Green and sustainable finance

Green and sustainable finance – standards and guidelines

The green and sustainable finance market has grown significantly in recent years and is still experiencing an upswing despite the Corona crisis. The European climate targets and the sustainability policy are also addressing the financial system. "Making finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development", demands the Paris Climate Agreement. The European Commission's Action Plan on Sustainable Finance aims to strengthen the role of the financial sector in achieving a functioning economy in which environmental and social policy goals are achieved. To this end, numerous standards and guidelines are provided at regulatory and organisational level.

Taxonomy as a legal framework

Regulation (EU) 2020/852 of the European Parliament and of the Council of 18 June 2020 on the establishment of a framework to facilitate sustainable investment, and amending Regulation (EU) 2019/2088 (Taxonomy Regulation) entered into force on 12 July 2020. It provides the legal framework for an EU-wide uniform classification system for sustainable investments and the criteria for determining when an economic activity can be classified as environmentally sustainable. In the future, this taxonomy can also be used as a guide in the area of credit financing. 

Green and sustainability linked loans

Green and sustainability linked loans are being issued more and more frequently. The difference between these two credit instruments is significant. Whereas green loans require the loan proceeds to be used for green projects, sustainability linked loans are linked to the sustainability performance of the borrower and align the terms of the facility agreement, such as the margin, to the borrower’s performance against the relevant predetermined sustainability performance targets.

Green Loan Principles and Sustainability Linked Loan Principles

For these loans, the three major associations for the development of documentation standards for international financing, the Loan Market Association (LMA), the Asia-Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA), have created non-binding guidelines – Green Loan Principles and Sustainability Linked Loan Principles – as well as related guidelines – Guidance on Green Loan Principles and Guidance on Sustainability Linked Loan Principles – which should be observed in the context of lending. In order to ensure that the requirements for green and sustainability linked loans are met, it is important to comply with the guidelines laid down in these principles.

In the case of green loans, these criteria are as follows:

• use of the proceeds for green projects
• process for project evaluation and selection
• managing the proceeds for the green tranche separately from other tranches, and
• reporting on the green projects and the use of the proceeds for this purpose.

Sustainability linked loans are tied to the following requirements: 

• agreement and communication of sustainability performance targets
• measurability of the borrower's sustainability
• reporting on the sustainability performance, and
• (external) verification of the fulfilment of the sustainability performance targets.

Documentation of facility agreements

So far, no uniform standards have been established for the documentation of green or sustainability linked loans. However, the LMA, APLMA and LSTA do provide recommendations in their guidelines on how the requirements for green and sustainability linked loans can be implemented in the facility agreement documentation.

When documenting green loans, the following aspects should be taken into account in particular:

• The use of the loan proceeds to finance green projects should be specified as the purpose of the loan.
• The non-use of the proceeds for a green project can be qualified as an event of default.
• The establishment and maintenance of a separate account for the green tranche may be included as an undertaking in the facility agreement.
• Reporting requirements should be laid down with regard to the use of the proceeds and the implementation of green projects.
• Representations and warranties linked to the reporting requirements may be specified.
• In the event of a breach of reporting obligations, the occurrence of an event of default could be considered.

The following arrangements should be considered for sustainability linked loans:

• Clearly defined in the facility agreement, for example as covenants.
• If necessary, requirements for any updates of the sustainability performance targets must be specified in the facility agreement.
• Disbursement of the loan may be made dependent on a third party opinion on the appropriateness of the sustainability performance targets.
• Failure to meet the sustainability performance targets will usually not constitute an event of default, but will have economic effects, such as a margin premium.
• As with the green loan, the reporting obligations should be laid down in the facility agreement on the basis of reporting requirements. Similarly, an event of default could be provided for in case of a breach of the reporting obligations.

Conclusion and outlook

In recent years, green and sustainable finance has developed significantly on the regulatory and market level. Even the Corona crisis has not significantly affected this financial segment. On the contrary, the crisis could serve as an incentive to continue pursuing sustainable governance and financing. The goal of a sustainable financial system is also being constantly developed at the European government level. For example, the European Commission's Renewed Sustainable Finance Strategy is expected to be published in the third quarter of this year.

The taxonomy and the guidelines of the LMA, APLMA and LSTA provide market participants with helpful tools for tailoring facility agreement documentation to the individual case. If the number of green and sustainability linked loans continues to rise steadily, uniform standard documentation should be developed.