SUSTAINABLE LENDING August 2020

By MATTHEW GIBSON, Published in BANKING & FINANCE IN AFRICA FEATURE

Sustainable lending (also known as green finance) is a financial product which has gained traction internationally over the past few years as a response by market participants to the convergence of for-profit capitalism and non-profit charitable endeavours. Recent developments have shown that investors now actively seek performance with greater social impact and need not sacrifice returns for increased social value. Furthermore, studies have shown that companies that focus on environmental, social and governance (ESG) metrics and policies are able to increase their profitability (and are hence better able to repay their debt).

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Whilst the European market accounted for 74 percent of green and sustainability linked loan volume in 2019, there has been increased interest in such loans in the rest of the world. With development finance institutions and other lenders taking a greater interest in these loans, there is tremendous scope for growth across Africa.

In recent years two sets of principles have been developed to facilitate sustainable lending across the globe – the Green Loan Principles in 2018 and the Sustainability Linked Loans Principles in 2019. Sustainable lending aims to facilitate and support environmentally sustainable economic activity and these principles were developed to promote the development and integrity of these loan products.

The Green Loan Principles define green loans as:

'… any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible Green Projects. Green loans must align with the four core components of the Green Loan Principles, as set out in the Green Loan Principles.'

The Green Loan Principles define Green Projects to include projects in the following categories:

  • renewable energy;
  • energy efficiency;
  • pollution prevention and control;
  • environmentally sustainable management of living natural resources and land use
  • terrestrial and aquatic biodiversity conservation;
  • clean transportation;
  • sustainable water and wastewater management;
  • climate change adaptation;
  • eco-efficient and/or circular economy adapted products, production technologies and processes; and
  • green buildings which meet regional, national or internationally recognised standards or certifications.

The four core components of the green loans are (a) use of proceeds for Green Projects, (b) process for project evaluation and selection to determine whether the project falls within the eligible categories of Green Projects, (c) management of proceeds to ensure that the proceeds are accurately tracked, and (d) reporting during the term of the green loan.

The Sustainability Linked Loans Principles defined sustainability linked loans as:

'…any types of loan instruments and/or contingent facilities (such as bonding lines, guarantee lines or letters of credit) which incentivise the borrower's achievement of ambitious, predetermined sustainability performance objectives. The borrower's sustainability performance is measured using sustainability performance targets, as set against key performance indicators, external ratings and/or equivalent metrics and which measure improvements in the borrower's sustainability profile.'

Categories of sustainability performance targets include:

  • energy efficiency;
  • greenhouse gas emissions;
  • renewable energy;
  • water consumption;
  • affordable housing;
  • sustainable sourcing;
  • circular economy;
  • sustainable farming and food;
  • biodiversity; and
  • global ESG assessment.

While a loan can follow both the Green Loan Principles and the Sustainability Linked Loans Principles, such loans are unusual.

The fundamental determinant of whether a loan is a green loan is the utilisation of the loan proceeds for Green Projects. Whilst use of proceeds is the key determinant, the other core components for green loans set out in the Green Loan Principles must also be met for a loan to constitute a green loan.

In the case of sustainability linked loans, the use of proceeds is not key to its categorisation. Under the Sustainability Linked Loans Principles, the focus is on incentivising borrowers to improve their sustainability profile by aligning loan terms with agreed and pre-determined sustainability performance targets by way of external ESG ratings, key performance indicators or a combination of both. The targets are intentionally set to be both material and ambitious. Interest rates in respect of the sustainability linked loans are linked to such targets and this allows borrowers to reduce their margins as they actively improve their ESG ratings or meet specific internal or external key performance indicators.

In recent years, sustainability linked loans have superseded green loans. In fact, of the green and sustainability linked loans announced in 2019, more than 90 percent were sustainability linked loans. There are a number of reasons for this. First, companies are more easily able to use external ratings or key performance indicators to measure metrics relating to sustainability linked loans than to satisfy the strict use of proceeds criteria for a transaction to be classified as green. Secondly, sustainability linked loans provide greater flexibility to borrowers than green loans as the use of the facilities is not limited to a specific green project, but can be used for general corporate purposes. Thirdly, the increased prevalence of sustainability linked loans has resulted in a decrease in costs and experience has eased borrowers' fears that such loans might increase administration and workload in legal documentation and auditing.

While the world grapples with the immediate challenges posed by COVID-19, this should not impede the continued development and growth of sustainable lending in Africa, and across the globe, for our long-term sustainable future.

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Gibson is a Partner of Webber Wentzel.