As reports highlight the impact of how we build the buildings that we live and work in have on climate change and the emission of greenhouse gases, it is no surprise that lenders who fund real estate projects find themselves under ever-increasing pressure from governing bodies to demonstrate how they are contributing towards a more sustainable way of living and tackling the issue of climate change through their lending.
Many of the larger mainstream lenders have established sustainable debt funds to evidence that they are aligning themselves with the UK's net-zero commitment. The knock-on effect of this is to put pressure on borrowers and developers to reduce their carbon emissions as lenders are now dissecting the sustainability of real estate projects. Not only are lenders looking at whether a building is sufficiently “green”, they may also be assessing the environmental, social and governance aspects of the borrower’s group and whether these also meet the lender’s sustainable criteria to enable it to provide financing for a project.
As has been stated by the Loan Market Association, Green Loans exclusively finance green projects, whereas SLLs do not require the use of loan proceeds for green projects. Instead, SLLs focus on incentivising a borrower to make improvements to its sustainability performance by aligning the terms of the loan with a set of pre-defined sustainability performance targets.
Features of Green Loans
If an asset can be linked with a form of sustainable economic activity it may be able to be funded with a Green Loan. A Green Loan can only be used to finance or refinance a ‘green’ project, although, each loan’s specific terms will need to be discussed and agreed between lender and borrower at the beginning. The Loan Market Association provides detailed guidance in its Green Loan Principles which sets out what lenders normally look for when assessing whether it will fund a borrower’s project with a Green Loan.
Often, Green Loans will come with a preferential interest rate, which is commercially important to any borrower. A green asset will have reduced carbon emissions, which is positive from a reputational point of view. It may also be appealing to future buyers and lenders when the asset is refinanced or sold.
In counterbalance to the positive aspects, Green Loans come with an increased administrative and reporting burden for the borrower. A borrower needs to assess whether it has the ability, operationally, to comply with these added obligations once the loan documentation is in place.
Features of Sustainability-Linked Loans
SLLs are any type of loan facilities which incentivise a borrower to achieve a set of documented sustainability performance objectives. The borrower’s performance against these objectives is measured by the lender using predefined performance targets which relate to sustainability and are measured by a matching set of key performance indicators. These key performance indicators, or “KPIs”, can include external ratings and/or equivalent metrics and they are designed to measure improvements in the borrower’s sustainability profile.
For example, the KPIs may document a set of predetermined energy efficiency targets. If the borrower is able to improve its energy efficiency by meeting or exceeding the target, the interest margin on the loan will be reduced. SLLs also carry a higher reporting and administrative burden on the borrower which will be detailed within the loan documentation. They can carry a cost burden where the lender uses an external party to assess performance against the targets. It is also vital that borrowers carefully consider the level at which the sustainability criteria and KPIs are set. For example, the bar should not be set so high that the borrower cannot meet the standards, as that will result in a higher rate of interest and may also result in a default on the loan.
The future is green
Given the increasing importance that sustainability, in all its forms, has in the market generally, and more specifically in the real estate lending sector, it is clear that Green Loans and SLLs will become more prevalent in the coming years. At the moment, the metrics by which Green Loans and SLLs are measured fluctuate between deals but we anticipate that some of these will start to become more commonplace, setting the standard for sustainable finance transactions more generally in the coming years.
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