Global Bank Review: Sustainable loans – are we there yet?

Sustainable loans are booming, but not yet for every borrower.

This article is part of our 2021 Global Bank Review – ESG: Creating a purposeful future, an annual publication by our Global Banks Sector Group which brings together our people who live and breathe banks.

Sustainability-linked loans, which have incremental pricing benefits for borrowers that meet set sustainability-linked targets, have dramatically increased in popularity in the last 18 months, reflecting wider growth of ESG-driven financing. We are yet to reach the point, however, where they are mainstream options for all borrowers.

For example, the popularity of sustainability-linked loans varies considerably by region. They are now common in Europe, with 65% of the corporates surveyed in our recent Corporate Debt and Treasury Report 2021 intending to include ESG features in their next financing, and 35% of those looking specifically at sustainable lending. In comparison, take-up is far lower in Asia, where only sophisticated borrowers have the procedures and policies to tap this pool of capital.

Some KPIs we see go beyond climate factors, though they are almost always combined with an environmental target in sustainable loans. Such benchmarks may include governance targets, such as board diversity or supporting customers to use resources wisely, or social targets such as increasing charitable giving.

There are usually two to four KPIs, which can be drawn from across the ESG spectrum. The KPIs often relate to traditional metrics around reducing CO2 emissions and increasing the use of renewable energy and energy storage capacity. Third-party certifications may also be used to assist in comparability and evidencing objectivity; projects, infrastructure and buildings have a number of external certifications which can assess the sustainability of that asset’s construction, performance and refurbishment requirements, for example. At a business level, an improvement in a corporate’s sustainability rating could also be used to set the sustainability targets.

Some KPIs we see go beyond climate factors, though they are almost always combined with an environmental target in sustainable loans. Such benchmarks may include governance targets, such as board diversity or supporting customers to use resources wisely, or social targets such as increasing charitable giving.

Where a borrower already makes sustainability disclosures in line with recommendations of the Task Force on Climate-related Financial Disclosures (TFCD) recommendations or other established standards, KPIs can be closely aligned to the borrower’s sustainability strategy. A member of the syndicate will usually be appointed as sustainability co-ordinator or structuring agent to assist in setting KPIs acceptable to the lenders and to ensure the borrower’s targets are sufficiently stretching to counter any claims of greenwashing.

It would be rare for a breach of a sustainability target to be an express default: instead, control is largely via reputational concerns at the lender and borrower level. Lenders’ policies and eligibility criteria will largely determine which borrowers can access sustainable loans, and the available debt terms. Lenders may conduct diligence on factors outside the narrow scope of the KPIs to reflect their own ESG policies to mitigate the risk of reputational damage, particularly in relation to social and governance factors, and this diligence may be intensified in sustainability-linked products.

Additionally, lenders may have to report on their sustainability performance in their own investor disclosures or annual reports. It is critical that loans badged as sustainable actually fulfil the relevant criteria and do so objectively. Verification of compliance by third-party reviewers or auditors is therefore a feature of many sustainable loans, particularly when so-called ‘brown’ industries are involved.

50 shades of green, eventually

Disclosures against TFCD recommendations are currently voluntary in most countries. However, the COP26 Private Finance Hub, an initiative to co-ordinate industry action around this year’s UN climate change conference, has cited improved reporting and forging a strategy to implement TCFD more widely as part of its four key objectives. Many larger European corporates already make sustainability disclosures in line with some TFCD benchmarks on a voluntary basis, producing sustainability reports which may be reviewed by their auditors.

However, for companies that do not do so, the time and cost associated with producing suitable KPIs and demonstrating progress can be significant, and more than outweigh the relatively small pricing benefit of a sustainable loan. Moving to mandatory TFCD-style disclosures, another aspiration of the COP26 Private Finance Hub, will increase availability of such verified information and better align corporate policies with established ESG lending policies, which should enable more borrowers to tap this source of finance.

The challenge will be to maintain the flexibility of sustainable lending products: Mark Carney, the former Governor of the Bank of England turned sustainable investment champion, has talked of recognising 50 shades of green in moving economies to net zero. The much-touted EU Taxonomy was developed as a classification system to help investors determine which activities are environmentally sustainable, but this is not an easy task across all businesses. The Taxonomy is highly prescriptive and technical and has taken time to develop.

So far its focus has been on the first two of its stated six core objectives (climate change adaptation and mitigation) with some politically sensitive activities, such as nuclear power, left out entirely. The UK is intending to produce its own taxonomy, which could be more principles-based to avoid becoming mired in stagnant administrative standards, but taxonomies have inherent limitations and have been resisted elsewhere.

Various government and trade body initiatives aim to widen the class of borrowers that have developed sustainability policies. However, it is noticeable that there is a significant gap between borrowers able to access the trillions of dollars of available ESG capital globally, and those which are not. Despite the booming market in sustainable lending, there is some way to go before such loans are accessible to all.