Green and sustainable debt financing
Green and sustainable finance market
Green and sustainable finance market continues to grow as lenders and borrowers increasingly integrate sustainability into their business for tackling environmental, social and governance challenges to their businesses. According to Precedence Research, the global sustainable finance Market size was USD 5.49 trillion in 2023, estimated at USD 6.61 trillion in 2024 and is anticipated to reach around USD 38.19 trillion by 2034. While green and sustainable projects are mainly financed by green bonds proceeds of which are used entirely for climate and environmental projects, the relatively new sustainability linked loans (SLLs) which are linked to the borrower’s performance on defined environmental, social or governance (ESG) criteria and parameters are increasingly popular.
Legal consideration in green and sustainable financing
The legal issues faced by financiers in their acquisition of green or sustainable debts include the following:
1. Definitions
There are varied interpretations of green or sustainable projects. Financial institutions (FIs) may consider using the Green Bond Principles published by the International Capital Market Association (ICMA) or the Climate Bonds Standard published by the Climate Bonds Initiative or establish their own criteria, which should be transparent and rigorous, in the evaluation and categorization of green and sustainable projects.
2. Reporting
There may be greenwashing risk, i.e. the risk of misrepresentation of sustainability of projects by debt issuers. Financiers should establish stringent reporting guidelines on environmental impact of projects. To ensure credibility, third party entities may be hired to validate green credentials of projects.
3. Regulatory compliance
Different countries may vary substantially in green financing regulations. It is important for financiers to conduct comprehensive research on the regulatory framework of the concerned jurisdictions. Hiring legal experts from the concerned jurisdictions can help in evaluating the complexities and ensuring compliance.
4. Contractual challenges
Contract terms on environmental objectives might lack of specificity, leading to potential disputes. Contracts need to be explicit on the environmental objectives, methods in measuring compliance with sustainability performance targets (SPTs), and potential penalties for non-compliance. Contracts can include provisions for periodic reviews to ensure that undertakings on environmental objectives are met.
5. Risk management
Green projects, especially those in nascent sectors, can have substantial unforeseen environmental and financial risks. Detailed assessment of environmental and financial risks before investing is crucial.
6. Performance measurement
Financiers should adopt or develop standardized performance metrics for evaluating green projects. The metrics should evolve with development of the industry. Regular updates by using new data and feedback can help in maintaining relevance.
7. Stakeholder engagement
Involvement of key stakeholders including investors, employees, local communities and governments from the onset of the project can help understanding concerns and addressing them proactively. Keeping decision-making processes transparent can foster trust and confidence and facilitate project implementation.
8. Regulatory changes
Financiers should build capability in monitoring global environmental trends and potential regulatory shifts. Building flexibility in tackling global environmental trends and regulatory shifts can buffer project viability despite regulatory changes.
Loan documentation
While there are no market norms of green or sustainable loans nor provisions used for such loans, the following provisions are generally included in loan transaction documentation:
1. Loan purpose
The loan documentation should clearly specify for which green projects the loan proceeds will be applied toward.
If the green loan takes the form of a revolving credit facility, use of proceeds may be less detailed in comparison with term loan, as long as the purposes of the revolving credit facility fall within the scope of the GLP (as defined below). Tracing the proceeds of a revolving credit facility may be facilitated by splitting the revolving facility into tranches for general corporate purposes and for green purposes. Only the green tranches will be classified as green.
The focus of SLLs is on the performance of the borrower’s SPTs, rather than the use of proceeds.
2. Interest margin adjustment
Green or sustainability-linked loans characteristically try to motivate borrowers to achieve ambitious, predetermined SPTs. If targets are met then interest margin will be reduced, and vice versa. The mechanism for the measurement of the borrower’s improvement against the predetermined SPTs should be documented in the facility agreement.
3. Conditions precedent
Lenders often require external review of borrowers’ green loan framework or alignment with the GLP or the SLLP (as defined below) by consultants or other qualified parties. The external review will be a condition precedent for the availability of the relevant loan facility.
4. Information undertakings
Borrowers are in general required to provide their lenders periodically with up-to-date information on the use of green loan proceeds and achieved impacts in respect of the SPTs.
5. Undertakings / representations
Green or sustainability-linked loans will contain undertakings or representations by borrowers that (i) value of the relevant green assets shall exceed amounts drawn under the green loan; (ii) the SPTs will be met; (iii) proceeds of green loans will be applied towards specific green projects.
Failure to comply with the relevant undertaking / representation may result in higher interest margin (in borrower-friendly loans) or triggering off an event of default pursuant to which lenders may cease to further provide the facilities or accelerate repayment of loans drawn (in lender-friendly loans).
While there are no market norms, the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA) have jointly organised experienced representatives from leading FIs active in the syndicate loan market in the development of the Green Loan Principles (GLP) and the Sustainability Linked Loan Principles (SLLP) for the reference by the financing market.
The GLP defined a green loan as any loan instrument exclusively to finance, re-finance or guarantee, wholly or partly, new and/or existing eligible green projects aligned to the four core components of the GLP:
1. Use of loan proceeds
It should be clearly stipulated in the loan documentation the green projects to which the loan proceeds will be applied towards.
2. Process and project evaluations
Borrowers should inform lenders (i) the environmental sustainability objectives of the green projects; (ii) the process by which borrowers determine how the project(s) to be funded within the eligible green projects categories; and (iii) other eligible criteria of green projects.
Borrowers may be required to disclose any green standards or certifications referenced in project selection.
3. Monitoring of use of proceeds
Proceeds of a green loan should be paid into dedicated accounts for identifying their application so as to maintain transparency and promote the integrity of the products.
4. Reporting
Borrowers should make, and keep, readily available up-to-date information on the application of proceeds regularly, and on a timely basis in the event of material developments. Such periodic reports should include a list of green projects to which the green loan proceeds have been applied towards, brief description of the projects, the amounts allocated, and their expected and achieved impact. The GLP recommends the use of qualitative as well as quantitative indicators, and quantitative performance measures and disclosure of the key underlying methodologies and/or assumptions used in the quantitative determination in the communication of expected and/or achieved impact of projects.
The GLP recognises broad, non-exhaustive categories of green projects, which contribute to environmental objectives such as climate change mitigation, climate change adaptation, natural resource conservation, biodiversity conservation, and pollution prevention and control. Green projects include assets, investments and other related expenditures such as R&D that may relate to more than one category and/or environmental objective.
The SLLP defined a sustainability-linked loans (SLLs) as any type of loan instruments and/or contingent facilities for which the economic characteristics can be varied for motivating the borrowers’ achievement of ambitious, predetermined sustainability performance objective. In most instances, SLLs will be used for general corporate purposes to support a borrower in improving its sustainability performance.
SLLs must align with 5 components:
1. Selection of KPIs
The KPIs must be (i) relevant, core and material to the borrower’s overall business; (ii) measureable against a consistent methodological basis; and (iii) able to be benchmarked to the extent possible against an external reference or definitions to facilitate the assessment of the level of ambition of the SPT.
2. Calibration of SPTs
The SPTs must be set in good faith and remain relevant and ambitious throughout the life of the loan.
3. Loan characteristics
An economic outcome of an SLL is linked to whether the selected predefined SPT(s) are met. The interest margin under the relevant loan agreement will be reduced where the borrower satisfies a pre-determined SPT as measured by the pre-determined KPIs and vice versa, and the mechanism may include a bracket in which no margin adjustment applies.
4. Reporting
Borrowers should provide lenders with periodic updates of their SPTs.
5. Verification
Borrowers must obtain independent and external verification of the borrowers’ performance level of each SPT for each KPI for any period relevant for assessing the SPT performance leading to adjustment of the SLL economic characteristics.
The objectives of the GLP and SLLP are to promote the development and integrity of green loan product, and to provide a commonly acceptable approach for granting green and sustainable loans to facilitate environmentally and sustainable economic activity.
Regulatory supervision
In respect of regulatory supervision of FIs’ activities in green and sustainable financing, the HKMA has issued its circular to authorized institutions (AIs) on due diligence process for green and sustainable products on 9 December 2022 to share with the banking industry some good practices relating to the development and ongoing management of green and sustainable products offered by AIs to ensure that these products are managed in a way consistent with their climate strategies so as to reduce any potential exposure to greenwashing risks. These practices are summarized into 5 high-level principles for the reference by the banking industry:
1. Setting up a robust governance framework by the development of internal product-specific guidelines on the design, origination and classification of green and sustainable products, building on international or industry practices and principles, and embedded the identification and assessment of climate-related risks in product due diligence process.
2. Conducting comprehensive “greenness assessments” of clients and transactions due diligence for green lending as part of the KYC and credit approval process, and seeking external verification from clients in the transaction approval process to indicate greenness of their projects for clients belonging to climate risk sensitive and high-carbon-emitting sectors.
3. Performing post-offering monitoring and controls to ensure proper management of green and sustainable products by conducting regular reviews of green products portfolios, closely monitoring the allocation of proceeds of their green liabilities, assessment of clients’ use of proceeds or their performance against pre-agreed KPIs and SPTs in the credit review process, and putting in place policies and procedures in the handling of potential breaches of the terms and conditions of green and sustainable product transactions.
4. Enhancing transparency and accountability in respect of green and sustainable products through publishing product-specific portfolio-level impact reports and issuing utilisation or allocation reports of green deposits and green bonds regularly to inform clients of the use of proceeds.
5. Building appropriate expertise and capabilities in product development and comprehensive due diligence process through providing relevant training and development of guidance notes for staff.
For enquiries, please feel free to contact us at: |
|
E: banking@onc.hk T: (852) 2810 1212 19th Floor, Three Exchange Square, 8 Connaught Place, Central, Hong Kong |
|
Important: The law and procedure on this subject are very specialised and complicated. This article is just a very general outline for reference and cannot be relied upon as legal advice in any individual case. If any advice or assistance is needed, please contact our solicitors. |
|
Published by ONC Lawyers © 2024 |
