ESG, green loans and sustainability linked loans – these buzzwords in the field of green financing are gaining more popularity but the details are still a little unclear. Here we shed some light on these terms and provide a more differentiated view on the options available for real estate players.
ESG (short for Environment, Social and Governance) basically describes criteria that are now playing an increasingly important role with regard to financing. We often see and read about financings structured as green loans or sustainability linked loans. Mainly focusing on the E in ESG, the term green loan is further defined by the Green Loan Principles (GLP) developed by the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA). The catalogue of principles is not binding, but serves primarily as a guide and can be understood as a motivation to develop possible financing and documentation standards.
Financing green projects through green loans
Pursuant to the GLP, a green loan may generally be described as a loan instrument that serves exclusively to finance or re-finance suitable green projects and at the same time complies with the following four basic principles of the GLP.
Use of proceeds
The loan proceeds of a green loan must be used for what is called a “green project.” Such purpose should be appropriately described in the documentation. Examples of eligible categories of green projects are listed in Appendix 1 (Indicative Categories of Eligibility for Green Projects) of the GLP. The catalogue is still quite generic but the green project or purpose of the loan should provide clear environmental benefits. These environmental benefits should also be measurable and where appropriate be covered by specific reporting of the borrower. If only individual tranches are to fall under the green loan category (while others cater for what may be considered “dark green” or “brown purposes”), this should be clearly stated in the documentation.
Process for project evaluation and selection
The borrower of a green loan should clearly communicate to the lender its environmental sustainability objectives, the borrower’s process by which it determines how its project fits within the categories set out in Appendix 1 of the GLP and which related eligibility criteria are used for this purpose.
Management of proceeds
The proceeds from a green project should be credited to a dedicated account or, alternatively, transparently tracked by the borrower in an appropriate manner, to avoid commingling with non-green proceeds. Borrowers are encouraged to establish an internal governance structure that verifies that the funds drawn are actually put towards green projects.
Borrowers should make and keep readily available up-to-date information on the use of proceeds. This information should be updated regularly, eg on an annual basis.
Sustainability linked loans
Sustainability linked loans (often also referred to as ESG linked loans) are based on the Sustainability Linked Loan Principles (SLLP) which – like the GLP – were also developed by LMA, APLMA and LSTA. However, the concept of sustainability linked loans must be distinguished from the concept of green loans as described above.
Link to general sustainability goals
Sustainability linked loans are loans that are characterized by the fact that the margin is linked to predetermined sustainability performance targets (SPTs) on the part of the borrower and not to the asset or purpose of the financing. The catalogue of SLLP includes the following components:
Selection and calibration of KPIs and calibration of SPTs
Since sustainability linked loans are intended to improve the borrower’s sustainability profile, the loan terms should be aligned to the borrower’s performance, which is measured against one or more key performance indicators (KPIs). These KPIs will have to be pre-selected and should be relevant, core and material to the borrower’s overall business, of high strategic significance to the borrower’s operations, measurable and benchmarkable. The borrower will then have to determine which targets it is ready to commit to, thereby calibrating the SPTs against the KPIs.
Loan characteristics and margin ratchet
These targets or SPTs may then be used as a benchmark for any margin adjustments (also called margin ratchet). If the review of the SPTs shows a positive deviation, this has a positive impact on the lender's margin. The margin is then reduced based on a predefined key. However, a negative development of the SPTs may also affect the margin if pre-agreed between the parties. Other elements of SLPs include a regular reporting obligation of the borrower and the independent and external verification of the borrower’s performance level.
What are the differences between green loans and sustainability linked loans?
Green loans focus on the purpose of the loan or eventually look at the asset to be financed. The intention is to grant financing for a green asset or green project. Sustainability linked loans on the other hand refer to the borrower itself and how it is increasing (or decreasing) its own sustainability standards.
Where do we stand?
Clients’ awareness of green loans, ESG linked loans or sustainability linked loans has increased, and banks and other lenders face stakeholder pressure requiring them to make their loan books "greener." Borrowers, too, are beginning to demand green loans from their (potential) lenders. But what does this mean for our current practice? Are green or sustainable loan documentation already standard? There is no clear answer.
Market participants do agree that green finance will play a predominant role in the future. The concepts presented, based on LMA publications, are a valuable starting points towards a common, standard documentation. We see financing transactions with a strong focus on green elements, where lenders cover their requirements solely in their internal application process for credit approval. Such loan applications then only focus on the fact that the property to be financed meets certain internal green requirements. However, further documentation (in particular in the finance documents) specifically addressing green loan standards may not necessarily be agreed between the parties. In other cases, huge progress has already been made, especially on the part of financiers, who partially demonstrate deep knowledge and expertise when dealing with the topic. In addition to preparing the first green loan standard documents, several financiers have already developed so-called Green Loan Frameworks. These Green Loan Frameworks mainly serve as an internal set of requirements for green financing. That way, lenders can ensure that a uniform standard is being followed, at least internally. Green Loan Frameworks are often based on the catalogues of the Green Loan and Sustainability Linked Loan Principles described above. Lately these are further supported by the Taxonomy Regulation, which is now being supplemented by so-called delegated acts.
With regard to real estate financing, the catalogue described by the Taxonomy Regulation and the corresponding delegated act now provides certain technical screening criteria for what can be considered ecologically sustainable in the building sector.
In practice, market participants might face difficulties when verifying compliance with the criteria as this depend on the availability of corresponding data. Therefore data-collection is something that lenders and borrowers should take into account when preparing and negotiating loan documentations.
In summary, both the LMA Principles and the Taxonomy Regulation give reason and provide support to adapt and supplement loan documentations with a focus on green and or ESG criteria accordingly. Market participants have largely started dealing with the new requirements and are beginning to start developing corresponding standard documentation. However, it is also fair to say that an overarching market standard has not yet been established.