Sustainability and sustainable financing are buzzwords now. However, the intricacies of these financing deals and their frameworks are largely a mystery to the public. During my stint in the Treasury team of a leading Indian NBFC, I was grateful to have the opportunity to work on multiple sustainable financing deals with foreign banks and multilateral organisations. Based on my experience, I gained deeper insights into the instruments and principles of sustainable financing and lay them down here.
What exactly is Sustainable Finance?
Sustainable financing is the process of giving due consideration to environmental, social, and governance (ESG) factors while making investment decisions. Asset managers are increasingly cognizant of the fact that healthy long-term returns can be generated through sustainable projects. As an example, a power plant that does not treat its effluents prior to discharge may generate good cash flows in the short run – however, in the long run, it will affect the local community’s health, thus affecting the plant’s productivity (if not regulatory pressures), and long-term economic viability.
Sustainable financing instruments
Debt-based instruments are commonly used modes of sustainable financing. Debt can be raised through green loans and sustainability-linked loans.
Capital raised for a green-eligible project, with the proceeds of the loan are used for an environmentally beneficial end use, such as renewable energy projects. As per the Asia Pacific Loan Market Association Principles (APLMA), a green loan has the following four core components :
Sustainability linked loans
Such loans can be used for any purpose, including the administrative purposes of the company. However, the loan is issued subject to a commitment to sustainability targets by the borrower. If the targets are not achieved, then the borrower will pay a penal interest rate. Consequently, if the targets are achieved, the borrower will enjoy a concessional rate of interest.
For example, Bank A lends INR 100 crore to organization B, at 8% p.a.
Organization B commits to the achievement of 2 targets:
|Target||Base Value (December 2022)||FY 2024||FY 2025|
|1: The Company will become water positive.||Water Neutral||Water Positive||Water Positive|
|2: The Company will sequester 500 tonnes of CO2 annually through plantation of trees.||200 tCO2e||500 tCO2e||500 tCO2e|
Organization B will enjoy benefits/penalties in the interest rate of the loan, subject to the achievement of agreed targets.
|Number of Target Values achieved||Applicable Margin adjustment (bps per annum)|
|1||1 bps decrease|
This incentivizes (including in financial terms) the organization to strive its utmost to achieve the ambitious targets related to water and carbon sequestration, leading to good for the community and the planet.
As per APLMA, a sustainability linked loan has the following four components :
However, if a lender insists on independent verification, then the target achievement can be verified by an auditor, environmental consultant, and/ or independent ratings agency, at least once a year.
The end-use restriction of green loans led to a financing gap in the market. Organizations wanted flexibility in the use of their funds while simultaneously benefiting from their CSR activities. The lacunae were solved through the introduction of sustainability-linked loans.
I believe that the financial services sector can use capital as a potent weapon in its arsenal. This can make tangible changes in industrial policies. I hope that the sector seizes this opportunity to exercise its soft power and bring sustainability to the forefront of organisational decision-making.