Decoding sustainable financing

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.

Green 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 ^[1]:

1. Use of proceeds: Loan proceeds should be used for designated green projects whose environmental benefit can be quantified and reported by the borrower. These projects can address issues such as climate change, natural resource depletion, and loss of biodiversity, amongst others. Funds may be used for financing a fresh project or refinancing an existing project.
2. Process for project evaluation and selection: Before making the funds available to the borrower, a lender must clearly assess the sustainability objectives of the project, the process by which the borrower has determined that its project is ‘green eligible’, and the process applied by the borrower to identify and manage environmental risks associated with the project.
3. Management of proceeds of a green loan should be credited to a dedicated account. Borrowers are encouraged to establish an internal governance process to track the allocation of funds.
4. Reporting: Information need only be provided to institutions participating in the loan. Borrowers should communicate up-to-date information at least on an annual basis and in the event of material developments.

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:

Organization B will enjoy benefits/penalties in the interest rate of the loan, subject to the achievement of agreed targets.

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 ^[2]:

1. Relationship to Borrower’s overall CSR Strategy: The borrower should clearly communicate its sustainability objectives, as set out in its CSR strategy, and how these align with its proposed targets.
2. Target setting: The targets should be ambitious in comparison to the borrower’s recent sustainability performance levels. The guidelines encourage borrowers to seek a third-party opinion regarding the appropriateness of their targets. However, due to cost considerations, borrowers often chose not to involve a third party and instead leverage the expertise of their internal CSR and sustainability departments to verify the target-setting methodologies.
3. Reporting: Borrowers are encouraged to include information about the achievement of their sustainability targets in their annual report or CSR report. However, a borrower may also choose to share this information privately with the lender.
4. Review: For publicly traded companies, it may be sufficient for lenders to rely on the borrower’s public disclosures to verify its performance against the targets.

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.

In conclusion

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.

References

1. Loan Market Association, Asia Pacific Loan Market Association, Loan Syndications & Trading Association. (2021, February). Green Loan Principles. https://www.lsta.org/content/green-loan-principles
2. Loan Market Association, Asia Pacific Loan Market Association, Loan Syndications & Trading Association. (2022, March). Sustainability Linked Loan Principles. https://www.lsta.org/content/sustainability-linked-loan-principles-sllp