A crucial challenge for the decarbonisation of the economy is the funding of the transition to a low carbon future. Aside from regulatory compliance, what should participants in UK financings be considering with respect to funding transactions to take into account the wider market focus on green and sustainable financing?
In this Insight, we consider some of the points we are seeing our clients (sponsors, borrowers, clearing banks and credit funds) dedicate their attention to on new transactions, based on our experience working on numerous recent green transactions, further details of which can be seen here.
It is important at the outset to distinguish between two types of finance that have a role to play in decarbonisation:
- a green loan funds a project which has an environmental purpose at its core (such as wind farms, solar farms or hydro-electric dams). If the purpose changes, the parties must exclude that loan from being categorised as 'green'. This is known as "Financing Green".
- a sustainability linked loan funds a company. Rather than being linked to a green project, it is governed by green targets and structured so that if the targets are met, the pricing of the loan reduces or increases very marginally. This is known as "Greening Finance".
There is a lot more to these types of financing arrangement than just pricing adjustments. The marginal pricing alteration is arguably the least important part of a green or sustainability linked loan when looking at the wider impact and intention behind such loans. Instead the primary focus should be on regulations, reporting and monitoring.
The lending document through green tinted glasses
Given how recent the arrival of green and sustainable lending is in certain markets, there is some trepidation among lenders and borrowers when it comes to including ESG provisions in financing documents for the first time. To overcome this, we recommend thinking of ESG reporting and monitoring as nothing more than a new key performance indicator (KPI). From a documentation perspective, we need to look to conditions to utilisation, conditions precedent, representations and undertakings to incorporate this KPI (or series of KPIs) into an ongoing obligation and reference point.
Reporting: The day one and ongoing reporting obligations should be included as part of the condition precedent package (represented/warranted for accuracy where applicable) and the information undertakings. They can be based on a variety of sources: internal metrics, external third party analysis or verified sector specific industry frameworks. An example of an external source would be the Sustainability Accounting Standards Board Materiality Map, which presents an assessment of numerous sustainability metrics on an industry-by-industry basis.
In all cases, the KPIs selected should be ambitious and meaningful in the context of the business. We have seen a variety used, including: CO2 emissions, ratio of electric to non-electric vehicles in a fleet, renewable energy usage and energy efficiency ratings. LMA guidance states that reporting should be at least annual and there is strong encouragement that the sufficient and reasonable details of the methodology and/or assumptions are included. The ESG reporting can be incorporated in the compliance certificate or a stand-alone ESG certificate; either way, the reporting should be certified and represented as accurate.
Monitoring: The ESG reporting mechanics in the funding documentation are not "set and forget" provisions. There needs to be certification (internal or external) that the KPIs selected on day one remain ambitious and meaningful. The lender should also have the ability, either unilaterally or through good faith discussions to amend, update and/or introduce new ESG KPIs following dialogue with the borrower and/or third party expert using quantifiable data relevant to the proposed ESG KPIs.
There is no established market standard as to what constitutes a sustainability breach, default or event of default by failing to meet a KPI on ESG sustainability linked funding structures. However, there may be an increase or decrease in margin depending on the pricing structure and whether the KPI is met or missed. The absence of a default or event of default should not be a blocker to lenders introducing ESG provisions, as these are in relative infancy, with many businesses feeling their way as to the best way to address and assess ESG impacts.
However, we know first-hand that for some lenders and borrowers, including ESG provisions in any meaningful way in their current transactions is outside of their comfort zone. In this respect, we are seeing an ever-increasing focus on ESG work being undertaken prior to the drafting of the terms of the transaction.
This can take a number of forms, taking into account the following considerations:
- Due diligence: Extracting due diligence information about a borrower client, whether directly or by paying a report provider to produce, is a bedrock of finance transactions. Including ESG into the suite of due diligence deliverables should be a simple and efficient way to understand what the borrower or target group is exposed to and what it is doing to respond to such exposures. Several lenders have non-sector specific ESG questionnaires which have to be filled in to form part of the information package, and so have the benefit of the associated customary representations as to accuracy.
- Policy: In the same way as it is common to ask for the borrower group to undertake that they maintain policies and procedures designed to promote and achieve compliance with anti-corruption laws, it is a logical step to replicate this for ESG regulations and guidance, or at a minimum the internal ESG policy of the borrower group. Having an internal ESG policy is something that is being strongly encouraged in the market and can be as simple as building out the existing CSR policy that is likely to already be in place. Depending on the relevant sector of the borrower group and applicability of regulations, it would also be advisable to include compliance with ESG regulations and guidance. Certain lenders are also asking borrowers to sign up to the lender's own ESG policies and best practices.
- Point person: Having a borrower be required to train and nominate an ESG point person or team in their organisation should not be a controversial ask, as it benefits all parties. This also protects against any 'best of knowledge' qualifiers as they relate to certifying or making undertakings in relation to ESG points. The growth, particularly in the large-cap space, has seen such an internal role expand away from being a subset of a compliance team to the become a department of sustainability managers specifically reporting to senior management. Clearing banks and other professional advisers are also offering services to act as sustainability advisors to provide third party expertise to borrowers and transactions that are particularly heavily exposed to ESG reporting due to the sector involved or the transaction specifics.
As we had predicted, 2020 saw a significant rise in green and sustainability-linked financing. This will only continue to grow through 2021 and beyond. Funding a low carbon future is not a trend, it is a fundamental shift that impacts all aspects of financing transactions, from raising capital to origination, structuring, execution and syndication.
This "green squeeze" is affecting market participants: lenders are obliged to adapt due to their shareholders or funders whose constitutive documents or investment/funding agreements expressly articulate ESG requirements be met and maintained; and sponsors/borrowers feel it by virtue of the end customer deciding environmental factors should form a more material element of their decision-making process.
Lean, green and sustainable future
As these topics continue to be explored, we also anticipate the following developments will play a role in funding the transition to a low carbon future:
- More market participant scrutiny, such as the UK government's establishment of new green finance research centres based in London and Leeds to advise the private sector on sustainable investments.
- Further regulations, such as the enforced reporting resulting from the UK government's Task Force on Climate-related Financial Disclosures.
- Growing expertise within organisations and the continuing establishment of sustainability managers hived off from compliance departments.
- The rise of third party experts, whether new bodies or new departments of well-known existing advisors.
To help reduce “greenwashing” (presenting a product or service as more environmentally friendly than it really is) market participants will have to show how financial products which promote themselves as having sustainable objectives or positive ESG characteristics actively justify those labels.
It is no longer sufficient to show that an ESG process is in place, the outcomes demonstrating the efficacy of that ESG process must also be evident. In short, market participants simply 'talking-the-talk' will need to start 'walking-the-walk'. We look forward to supporting our clients on this journey.