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AN INTRODUCTION TO GREEN LOANS AND SUSTAINABILITY LINKED LENDING IN THE UK

Updated: Mar 9, 2022

This is the published version of an NFT that is owned by SeedBomb ASA Limited. SeedBomb ASA Limited owns the copyright to this content and it may not be reproduced by anyone without the express permission of SeedBomb ASA Limited. You can view the NFT here.


Introduction


We are finally in an era where environmental, social and governance (“ESG”) issues are considered a central part of any successful major business venture in large parts of the world. As many of the businesses which now must improve their approaches to ESG issues are well established, it is no surprise that traditional products and methods are being adapted to better suit the current ESG landscape instead of being built from scratch. One area which has seen substantial change so far (though notably, there is still much to be done) is the lending market in the United Kingdom. The government in the United Kingdom has stated that it is focused on “aligning private sector financial flows with clean, sustainable and resilient growth”, though it remains unclear on how successful this has been to date (Commons Library, 2022). One thing which is clear, is that mobilising capital for green finance presents many challenges and many opportunities for all involved (OECD, 2022).


Types of Green Lending


Before we consider the changes that have been made in the UK lending space, we should first be clear about what we mean by lending. Essentially, lending is simply the activity of making money available to another party on a temporary basis, most commonly in exchange for repayment with interest. Interest is specified in the agreement to loan out the money, which contains a description of the % on top of the amount loaned to be repaid. The person who has been loaned the money, “the borrower”, must pay back the initial amount loaned and the interest applicable to “the lender”. If they do not, the lender may be able to take some of the assets that the borrower or another party providing collateral for the loan owns in compensation.


So, having cleared that up, what are these ESG changes and why do they matter? While all green lending tends to benefit from a reduced interest rate to incentivise borrowers to adhere to ESG principles, in the UK, green lending can be split into two categories: 1) Green Loans; and 2) sustainability linked lending. These are explained at a high level below:

  1. Green Loans: loan proceeds must be applied to “green purposes”. This means that the amount borrowed must be directly invested into green products or for green purposes.

  2. Sustainability Linked Lending: loans may be utilised for non-green topics, but the overall performance of the borrower against certain pre-determined ESG criteria may allow the borrower to obtain a discount on their interest rate.

So, in a nutshell, Green Loans must be used to invest in green projects whereas Sustainability Linked Loans offer a discount to the borrower if they meet certain ESG criteria.







How Do These Loans Work in Practice?


Green Loans


Green Loans have quite strict implications for a borrower. If the borrower is to benefit from the reduced price of the loan, they must allocate resources clearly and provably to green projects (Linklaters, 2022). To do this, they must keep up to date information on the use of loan proceeds and will often keep these funds in a separate account so they can be easily identified. The borrower will be expected to report back to the lender on the status of their green projects in most cases. Where a project that the borrower has invested in ceases to be “green” and the project is reclassified, the borrower will not often lose the benefit of a pricing discount.


Many Green Loans also include provisions for third parties to review the performance of the borrower (A&O, 2022). To do this, the borrower and lender must agree on the metrics to be used at the outset as there is not any coherent ESG metric which can be followed for finance generally. As a result, accusations of “Greenwashing” are common. Greenwashing for lending purposes is where the borrower is seen to be being ecologically responsible with loan proceeds when in fact, they are investing in activities which are not good for the environment or, at worst, are potentially harmful to it.


Sustainability Linked Lending


Sustainability Linked Lending is quite different. Here, the borrower must prove that they are meeting certain ESG criteria in their business, but they are not obliged to apply the proceeds of a loan to green projects. This means that you could, theoretically, be investing in some ecologically harmful industries but, on balance, meeting your obligations under the loan documents. This is because the lender and borrower agree together on a set of Key Performance Indicators at the outset of the loan, specifying certain ESG criteria the borrower must meet on each test date. Clearly, there is scope here for Greenwashing owing to the lack of third party or regulatory oversight.


This issue is compounded by the lack of an agreed accounting method or ESG index to monitor these loans. Different standards will apply on a lender by lender basis and, sometimes, on a loan by loan basis within the same lender. This flexibility is helpful commercially, though opens the door to Greenwashing due to the ability to negotiate the quality and breadth of the Key Performance Indicators. Downsides aside, largely owing to the flexibility these products offer their use is growing far more quickly than Green Loans (Linklaters, 2022).



Key Considerations Going Forwards


The two types of green lending in the United Kingdom offer a genuine opportunity to benefit from being greener as an enterprise through pricing discounts. However, they also expose a few key floors in the way that ESG metrics are quantified in the United Kingdom and elsewhere, because both types of loan can be prone to Greenwashing by borrowers and lenders alike. A key step to prevent this would be to create a recognisable and agreed system of ESG metrics, much equivalent to GAAP accounting, so that it is possible to monitor the performance of borrowers and lenders, but also so that products can be compared across different lenders more readily. It should be the case that those with “greener” approaches are rewarded, and borrowers cannot seek out lenders with less green approaches and bigger discount rates. Improving comparability across the market through standardised metrics should help reduce the likelihood of Greenwashing.


It is also interesting to consider more broadly how green lending is to be applied around the world and the growth we are likely to see. In an article from October 2021, the World Bank confirmed that "Developing countries currently account for just $1.6 billion of the estimated $33 billion in outstanding green loans. But the market is growing rapidly, outpacing the growth of the green-bond market in the near term" (World Bank, 2022). This is largely because there is much required infrastructure to build in developing countries which are understandably prioritised over certain green projects. However, a key next step both for the United Kingdom’s approach to green lending and green lending globally will be to improve access to green lending in developing markets and aim to achieve sustainable development. This is also a big commercial opportunity for lenders and developers alike because, in many cases, developing in an ESG compliant way from the start produces better outcomes than adapting old products. In many instances this could result in a competitive advantage for developing countries.





References


  • (A&O, 2022) Sustainable finance: Key considerations for loan documents. Available at: https://www.allenovery.com/en-gb/global/news-and-insights/publications/sustainable-finance-key-considerations-for-loan-documents. Accessed on: 2 March 2022.

  • (Commons Library, 2022) Green Finance Mobilising Investment for Green Growth Available at: https://commonslibrary.parliament.uk/green-finance-mobilising-investment-for-green-growth/ Access on: 21 February 2022

  • (Linklaters, 2022) The Rise of Green Loans and Sustainability Linked Lending. Available at: https://www.linklaters.com/en/insights/thought-leadership/sustainable-finance/the-rise-of-green-loans-and-sustainability-linked-lending Access on: 21 February 2022

  • (OECD, 2022) Green financing: Challenges and opportunities in the transition to a clean and climate-resilient economy. Available at: https://read.oecd-ilibrary.org/finance-and-investment/green-financing-challenges-and-opportunities-in-the-transition-to-a-clean-and-climate-resilient-economy_fmt-2016-5jg0097l3qhl#page7. Accessed on: 2 March 2022.

  • (World Bank, 2022) What You Need To Know About Green Loans. Available at: https://www.worldbank.org/en/news/feature/2021/10/04/what-you-need-to-know-about-green-loans. Accessed on: 2 March 2022



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