With the environment rapidly moving up the agenda for all business stakeholders, lenders are the latest constituency to increase their focus on a company’s ESG credentials when looking to make loans.
Where businesses have fallen foul of the increasingly high standards expected in terms of environmental, social and corporate governance (ESG) responsibilities, the banks that have financed their activities are now coming in for criticism, putting further pressure on financial institutions to take up the mantle as arbiters of good corporate behaviour.
Katharine Lewis, banking and finance partner at Trowers & Hamlins, says it is not just public opinion that is demanding banks check out the ESG policies of companies before they lend to them. “It is also a response to regulatory pressure,” she says. “Mark Carney, the governor of the Bank of England, has been at the forefront of discussions around the world about the risk to the economy posed by the climate crisis, and central banks have recognised the risk of the climate crisis to macroeconomic and financial stability.”
Katharine Lewis, banking and finance partner at Trowers & Hamlins, says it is not just public opinion that is demanding banks check out the ESG policies of companies before they lend to them. “It is also a response to regulatory pressure,” she says. “Mark Carney, the governor of the Bank of England, has been at the forefront of discussions around the world about the risk to the economy posed by the climate crisis, and central banks have recognised the risk of the climate crisis to macroeconomic and financial stability.”
She adds, “A taskforce has been set up to ensure that banks and their businesses are doing the right things. The Bank of England has also said that in its next round of financial system stress tests it will stress test banks against “different climate pathways including the usual catastrophic business as usual test” and the transition to net zero by 2050. So banks are feeling pressure both downward from global regulators and upward from other stakeholders, so this is an issue they are having to take seriously.”
The result is that banks are developing products and offering specific types of loans to companies that are looking to finance projects that are designed to address ESG challenges, like energy efficiency, for example. They are also offering positive incentive loans for companies that are prepared to commit to certain green or sustainability linked targets.
Lewis says: "We are now seeing a set of green loan principles being applied, which are very much focused on how the borrower is going to be using the proceeds of the loan.
“They have to demonstrate they will be using the money for certain types of projects that have an environmental benefit, and if so, there is no guaranteed upside in terms of pricing, but lenders will often reduce the margin for the bit of the loan being used for a particular type of project.”
Likewise, there are sustainability linked loans on offer that can be used for any purpose, including general working capital, but include certain targets that the borrower has to meet in relation to ESG, like perhaps employing a certain number of people out of long-term unemployment, for example. “There,” says Lewis, “the margin is reduced if the targets are met but will go back up again if there is a failure to meet them.”
Lenders are increasingly factoring ESG criteria into their overall credit risk assessments, so they are looking for clear evidence that a business is taking its governance and stewardship responsibilities seriously, and taking a considered approach to reporting on its social impact, before they will lend.
Globally, green bond and loan issuance exceeded $200bn in 2019, with the market quadrupling in size since 2015. “This is still a very small part of the market, but it is growing rapidly,” says Lewis. “It is now very easy to access green finance and it can apply to all the different types of loan that a business might like to borrow, including green revolving credit facilities. Banks in the UK are very much looking to make sure that the green products they are offering meet the needs of all the different types of customers that they are supporting.”
HSBC, for example, has committed to providing $100bn in sustainable financing and investment to clients by 2025 and has already provided green loans valuing £600m to UK businesses as part of a pilot. In July 2019 it unveiled a new range of green finance offerings including a green loan, the UK’s first green revolving credit facility, and a green hire purchase, lease and asset loan.
However, the market is very much still developing when it comes to clear definitions of what can and cannot be defined as ‘green’.
Amanda Stubbs, partner in the planning and environment team at Trowers & Hamlins, says: “One of the problems for the banks is that in order to make these loans and decide on lending strategies, they need a set of criteria to assess the green credentials of a business. That is a really interesting area into which the banks are going to have to drill down further as this evolves.”
Rebecca McKay, a partner in the pensions practice, says: “There are so many elements to this and it is an incredibly complex area for banks and investors to assess. Just because a business is good on its environmental credentials, it could be really bad on governance and social impact. If companies want to attract banking interest on the back of ESG then they really need to be able to project what they are doing in a meaningful and coherent way.”
It is not just banks that are having to address the issue. As of October, 2019, new rules for UK pension funds mean trustees must outline their approach and demonstrate how they take account of financially material factors including ESG and the climate crisis considerations when making investment decisions.
Pressure is also being placed directly on large UK companies. The government published its Green Finance Strategy in July this year and the Financial Reporting Council made it clear that the boards of UK companies should now address, and where relevant report on, the effects of the climate crisis.
"Companies should also reflect the current or future impacts of the climate crisis on their financial position,” it said.
Expectations are also increasingly moving beyond just the environmental agenda. McKay says: “A lot of companies are aware of environmental issues because that is the most high-profile area. But social impact and governance are going to become more important too, so don’t forget about those when you are looking at your ESG profile – you need to look at it holistically across the board.”
Lewis concludes: "If you are going to a bank and wanting to borrow a green loan or a sustainability linked loan, you have got to have done your homework. You will need to have a framework in place and have had that verified professionally by a third party so that you can demonstrate that what you are saying you are doing is genuinely going to have a positive impact.
“You will also need to agree to report back to lenders on a regular basis in an open and transparent way.”
As lenders and investors continue to heighten their interest in ESG metrics when assessing company characteristics, it makes sense for borrowers to up their game.
