Although sustainable finance has been with us for more than a decade, its pace of growth in the finance market over recent years – in particular during the last 24 months – has been rapid. ESG and sustainability more generally, have become dominant themes across all sectors; representing a key issue as well as market opportunity for growth, to the point that, for many businesses, ESG and sustainability now play a key factor in all strategic and investment decisions.
Sustainable finance lending products fall within two broad categories; green (or 'purpose') loans and sustainability-linked loans. Over a relatively short period of time, we have seen new products emerge and their use rapidly grow to the point that sustainable finance now makes up a substantial part of the debt market. This trend is only likely to continue as sustainability considerations, and regulation, permeate consciousness and influence behaviours.
Over a series of articles, we will discuss the impact of ESG and sustainable finance trends across a number of markets and sectors, exploring current issues and potential hurdles and opportunities as well our short and medium-term predictions on the role sustainability-linked lending will play in those sectors.
In future articles we will tackle, sector-by-sector, the role of sustainability-linked lending and how sustainability, and the ESG agenda, is shaping the relevant market. However, in this article, we will start by looking in general at the direction of travel of sustainability-linked lending and what is driving its emergence and acceleration as well as giving our predictions for the short and medium-term.
The emergence and growth of sustainable finance
The first recognised green loan (a type of sustainable finance) was issued in 2014. In the subsequent two decades, sustainable finance has gone from an anomaly to a mainstream product. But what has driven this?
As with many changes to the financing markets, the growth of sustainable finance has been influenced both by internal and external factors.
With the growing awareness of global issues, such as climate change, affecting society, businesses – like the public – are becoming more recognisant of the part they play in supporting and developing solutions. It is also becoming clear that for many businesses, its attitudes towards ESG and sustainability and the actions it takes make a material difference to its potential investor, and in some cases customer, base. Many institutional investors – like large pension schemes, funds and managers – have specific investment policies and requirements in terms of ESG. Similarly, many end-consumers are also demonstrating active interest in a business's credentials. For business, it is, therefore, inevitable that investor and consumer interest is driving changes in some businesses' attitudes and behaviours and shaping ESG policies.
Government policy and regulation, too, is beginning to have an impact. Although (with the exception of limited reporting obligations on the largest organisations in line with TCFD recommendations) there are no ESG commitments binding on UK businesses currently, international regulation and UK Government's roadmap on sustainability are beginning to have an effect. A clear example of this in the UK is in relation to EPC requirements, where the prospective changes to minimum efficiency ratings are already impacting maintenance and refurbishment of existing buildings and new build specifications.
Reflecting increased demand and focus, the lending market has responded first with the emergence of green (or purpose) loans and, subsequently, with sustainability-linked loans (and, in each case, equivalents in the bond market).
Growth of sustainability-linked lending
With green loans specifically conceived for use with individual, 'green' assets and projects, the funding of new buildings and green assets (for example energy infrastructure) has been an obvious fit. The credentials of many, if not most, new developments are likely to meet the criteria of a 'green project' and allowing, with minimal additional processing, the associated funding to be badged as green.
However, in the last 12-18 months, we have seen an increase both in the use of, and appetite for, sustainability-linked loans (or SLLs) across all sectors, including real estate (where traditionally there would have been a greater use of green loans).
Whilst green loans must be used for a specific green project to be badged as such, SLLs principally require ongoing monitoring and assessment against agreed KPIs and, as such, there is a great deal more flexibility in how they may be applied. Focussing on maintaining an upward trajectory of sustainability, SLLs do not require adherence to a universal, prescribed list of criteria but rather look to measurement against individual, targeted sustainability performance outcomes.
For businesses and investors, being able to utilise debt across a broader range of projects or a whole business, rather than financing a single asset, is clearly beneficial. Moreover, allowing such loans to be made available for purposes which may or may not themselves be 'green' but do generate other environmental, social and/or governance benefits makes these loans more relevant to businesses more generally and is reflective of broader considerations than purely climate change, where so many headlines have been focussed in recent years.
The SLL market has steadily grown in recent years, with Bloomberg reporting that over $530billion in sustainability-linked loans and bonds were originated globally in 2021 – a fourfold increase over figures from 2020. We predict this trend will continue in 2022 and beyond as more businesses become alive to the availability of SLLs and more lenders look to increase their product lines to meet demands from businesses, and their own investors.
In particular, we anticipate that the majority of existing facilities which are refinanced in the coming years will, at minimum, begin to accommodate SLL principles.
Will we see a homogenisation of KPIs?
As the overarching SLL principles do not prescribe specific KPIs, for borrowers this allows for flexibility and for targets to be agreed on a case-by-case basis with lenders and associated advisors.
Whilst we are seeing some KPIs emerge more consistently across certain sectors (improvements in EPC and BREEAM ratings in real estate, for example), in our experience, what may be appropriate for one business will not necessarily be appropriate for another. Similarly, businesses may be eager to avoid having KPIs common across the sector to avoid comparisons where they may not be appropriate.
As such, although many commentators question whether we will see a move towards a homogenous set of KPIs adopted across various sectors, we don't consider this likely – although we do anticipate that, as the SLL market in the sector matures, separate suites of sector-relevant KPIs will become more commonly used.
We are advising borrower clients, in particular, to come armed to their (re)financing discussions with suggested measurable targets based on their own business plan alongside usual financial and business information to direct the conversation on KPIs.
Slowing down the process of execution
Whilst there are clear advantages to the use of green loans and SLLs, in many cases it is inevitable that the process of execution is more involved – in particular in the case of SLLs. Critical to the self-regulation of the market, lenders have been mindful of the need to ensure that targets are properly interrogated and levels, requiring a consistent improvement, appropriately set.
The result of this increased upfront work is that we are typically seeing transactions structured on a green or SLL basis taking longer to execute as appropriate KPIs, targets and terms are discussed and agreed. Whilst we anticipate that this impact will soften over time as markets become more familiar with sustainable finance, in the short to medium term, this will remain a consistent theme and one which should be factored in by borrowers and lenders alike.
For more information on the issues discussed in this article please get in touch with Alistair Rattray. You can also visit our Banking and Finance and Sustainable Finance pages for more information.