onerous or complex terms and conditions.
A green loan is a form of financing that seeks to enable and empower businesses to finance projects which have a distinct environmental impact, or rather, which are directed towards financing ‘green projects’. However, the concept is broader in that it encapsulates a green-oriented methodology across the entire process of selecting, structuring, utilising and reporting on the green loan. In this respect, whilst various methodologies of what qualifies as a green loan or a green project may be postulated, the litmus test, or industry benchmark, is represented by the criteria set out in the ‘Green Loan Principles’, published in 2018 by the Loan Market Association (LMA), as supplemented by the Guidance Note issued in May 2020, The Green Loan Principles (‘GLPs’) create a high-level framework of market standards and guidelines, providing a consistent methodology for use across the green loan market, whilst allowing such market to retain flexibility as it evolves. The GLPs are non-mandatory recommended guidelines, to be applied by markets on a deal-by-deal basis, depending on the driving characteristics of the transaction.
The GLP framework sets out four defining criteria for the purpose of establishing what makes a loan a green loan:
(1) Use of proceeds
An intrinsic component of a green loan is that the funds are advanced to exclusively finance or re-finance green projects. The GLPs set out a non-exhaustive list of eligible projects, with the common denominator being the clearly identifiable and distinguishable environmental impact and benefit, which must feasible, quantifiable and measurable, and includes projects that seek to address climate change, the depletion of natural resources, the loss of biodiversity, as well as combatting pollution. Interestingly, in terms of the GLP Guidance Note, green loan financing is not the exclusive preserve of purely green borrowers, noting that projects that significantly improve the efficiency of utilisation of fossils fuels are potentially eligible, subject to meeting all the other eligibility criteria and further that the borrower has committed itself to a decarbonisation pathway that is aligned with the Paris Agreement (UNFCCC Climate Agreement 2016).
(2) Green project evaluation and selection
With a view to ensuring transparency and integrity in the selection process, the GLPs set out key elements of the proposed green project that are to be communicated by the prospective borrower when seeking a green loan. A prospective borrower should communicate, as a minimum, the environmental sustainability objectives of the project, as well as the process by which it has assessed that its project qualifies as an eligible green project. The assessment should be an objective and balanced one, highlighting the potential material environmental risks associated with the proposed green project, as well as underlining any green standards or certifications the prospective borrower will strive to attain in order to counter-balance such risks.
(3) Management and monitoring of use of proceeds
The third component of the GLPs focuses on how borrowers manage the actual use of proceeds. The GLPs recommend that the proceeds of the green loan are credited to a dedicated account to promote the integrity of the funds and allow the borrower to trace outward flows. Where a green loan takes the form of one or more tranches of a loan facility, each green tranche(s) must be clearly designated and credited. Furthermore, borrowers are encouraged to establish an internal governance process through which they can track the allocation of funds towards green projects. The borrower and lender(s) should agree a priori whether an external independent review will be required to assess performance during the lifetime of the loan. Practice demonstrates that that where the lenders have a broad working knowledge of the borrower and its activities or where the borrower has sufficient internal expertise, self-certification is seen to be appropriate. Absent such elements, third-party review is recommended.
The GLPs promote transparency in reporting by recommending that borrowers report, on at least an annual basis, on the utilisation of proceeds and actual allocation of proceeds towards green projects, as well as information on the environmental impact thereof. The GLPs recommend a mix of qualitative performance indicators and, where feasible, quantitative performance measures (for example, energy capacity, electricity generation, greenhouse gas emissions reduced/avoided, etc.), as well as the key underlying methodology and/or assumptions underpinning the determination.
In essence, the GLPs set out a guiding taxonomy for the identification, selection and management of green loans and may be applied across various loan instruments, including green syndicated loans, green revolving facilities, green asset finance, green supply chain finance.
Having explored the key features of a green loan, we now turn our attention towards critically assessing their attractiveness to entrepreneurs and financiers alike. In reality, even though the economic drivers may differ amongst market players, the over-arching motivation effectively remains one and the same - the attainment of sustainable projects that have a positive environmental impact. From a reputational and corporate governance perspective, green loans may have a ‘halo effect’, allowing borrowers and lenders to tangibly demonstrate their commitment towards the development of a sustainable economy, a commitment that has grown in importance with heightened expectations of shareholders and the wider stakeholders and market forces at play, including regulators’ and employees’ expectations. Furthermore, green loan instruments allow borrowers to gain access to a wider and more diverse pool of investors, particularly those seeking investment with a positive environmental, social and governance (‘ESG’) focus.
From a purely financial perspective, the general market trend observed is for lenders to charge lower interest rates to finance green projects, or the easing of financial or other restrictive covenants, incentivising borrowers’ up-take of such instruments. Moreover, there is evidence to suggest that borrowers operating on a sustainable basis are likely to have in place better risk management and good governance procedures, resulting in a better individual credit risk profile for the borrower, and an enhanced aggregate credit risk profile for lenders. From a regulatory capital point of view, although there is as yet no concrete regulatory advantage to green loans, the EU Commission has opened the door to this possibility, announcing that it is studying the viability of easing capital requirements for such types of instruments in its communication on the European Green Deal.
It is also pertinent to consider the concept of ‘greenwashing’, a practice that is frowned upon in the green loan market and is used to describe borrowers who hold themselves out as having green credentials and yet whose claims are misleading, inaccurate or inflated. Prospective green loan market participants should be cautious of the serious implications of greenwashing practices, including the adverse impact on investor confidence and the real threat of a detrimental reputational fallout or even litigation. In this respect, the GLP Guidance Note emphasises that borrowers of green loans should ensure that the use of proceeds remain green for the entire duration of the loan, and not merely at the outset of the loan draw-down.
Looking over the horizon for the green loan market in the years to come, promising indicators are abound. For instance, the European Investment Bank (EIB) has cemented the fight against climate change and environmental protection as one of its pillars, with no less than 25% of its annual investment programme dedicated towards green projects, including the protection of biodiversity, sustainable transport and renewable energy projects. Furthermore, the European Green Deal Investment Plan, presented in January 2020, sets out an ambitious investment mobilisation plan to unleash a green investment wave of up €1 trillion in public and private sector funds to be channelled towards attaining the EU’s commitment to becoming the first climate-neutral block by 2050. At a local level, the Malta Development Bank (MDB), established in November 2017, has, as one of its founding objectives, the promotion of inclusive and environmentally sustainable economic growth. Towards this end, the MDB has, among other initiatives, embedded social and environmental factors in its investment appraisal and risk assessments processes, and has identified the funding of projects with a green dimension as one of its strategic pillars, with investment in renewable energy and energy efficiency at the forefront of this strategy.
With a burgeoning environment-first conscious, the green loan market has gone from strength-to-strength, enjoying year-on-year growth and attracting an ever-widening pool of banks and other financial institutions to the green loan market. In more recent months, we have witnessed a gradual evolution in the concept of green lending, green loans spawning into more complex loan instruments, better known as ‘sustainability-linked loans’ or ‘SLLs’. SLLs will form the subject of our next publication in this Sustainable Finance series.
This piece forms part of Camilleri Preziosi’s ‘Sustainable Finance’ series, in which members of the firm’s Capital Markets and Finance practice groups explore and evaluate the emerging trends and opportunities in the sustainable finance economy. For further information, contact firstname.lastname@example.org.