Amid the increasingly clear and dire toll of climate change, and in the face of governments lacking the funds needed to support an energy transition of dramatic scale, private investors are being called upon to help foot the bill and avert, or at least diminish, future weather-related catastrophes.
The surging demand for green bonds is a positive step towards this transition. Yet the size of the climate challenge means we cannot rely on green bonds alone to do this. To enact real change, banks must also step up to the plate by incorporating climate issues into the conditions of loans.
Different shades of green
Green bonds are vital instruments through which issuers can raise capital, which is earmarked for specific environmentally friendly projects. This often makes them unsuitable for highly pollutive companies, or for those looking to use the proceeds for generic and diverse purposes. Additionally, most companies worldwide do not issue bonds.
That is where novel forms of bank financing products come into play: green loans and sustainability-linked loans (SLLs). A green loan is granted by an authorised credit institution to an individual or company to finance a green project. SLLs, meanwhile, are loan instruments that incentivise borrowers to achieve green objectives. Their terms are linked to the borrower’s sustainability performance as measured by predefined environmental, social and governance (ESG) criteria. Enhanced sustainability performance lowers the interest rate, while unmet targets can lead to a rate spike.
The size of the climate challenge means we cannot rely on green bonds alone
One key difference between SLLs and green loans is that the borrower of the former is not restricted to put the loan exclusively toward green projects. Even so, the borrower is incentivised to improve its sustainability performance, as this lowers its financing costs.
The aggregate volume of SLLs has been recording a significant surge since 2017. In 2019, it totalled $140bn. After slowing down during the pandemic downturn, in the first six months of 2021 the total volume of SLLs was already $350bn.
SLLs have variable rates contingent on the achievement of a number of climate targets. For banks, if indeed climate change causes additional risks to lenders, it is in their best interest to consider these risks when offering loans to customers.
The Loan Market Association, Asia Pacific Loan Market Association and Loan Syndications and Trading Association, with the International Capital Market Association, have developed a set of minimum standards for SLLs. They include the borrower’s clear communication to its lenders of sustainability objectives, stringent target setting and measuring, accessible reporting of progress and an external review process to be agreed upon by the borrower and lender. If done well, with clear and challenging targets, such incentivisation of concrete sustainability actions by way of loans will lessen the risk of greenwashing that can arise from vague targets or poor reporting standards.
Entering the big leagues
In terms of the sustainability incentives attached to SLLs, banks are often willing to lower interest rates for companies making bigger green strides. For example, when AB InBev earlier this year secured the largest ever SLL (more than $10bn), it included a pricing mechanism encouraging improvement in the beverage giant’s water efficiency in global breweries, recycling of plastic bottles, renewable energy sourcing and greenhouse gas emissions.
This all came in response to AB InBev’s move to link its financing to sustainable practices. Under the terms of the loan, provided by 26 global banks, there is an agreed margin grid whereby the actual interest rate charged depends on the credit rating of the company, the level of utilisation of the credit facility and the four climate-related key performance indicators.
Other prominent examples of the growing stature of SLLs, and their incentive targets, include Royal Dutch Shell’s $10bn revolving credit facility, whose rate and fee depend on the company moving toward cleaner energies and reducing its net-carbon footprint, and General Mills’ $2.7bn loan with payment metrics reliant on shrinking greenhouse gas emissions and renewable electricity use.
These objectives should be clearly defined, include a timeline and be based on well-defined improvements relative to the previous year’s baseline. They must be negotiated between the borrower and the lenders, based on the borrowers’ sustainability strategy. Unlike publicly traded bonds, whose terms are clearly disclosed, loans are often private and their terms only known to lenders.
As the majority of companies worldwide do not issue bonds, it is crucial that the loans provided by normal banks start incorporating these climate issues as soon as possible. SLLs are a great innovation, with the potential to help companies and financial institutions align themselves with the Paris Agreement and the necessary transition to a low-carbon world. However, several challenges lie ahead. Lack of standards is one such challenge. Also, to prevent greenwashing concerns, sustainable targets should be clearly announced, linked to strategy and imply a clear commitment to change. They cannot be too easy, shallowly defined, non-transparent, or merely paying lip service to sustainability.
Nuno Fernandes is a full professor of finance at IESE Business School and the author of ‘Finance for executives: A practical guide for managers’.
