Green and sustainable lending is now an area of focus for many commercial lenders. This has brought with it the development of voluntary industry standards to help create robust products with a genuine sustainable purpose. However, with regulators increasingly seeking to embed sustainability throughout the global financial system, a whole new set of incentives and standards are coming into view. These have the potential both to improve green and sustainable lending products and entrench their use for the long term. 

Current products and standards

Green loans

Loans requiring the borrower to use the proceeds for a "green" purpose are nothing new. Financing of renewable energy projects has been around for many years. However, the potential market for green purpose loans is much wider than project finance – it includes any business needing finance to make its operations more environmentally sustainable. To help grow this wider market, the Loan Market Association published its Green Loan Principles (the GLPs) in March 2018. The GLPs:

  • define a green loan as a loan "to finance or re-finance, in whole or in part, new and/or existing eligible Green Projects"; and
  • set out a high-level framework of voluntary market standards and guidelines for green loans, relating to the use and management of proceeds, and project evaluation and reporting.

The key features of the GLPs mirror those set out in ICMA's Green Bond Principles, first published in 2014.

Sustainability-linked loans

The "sustainability-linked loan" has emerged as a distinct product over the last two or three years. Sustainability-linked loans are not characterised by the borrower's use of funds – many are revolving credit facilities for general corporate purposes. The sustainability "link" is that pricing is tied to the borrower's performance against certain pre-determined sustainability targets: if it meets all or a specified proportion of the targets, the margin will decrease. The performance targets are not necessarily all environmental. Some may relate to diversity and inclusion or other social objectives.

Sustainability-linked loans are currently hugely popular, particularly for large corporate borrowers. However, they have also attracted criticism, with some questioning the extent to which these loans always have a genuine impact on sustainability. In March 2019, the LMA published its Sustainability Linked Loan Principles with a view to addressing some of these concerns.

The new wave of sustainable finance regulation

A range of national and international regulatory initiatives on sustainability have emerged in recent years. Perhaps the most comprehensive and ambitious is the European Commission's Action Plan on Sustainable Finance (the EU Action Plan), launched in March 2018. One of its three main aims is to "reorient capital flows towards sustainable investment in order to achieve sustainable and inclusive growth". The UK government has formerly endorsed the objectives of the EU Action Plan in its UK Green Finance Strategy, published in July 2019.

The EU Action Plan has a much broader remit than the loan markets. However, the following "Action Points" in it illustrate how regulatory change might help to further develop robust green and sustainable lending.

Taxonomy

Action Point 1 aims to create a classification system, or taxonomy, to define what constitutes "environmentally sustainable" economic activity. The EU Commission described this as the "most important and urgent action": a number of the other actions rely on this taxonomy. The EU Commission, Parliament and Council have all put forward proposals for an implementing regulation and a Technical Expert Group is working on the detailed "Technical Screening Criteria". 

There will be no mandatory application of the taxonomy to commercial lending. However, the taxonomy will be the basis for a new EU green bond standard. So its potential use in categorising a loan as "green" is obvious. The taxonomy could also potentially be used to measure how much of a company's overall turnover comprises sustainable activities. Might parties use this to set performance targets in a sustainability-linked loan?

Non-financial reporting

Action Point 9 is to strengthen sustainability disclosure and accounting rule-making. The EU Non-Financial Reporting Directive 2014 had already introduced an obligation on many large EU companies to carry out mandatory reporting on environmental and other non-financial matters in their annual reports. In June 2019, the EU Commission published new guidelines on how companies within the scope of this regime should disclose climate-related information. These incorporate the 2017 recommendations of the Financial Stability Board's Task Force on Climate-related Financial Disclosures. While the Commission's guidelines are currently non-binding, this may not be the case for long.

So large corporate borrowers will increasingly be publishing climate-related information about their businesses based on common reporting standards. Lenders may look to use this information to set and test sustainability-linked performance targets.

The guidelines also include specific guidance for disclosure by banks. Banks should focus on disclosing the impact of their core business of lending and investing, rather than just their own operational emissions. For example, a bank should disclose both in absolute terms and as a proportion of its total loan portfolio its funding of "sustainable economic activities contributing substantially to climate mitigation and/or adaptation...according to the EU taxonomy". This may encourage banks both to provide more green and sustainable lending, and also to have that lending formally characterised as such.

Regulatory capital rules

Action Point 8 is to incorporate sustainability in prudential requirements. This encouraged speculation that a "green supporting factor" could be added to the regulatory capital rules to boost lending in low-carbon assets. However, many have argued this could create a "green bubble", and that prudential rules should solely address economic risk.

No broad changes are likely in the short term. As part of the changes to the EU Capital Requirements Regulation which came into force in June 2019, the European Banking Authority was mandated to produce a report on "whether a dedicated prudential treatment of exposures related to assets or activities associated substantially with environmental and/or social objectives would be justified". But this is not due until 2025. In its policy statement 11/19 published in April 2019, the Prudential Regulation Authority also ruled out any immediate changes in this area.

Conclusion

Regulators are re-wiring the regulatory framework to embed sustainability into the financial markets. The precise impact this will have on lending products and terms is not yet clear. But it suggests that green and sustainable lending is here to stay.

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