By Susan Hall
Sustainable Finance - The Differences Between Green Bonds, Green Loans And Sustainability Linked Loans
Interest in sustainable finance is increasing. At the same time, issuers and lenders are looking for clarity on the various financial instruments available to support their needs. There are several instruments which sound similar but differ in the way they are structured.
Sustainable finance refers to any form of financial service which integrates environmental, social and governance (ESG) criteria into the business or investment decisions for the lasting benefit of both clients and society at large. It consists of a number of different financial instruments, such as bonds, loans, revolving credit facilities (RCF) and more. Conceptually, whether a bond or loan is green or not, there is no real difference in the way the bond issuance is handled, or the loan is agreed. The differences relate more to the details, rather than the big picture.
There are several different types of bonds available under the sustainable finance banner:
- Green bonds:The funds from these bonds are committed to environmental or climate projects, such as investing in renewable energy.
- Social bonds: The funds are committed to social impact projects, such as investing in low cost housing for people with restricted access to the housing market.
- Blue bonds: The funds are committed to marine or water projects, such as investing in transition to sustainable fish stock.
- Sustainable bonds:The funds are committed to social or green impact projects which are aligned with the UN Sustainable Development Goals (SDG). For example, the capital raised can be used to provide energy efficient, low cost housing for people with restricted access to the housing market.
The International Capital Market Association (ICMA) has outlined the requirements for a bond to be considered green, social or sustainable. For more details, please read the Green Bond Principles, the Social Bond Principles and the Sustainability Bond Guidelines.
Loans are similar to bonds but differ in how the funding is raised. With bonds, funds come from the investor market, while funds for loans come from a bank.
Like bonds, loans can be classified as green or social etc.
- Green loans – The funds are committed to environmental or climate projects, such as recycling of plastic.
- Social loans – The funds are committed to social impact projects, such as training people with disabilities to improve employability
- Sustainability loans – The funds are committed to green and social impact projects, such as providing people with disabilities employment opportunities in a plant which recycles plastic
The Loan Market Association (LMA) developed the Green Loan Principles, a set of standards and guidelines providing a consistent methodology for use across the green loan market.
Sustainability Linked Loans and Revolving Credit Facility (RCF)
The emphasis of a Sustainability Linked Loan or RCF is on the ESG performance (i.e., the impact that ESG issues has on a company’s economic value) of the company itself, rather than on the use of funds.
Revolving Credit Facility linked with a Sustainability performance increases borrowing capacity. In this case, the interest rate on the loan or RCF is tied to the company’s sustainability performance commonly measured by the borrower’s ESG performance, or an ESG Rating. Hence, a Sustainability Linked Loan, or an ESG Linked Loan is most applicable to the use of proceeds, mainly in the case of RCF.
An improvement in the borrower’s ESG performance will translate to a decrease in the interest rate. Similarly, a decline of the ESG performance would result in an increase in its interest rate.
RCFs can be included in this category because while the funds are only drawn when needed, the same agreement – interest paid is based on ESG performance improvement – can be made.
It is important to note, that while the company’s ESG performance at the time of agreement to the Sustainability Linked Loan (as applicable to the RCF structure) is required – it is more important that the borrower demonstrates the potential for improvement and the commitment towards the improvement.
This style of loan or a RCF allows a company to benefit financially, even when it does not have pure green, social or sustainable projects to invest in at the time of the agreement. This type of arrangement also allows the company to send clear signals to the market and its intention to improve the ESG performance.
This distinction raises the important question – what exactly is ESG performance?
Environmental, social and governance (ESG) factors are used to determine how advanced a company is with respect to sustainability:
- Environmental performance looks at factors such as contributions to climate change through greenhouse gas emissions, waste management and energy efficiency
- Social performance covers issues like human rights and labour standards both within the company and in the wider supply chain, adherence to workplace safety, and diversity.
- Governance performance looks at a set of rules or principles defining rights, responsibilities and expectations between all parties involved in the company. This covers such items as the make-up of the board, policies on bribery and corruption.
A company may, for example, score well on its corporate governance but poorly on environmental factors. For such a company, maintaining its corporate governance expertise while working on addressing its environmental impact would lead to an improvement in its overall ESG performance and a lower interest rate for its Sustainability Linked Loan / RCF. A company should also consider the ESG performance of companies within its supply chain since this could impact its own ESG position.
A company does not have to be “green” to issue a green bond or to take a green loan. Any company can use these financial instruments regardless its ESG status. The important factor is how the funds are being used (i.e., the use of proceeds).
For a Sustainability Linked Loan as applicable to RCF, the ESG performance, and the commitment to improvements on ESG is most important.
For those wanting to go a step further, a company can tie its ESG performance to its green bond or a green loan. So, a company can use its ESG performance (usually measured through an external rating agency such as Sustainalytics’ ESG Risk Ratings) to support its green bond issuance at its bond issuance roadshows.
Similarly, funds from a green loan could also be linked to the ESG performance of the company, giving the advantage of a lower interest rate. Thus, a company is not just engaging in green, social or sustainability beneficial projects, it is also benefitting financially through a lower interest rate when it improves its ESG performance.
Sustainable finance will continue to play a significant role in tackling environmental and social issues. This will be driven largely by regulatory and industry bodies, investors, shareholders and, of course, clients. Research has written about the changing buying behaviours of the millennial generation which is now favouring companies and institutions that have a good ESG performance. Thus, to remain relevant as well as competitive, companies need to be engaged with sustainable finance. The first step is understanding the financial instruments on offer and choosing the ones that help them achieve their strategic (sustainable) growth objectives.
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