Accountability and measurability vital to avoid greenwashing
Benefit of certain loan terms could be linked to the borrower achieving negotiated sustainability performance targets
With only nine years left under the Paris Agreement for the world to reduce greenhouse gas emissions by 40%, governments, corporates and financial institutions are embracing and adopting environmental, social and governance (ESG) principles.
The international lending markets have shown great enthusiasm for green loans and sustainability linked loans. Over the past four years the volume of sustainable finance has grown 15 times.
There has been a marked increase in ESG and green financing transactions in SA too, a trend that is expected to increase steadily across Africa. Lenders and borrowers alike appear to be well aware of the dangers of greenwashing and are building accountability and measurability into their green transactions. The use of proceeds is the key characteristic of a green loan. These are used for a specified green purpose or project with clear environmental benefits.
Sustainability-linked loans are loans advanced for general corporate purposes (and not for a specified environmental use). The benefit of certain loan terms is linked to the borrower achieving negotiated sustainability performance targets. These should be ambitious and meaningful goals with measurable targets to avoid the risk of setting goals that would not reflect a genuine improvement if met — greenwashing.
Examples of typical sustainability performance targets are improvements in energy efficiency ratings, reductions in greenhouse gas emissions (usually in production or manufacturing), increases in renewable energy generated or used and water consumption reductions and water saving.
Other examples are increases in affordable housing units developed, increases in the use of verified sustainable raw materials or supplies, circular economy applications and increases in recycling rates or use of recycled raw materials and supplies, and sustainable farming and food.
Sustainability performance targets have also been linked to improvements in conservation and protection of biodiversity, and improvements in ESG ratings or achievement of a recognised ESG certification.
Encourage consistency
In addition to the Paris Agreement on climate change, the EU taxonomy has been a key driver internationally of green and sustainable financing. The EU taxonomy is a classification system that determines which activities can be regarded as environmentally sustainable for investment purposes across the EU. It also provides a common understanding and language of which economic activities can unambiguously be considered environmentally sustainable or green. We understand the National Treasury aims to implement similar measures.
Key loan organisations such as the Loan Market Association, Asia Pacific Loan Market Association and Loan Syndication Trading Association have jointly produced the sustainability linked loan principles and the green loan principles. These high-level market standards encourage consistency while recognising the need, particularly for sustainability-linked loans, for flexibility across sectors.
Some landmark green and sustainable finance transactions include the first international syndicated sustainability-linked loan to be implemented in SA. Motus Holdings, a non-manufacturing business in the car sector, agreed to reduce its consumption of fuel and water over a specified period in return for better loan pricing.
The first sustainability-linked bond listed on the JSE was that of Netcare, which will benefit from a lower interest rate if it achieves the sustainability targets set for energy consumption, total carbon emissions, renewable energy procurement water efficiency improvements. Johannesburg was the first municipality or metro to list a green bond on the JSE, using the proceeds raised to finance the city’s green initiatives.
Borrower benefits
Given the flexible nature of sustainability linked loans, they are more likely to be taken up than green loans as a first step towards sustainable financing. Whereas the pricing on a green loan or bond is typically fixed, sustainability-linked loans usually incorporate a margin ratchet, which operates with the borrower’s performance on pre-agreed sustainability performance targets.
The borrower benefits from a lower interest rate if it meets the sustainability performance targets in the given time frame. In some instances, it may need to pay a higher margin if it fails to meet the targets. The borrower’s performance against the sustainability performance targets is usually tested annually, with the pricing increase or decrease applying to the loan over the next 12-month period. With most funding transactions, the borrower commits to one or two targets.
Performance against the targets needs to be monitored and reported. Depending on the nature of the targets and the information available to assess these (such as utility bills), the borrower may be able to self-report. However, most funders will want a third party such as an auditor or specialist agency to verify the accuracy of the report or perform the monitoring and reporting. Some sustainability-linked loans include an ESG rating that needs to be achieved or maintained, with an external ratings agency annually issuing a certificate against which the sustainability performance targets are measured.
Depending on the size of the transaction and the number of credit providers involved, one of the financial institutions may act as a sustainability co-ordinator. Its role would be to obtain all the relevant information to assess the borrower’s current ESG performance and develop the appropriate sustainability performance targets for inclusion in the transaction. The sustainability co-ordinator may also have an ongoing role in monitoring compliance and assessing the ESG-related reports.
Our expectation is that incorporating ESG-linked financing terms will become part of mainstream financing transactions in SA in the near future. Developments in other markets certainly point in that direction.
• Wilkinson is partner, Naumann head of general finance, and Mellon knowledge and learning lawyer, all at Bowmans.