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Green Loans and Sustainability Linked Loans – same but different?

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This blog was co-authored by: Angela Paschalides

From a reputational and corporate governance perspective, green and sustainable activity both gain favour with shareholders and investors (particularly those who place emphasis on investment with a positive environmental, social and governance (ESG) impact). Green Loans and Sustainability Linked Loans have distinctive characteristics which should influence the type of loan offering borrowers consider.

A key distinction between Green Loans and Sustainability Linked Loans

There is a material differentiator between Green Loans and Sustainability Linked Loans. For Greens Loans, the entirety of the loan proceeds must be used for Green Projects (those which have a positive environmental impact such as projects that use renewable energy or clean transportation, or implement pollution and prevention control, or promote sustainable water and wastewater management).

In contrast, the proceeds of Sustainability Linked Loans are not limited to being allocated to Green Projects. Sustainability Linked Loans have variable terms that improve or become less beneficial according to the extent to which a borrower improves their sustainability profile against mutually agreed, material and ambitious, pre-determined sustainability performance targets (SPTs) in respect of predefined key performance indicators (KPIs).

Accessibility of Green Loans and Sustainability Linked Loans for different industries

As the defining characteristic for Green Loans is that the proceeds must be used for purposes of financing or refinancing Green Projects, this may appear to exclude borrowers in particular industries that are commonly environmentally damaging or rely on technologies of which the environmental impact is debatable. Nonetheless, it may remain possible for such borrowers to obtain Green Loans provided there is increased disclosure to the lenders of the environmental advantage that is being achieved. The LMA’s Green Loan Principles (GLPs) do not automatically disqualify a borrower with a weak, existing ESG profile. 

In contrast, the Loan Market Association’s Sustainability Linked Loan Principles (SLLPs) permit a borrower to use the loan proceeds as required for their purposes provided that the borrower materially improves its sustainability profile. This profile is measured against SPTs in respect of KPIs that may be tailored to be ambitious but obtainable in the context of a borrower’s business or particular industry.

For example, an airline may not be able to improve materially the efficiency of its utilisation of fossil fuels but it may be able to make substantial improvements in its waste management and use of Green buildings. However, borrowers should note that measurement of improvement as against SPTs of KPIs will require internal assessment and report-back to the lenders (which will necessitate sufficient internal expertise and human resources) and/or external oversight and review (accompanied by cost and administrative burdens).

Pricing benefits

It is common practice for lenders to charge lower interest rates or decrease the onerousness of financial or other restrictive covenants for Green Loans. However, this is commercial practice and is not specifically mandated by the GLPs. On the other hand, the SLLPs acknowledge that a key characteristic of a Sustainability Linked Loan is that an economic outcome is linked to whether the SPTs are met. This economic outcome may be:

  1. a reduced margin on the loan where SPTs are met (one-way margin ratchet); or
  2. a reduced margin on the loan where SPTs are met but an increased margin on the loan where SPTs are not met (two-way margin ratchet).

Parties should be circumspect when discussing a two-way margin ratchet. The SPTs should not be set at impractical levels such that lenders benefit from borrowers failing to improve their sustainability profile in line with the SPTs. This contradicts the spirit of the SLLPs.

This article is part of a short series of articles to be published by the firm on green financing.

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