The Growth of Green Finance

We had the privilege of hosting the latest Yorkshire Climate Action Coalition event in our Leeds office recently – with a focus on Green Finance.

Green Finance is a hot topic at the moment, though one that’s not widely understood. It also links to a wider focus of lenders (and the broader investment community) on Environment, Social and Governance (ESG), however given the focus of this latest conference I’m going to concentrate on the environmental aspects and a few considerations around that.

Broadly speaking there are two types of loans that have a direct link to environmental considerations:

• Green loans: These are loans where there is a specified purpose (i.e. the use of all or a portion of the funds) that has an agreed environmental benefit.
• Sustainably linked loans: The loan is a ‘normal’ corporate loan but includes specific ESG KPIs which are linked to a margin ratchet (whereby the borrower is rewarded or penalised based on achievements against these measures).

Green loans, by their very nature, are still restricted to specific projects and investments and therefore generally most aligned to situations where companies are looking to spend capex to reduce carbon emissions and/or make an investment that has a direct environmental benefit.

Sustainability linked loans have evolved rapidly from being a relatively niche portion of the lending environment, to something that we are now seeing in the majority of facilities we advise on.

So the question becomes, what is driving the increase in investor focus on ESG?

I would argue there are three key points:
 

• Increasing awareness in the lending community and a desire to showcase the work they are directly doing to help drive improvements in society;
• Increasing desire from consumers to invest their savings (pensions being a substantial component part of that) in strategies with a beneficial purpose (N.B. pension funds are a key investor in alternative asset classes such as private credit, so fund managers are therefore directly incentivised to create attractive, sustainably linked credit funds);
• Scope 1, 2, 3 reporting, with the largest financial institutions coming under increasing pressure to give full disclosure on the impact they are having on the environment.

The third element is a critical driver for all businesses looking for loan or equity investment. The term Scope, 1, 2, 3 emissions first appeared in the Green House Gas Protocol of 2001 and are the basis of mandatory Green House Gas (GHG) reporting in the UK. As a quick reminder, the different categories are:

• Scope 1 emissions – the GHG emissions that a company makes directly;
• Scope 2 emissions – these are emissions produced indirectly (e.g. when the electricity or energy it buys for heating or cooling is being produced on its behalf);
• Scope 3 emissions – all of the emissions a company is indirectly responsible for across the value chain, e.g. buying products from suppliers, to products its customers use.

Scope 3 is complicated, and lenders are therefore wanting, and may need to, understand the emissions of businesses they are providing finance to. As such, whilst initially the regulation is only requiring the largest companies and financial institutions to apply the full reporting framework, any company who is looking for loan finance is likely to need to be able to report on their own emissions well ahead of any mandated reported framework.

Where next?
 

At the moment we are in a transitional phase on sustainability reporting. Whilst it is clearly of increased importance for lenders, there is not yet a fixed standard of reporting requirements or KPIs, partly because the carbon footprint of any company is highly specific to their industry and operations. That said, we do expect the approach and framework on ESG metrics to become increasingly standardised over time.

Finally, I thought I would end with a personal prediction. In this evolutionary phase companies have been able to benefit from some margin benefit and flexibility on the nature of ESG metrics. Companies with a clear strategy and demonstrating leadership on ESG have also benefited from increased liquidity/capacity to raise finance. Over time I anticipate adhering to high standards on ESG (including Society and Governance) will become a binary, non-negotiable, diligence item for lenders as they assess credit opportunities.