Howard Kennedy have launched #CountdowntoCOP26, a series of articles and content analysing the risks and opportunities organizations may face in the transition to a low carbon economy. In this article, we will look at environmental banking – the financial instruments and methods financial institutions can use to help their clients become more environmentally conscience – and possible risks if they don't.
The Growing Importance of Environmentally Friendly Banking
The importance of operating in an environmentally conscious manner is mounting. It is already clear that any changes to the climate and environment will have a profound impact on many sectors, and financial institutions, like many organizations, realize that they need to take this into account. While the benefit to the environment is an obvious advantage of environmental banking, it is not solely an altruistic endeavour.
According to the Organisation for Economic Co-operation and Development (OECD) “heightened investor demand is making it critical to consider ESG factors" with a growing investor interest in considering environmental and social issues. Over $1 trillion US of assets are under the management of funds operating according to environmental, social and governance principles. Banks working towards a greener economy are not only benefiting the environment, but will be able to tap into a segment of the market which places value on such principles.
EU Sustainable Finance
Sustainable Finance Disclosure Regulation (SFDR)
The European Union's Sustainable Finance Disclosure Regulation came into effect in March 2021. The Regulation imposes transparency standards on "Financial Market Participants," a perhaps intentionally broad definition. The purpose of the Regulation is to balance the aims of economic growth with the necessity of sustainability.
The disclosure requirements apply both to firms and financial products themselves. Firms of over 500 employees must disclose the "principle adverse impacts" of their investment decisions and activities. Firms of any size must publish how sustainability considerations are incorporated into their investment decision procedures.
There is also the requirement for disclosure regarding the financial products. All products must include information that details how environmental risks are included in investment decisions as well as if the product itself has any environmental risks. Products that advertise themselves as ESG oriented (Article 8 or Article 9 products under the Regulation) have the further onus of providing information on the products' ESG target, key sustainability indicators, any adverse impacts of the financial product in question and more. The aim at every step of the Regulation is to provide the investor with pre-contractual disclosure information that they can rely on to determine whether the firm itself or the particular financial product is environmentally sustainable as well as its possible impact on the environment.
Taxonomy Regulations
The EU taxonomy is the European Union's classification system of environmentally sustainable economic activities. The premise behind having a unified classification system is to help companies, investors and policymakers across the EU identify economic activities which are environmentally sustainable. This would therefore be a tool to help investors and companies in becoming more environmentally sustainable, as they would have a clear definition of which economic activities the EU deems as climate friendly.
ESG Benchmark Regulations
The EU's ESG Benchmark was designed to help investors decide which investments are carbon friendly. The Benchmark comprises an analysis of the assets of an investment and calculates the trajectory of their carbon emissions or decarbonisation. The standard is based on the global warming target agreed to in the Paris Agreement. The benchmark is based on the agreement to keep global warming levels to 2 degrees Celsius. Investors will be able to use the benchmark to decide if the underlying assets of an investment are compatible with the decarbonisation goals of the Paris Agreement.
Environmental Disclosure in the United Kingdom
Task Force on Climate-related Financial Disclosures
In November 2020, the UK government announced that it would introduce legislation reporting of climate-related financial information. These rules will begin to be introduced in 2023, and by 2025 they will be required across the UK economy.
These disclosure regulations are expected to be in line with the recommendations proposed by the Task Force on Climate-related Financial Disclosures (“TCFD”). The recommendations are divided in four categories of disclosures: governance, strategy, risk management and metrics and targets.
For governance related disclosures, disclosures relating to the board's "oversights of climate-related risks and opportunities," as well as what the management's role in addressing these climate related risks and opportunities could be required. For strategy, companies should disclose any actual and potential effects of climate-related risks and opportunities on the company’s businesses, strategy, and financial planning.
Companies should also make risk management related disclosures. Essentially, here companies would be required to disclose the process with which their organization is identifying, assessing, and managing any climate-related risks. Finally, companies will also need to disclose the metrics and targets which they use to asses and manage any climate related risks and opportunities. This is a critical part of the disclose regulation, as it requires firms to disclose their emissions targets as well as their actual emissions and the related risks associated with these emissions.
Certified B Corporation
Another proposed change in legislation would be the extension of B Corporate certification. Currently, companies that have received Certified B Corporation Status are "they are legally required to consider the impact of their decisions on their workers, customers, suppliers, community, and the environment."
The Policy Council of B Lab (UK) wants s. 172 of the Companies Act 2006 to be redrafted so that the directors' duty, instead of simply promoting the success of the company, will be to advance the purpose of the company. The idea behind this is that the directors will be responsible not only for the interests of the shareholders, but for those of the stakeholders as well. A change to the Companies Act legislation would benefit the wider society and environment while reducing potential harms companies may create in society in the pursuit of shareholder value.
For more information about these proposals, please read our article here.
Green Loans and Sustainability Linked loans
Two of the most notable forms of environmental financial products are green loans and sustainability linked loans. While they may sound similar, they have significant differences.
A green loan is one where the proceeds of the loan must be applied for green projects. For example, a green loan may be used to fund renewable energy projects or for building energy efficient homes. In 2018, the Loan Market Association issued their Green Loan Principles, with the core components being use of proceeds, project evaluation and selection, management of proceeds and reporting.
As stated, the proceeds need to be used for an environmentally beneficial project, with a process for project evaluation and selection which makes it clear how the borrower will choose their project and evaluate its success against environmental criteria. In addition, there must be transparency in tracking and management of the proceeds so the lender can verify the use of the proceeds towards the green purpose, with transparent, comprehensive and current reporting on the use of the proceeds.
For example, the Government of Malaysia's Green Technology Financing Scheme, which has financed over 319 projects totalling nearly $900 million USD, incentivizes environmental projects by giving a two percent rebate on the interest rate paid by companies on loans invested in green projects.
A sustainability-linked loan (SSL) on the other hand is one which does not need to be used solely for environmental projects. It is a loan which can be used for any purpose but has sustainability performance targets (SPT) linked to financial incentives for the borrower. For example, a loan's interest rate could decrease over the term of the loan if the borrower keeps greenhouse gas emissions limited to a certain level. It relies upon the borrower’s existing ESG framework and similar to a green loan there is a need for transparency from the borrower to ensure that SPTs can be tracked. There is a requirement for the borrower to meet the SPTs, however target failure may not result in default. Rather, it likely means the borrower would not be able to capitalize on any financial incentives offered by the SSL (or face other financial penalties).
For example, Nokia, the Finnish telecommunications company, has an SSL in the form of a €1.5 billion revolving credit facility. The margin of the revolving credit facility is linked to a reduction in Nokia's greenhouse gas emissions, as we as a reduction of greenhouse gas emissions of customers using Nokia products.
The Chancery Lane Project, a lawyer led initiative to "create new, practical contract clauses that deliver climate solutions" has drafted model clauses for both green loans and Sustainability Linked Loans.
Other Sustainable Financial Strategies
In addition to those previously discussed, there are a number of other methods used in sustainable finance which can serve to incentivize environmental conscious behaviour.
• A sustainability-linked bond is a bond issued with its performance linked to sustainable performance indicators. For example, French oil and gas company TotalEngergies SE issued sustainability linked bonds, with the coupon rate linked to their emissions targets. Should the company miss its targets, the coupon rate increases, creating more expensive debt for the company and incentivizing them to keep emissions below certain targets.
• Impact investment is an investment strategy where the investor focuses not only on financial returns but on ensuring that the investment creates a positive environmental impact. For example, investing in companies producing carbon capture technologies.
• Green Trade and Export Finance is the use of a financial instrument to facilitate trade or export which benefits the environment in some way. For example, exporting clean transport such as electric cars.
Environmental Risks in Banking
There are inherent risks for financial institutions which do not take into account environmental factors. Lenders may face clients which encounter difficulties paying back loans due to fines, penalties or even simply higher operating costs because the clients did not account for environmental regulations and best practices themselves. More starkly, a client's operations can be severely disrupted because it failed to take into account environmental factors. These could be because of not adhering to environmental regulations or due to the client causing environmental damage, which could of course lead to further liability for the client. For example, in real estate finance transactions, some lenders may require sustainability disclosures in the CLLS Certificate on Title.
There is also the reputational risk that financial institutions may face for being associated with projects that attract negative attention due to their client's adverse impact on the environment. A financial institution which incentivizes clients towards environmentally friendly practices will be able to limit exposure to the above risks. This is borne out in the slowly evolving attitudes of our lender clients, who routinely factor the outputs from borrower/project sustainability reviews into their underwriting processes. Although there is some way to go before lenders offer green or sustainability linked loans as a significant part of their lending books, it does suggest the laying of the foundations for sustainable lending and borrowing as a growth area.
Conclusion
From a practical perspective, there are several key things for both borrowers and lenders to keep in mind. Lenders should evaluate which of their clients (and the projects their clients are borrowing funds for) pose a higher environmental risk where the lender may face some of the risks that were discussed previously in the article. Lenders should also ensure that they are using the appropriate type of loan for the specific circumstance, as a Sustainability Linked Loan for example may not be commercially suitable for every situation.
From a borrower perspective, before entering into an SSL or other environmental financial product, borrowers should ensure that they have the capacity and internal ESG frameworks to make sure they hit any sustainability performance targets that are required of them.
Environmental banking not only benefits the planet, but is a growing field with increased consumer demand. Financial institutions which neglect it may find themselves losing out on a burgeoning sector of socially responsible banking.
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