A Fundamental Reshaping of Finance
As Larry Fink, CEO of Blackrock, one of the world's largest asset managers has written there has been a fundamental shaping of finance because of climate risk. He goes on to say that this will in turn – sooner than many anticipate – lead to a significant reallocation of capital. So what does this mean for companies who want to attract investment or finance? Whether you are a company that needs to raise finance for a new infrastructure project, a hospital which requires a new wing or a property developer with a building programme you will need to understand the drivers behind your investors and banks lending decisions if you are to secure finance.
Since Mark Carney's ground breaking talk at Lloyds in 2015 UK banks are on notice that climate risks must be at the heart of their financial decision making. They are not alone. Central banks in other countries are also starting to factor climate change into their monetary policy and will in turn be applying pressure to the banks they regulate. In order to comply with the PRA's Supervisory Statement issued in April 2019 UK banks and other regulated institutions are reviewing their loan portfolios to identify whether any of them present financial risks they need to provide for. All will be keen to ensure that new lending meets sustainability criteria to avoid an exposure to climate risk. For companies wanting to tap the finance market this means that funding should be available for the right project and the right project will be one that is sustainable.
For a corporate there are a number of benefits in obtaining sustainable finance. It is widely available as loans that meet sustainable criteria reinforce banks' objectives to manage their financial risk. There are also a lot of investors looking for suitable investment opportunities that comply with their Environmental Social and Governance (ESG) objectives. In addition sustainable finance may be available on good pricing terms. There may, for example, be a lower interest rate on a loan if pre-agreed sustainable criteria are met as is the case with Great Portland Estates plc's new £450 million ESG linked unsecured revolving credit facility. Participating banks include Santander, NatWest, Wells Fargo, Lloyds Bank plc and Bank of China with Santander acting as "sustainability co-ordinator".
What is Sustainable Finance?
There is no agreed definition of what counts as sustainable finance which is a work in progress. It can vary from negative screening to exclude assets which are unsavoury through finance that takes ESG factors into account to impact investment where funds are only made available for projects where the prime impact on the environment or a social objective can be quantified and measured.
Amid this uncertainty one way forward for the borrower is to adopt the EU Commission's definition of "green finance" which "refers to the process of taking due account of environmental and social considerations when making investment decisions". One of the foundation stones of the EU Action Plan on Sustainable Finance is creation of a common way of classifying sustainable activity and a draft proposal for an EU sustainability taxonomy (the EU Taxonomy) was released in December 2019. Although the EU Taxonomy is voluntary it is likely to encourage a common understanding of what is sustainable and may come to be the gold standard.
Borrowers should be aware that under the EU Taxonomy the following criteria must be met for an economic activity to count as environmentally sustainable:-
- it must contribute substantially to one of 6 EU environmental objectives.These are:climate change mitigation; Climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy, waste prevention and recycling; pollution prevention and control; and protection of healthy ecosystems;
- it must not cause significant harm to any of the EU environmental objectives;
- it must comply with minimum social safeguards, and
- it must comply with technical screening criteria.
This could capture a wind farm or solar plant which avoids the use of fossil fuel, uses natural resources and avoids polluting emissions. A regeneration scheme for an industrial area in a flood plain which included flood defences is an example of climate change adaptation. Another is the retrofit of a factory with energy efficient equipment or development of technology to reduce water use in an industrial process.
What is a Green Loan?
There are two subsets of green finance: green loans and green bonds. Until the launch of the Loan Market Association's Green Loan Principles (GLP) in 2018 there was a similar lack of clarity about what counted as a Green Loan. The GLP provides a Framework with guidelines to ensure consistency in methodology. They define a "Green Loan" as "any type of loan instrument made available exclusively to finance or re-finance "Green Projects". A "Green Project" is one where the loan proceeds must be applied to projects that provide clear and demonstrable environmental benefits which should, as far as reasonably practicable, be quantified, measured and reported by the borrower. There is a non-exhaustive list of categories of project recognised to be "Green" which includes renewable energy, energy efficiency, pollution-prevention and control, biodiversity conservation and climate change adaption.
Borrowers should note that Green Loans will contain a number of additional obligations to satisfy the GLP. In particular:
- the proceeds must be credited to a separate account or tracked by the borrower;
- the borrower must report on the use of proceeds including the amount allocated to the project and its expected impact; and
- borrowers should obtain an external review where appropriate to verify that the loan meets the necessary green requirements.
While it is relatively straight forward to assess whether a term loan for a specific project meets the GLP criteria, the position is more difficult where a borrower is lent a revolving credit facility. In this case the lender and borrower will need to agree how best to evidence that the flow of funds is for a sustainable objective.
What is a Green Bond?
As borrowers will be aware there has been a huge growth in the green bond market. When a company issues a green bond current rules only require the issuer to provide information that enables investors to make an informed assessment of the security it is offering. Investors will want certainty and transparency on how the proceeds of the bond will be applied and this is addressed by a use of proceeds section in the prospectus which allows investors to assess whether or not the bond is sufficiently green for their purposes. There has been no universally accepted test of what counts as green although there have been some voluntary standards. The ICMA have issued the Green Bond Principles ("GBP") which set out a set of rules for verifying the green credentials of bonds. The GBP treat disclosure of the use of proceeds as central and this is then backed up by reporting and disclosure requirements and the provision of an independent opinion. Typically the proceeds of the bond are placed in a segregated account and their allocation is formally tracked by the issuer but, importantly, the use of proceeds, reporting and second party opinions do not form part of the terms and conditions of the green bond and do not create specific contractual obligations. In particular failure to allocate the proceeds for an appropriate green use may not trigger an event default. However the position is changing. One of the key limbs of the EU Action Plan is the development of an EU green bond standard ("GBS"). The EU GBS is intended to fill the gap left by the current regulation which does not impose any requirement on issuers to maintain green standards or comply with periodic reporting and verification after the bond has been issued. The intention is to link the EU GBS to the EU Taxonomy on sustainability. Although the use of the taxonomy is intended to be voluntary it is anticipated that it will quickly become a norm for determining whether a bond is truly green.
The high level of investment needed in sustainable finance offers an opportunity to borrowers to tap into new sources of finance as banks are incentivised by risk weighting rules to provide funds to green projects and will increasingly be penalised for the financial risks associated with brown projects. There should, therefore, be funding available for the right project that can demonstrate its environmental credentials.