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Whilst many landlords breathed a sigh of relief in September 2023 when the UK government scrapped proposals to introduce new minimum energy efficiency standards (MEES) for residential properties that are let, the existing regulations – which have applied to residential properties for several years – were augmented in April 2023 by new regulations for commercial properties.

Complying with MEES may still require landlords to take costly measures to improve the energy efficiency of their properties and as tenant demand for more sustainable properties increases, landlords not only need to find ways to improve the energy efficiency and sustainability of their properties but also find ways to fund those improvements.

In this article, Katharine Lewis of Trowers & Hamlins takes a closer look at the ways in which businesses and individuals may be able to borrow in a way which is both Shariah compliant and also meets 'green' or 'sustainability-linked' finance principles to help finance these costs.

'Green' mortgages for residential property

A 'green' mortgage is a form of home finance product which, in essence, rewards customers who are buying energy efficient properties or refurbishing properties in order to make them more energy efficient. That reward may come in the form of a small discount to the rental rate on a home purchase plan or offsetting the carbon footprint of the property for as long as the property continues to meet the agreed energy efficiency standard and is mortgaged to the lender.

'Green' mortgages for commercial property

Commercial property owners may also be able to take advantage of finance products which comply with either the Green Loan Principles (GLPs) or the Sustainability-linked Loan Principles (SLLPs). 
In the UK, the most common form of Sharia compliant finance used when investing into commercial property is the commodity murabaha. With a bit of careful thought it is possible to structure a commodity murabaha to follow either the GLPs or the SLLPs. This is because they are voluntary frameworks of market standards and guidelines that can be applied on a deal-by-deal basis depending on the underlying characteristics of the transaction.

What are the differences?

Despite the fact that key characteristics of 'green' and 'sustainability-linked' finance are different, the term 'green loan' is often used as a catch all to describe any type of green, social, sustainable or sustainability-linked finance.

For a commodity murabaha to be characterised as 'green' the funding needs to be applied to finance or re-finance, in whole or in part, new and/or existing green projects that specifically contribute to an environmental objective. 

If the finance isn’t going to be used to fund an 'eligible green project' (such as developing a new 'green' building or, in the case of existing properties, improving energy efficiency, installing solar panels or other renewable energy infrastructure or implementing measures to improve pollution control or enhance wastewater management) then it cannot be said to be 'green'.

But, if the purpose of the finance is to fund an eligible green project and both the bank and the customer wish to badge it as 'green', customers must comply with the remainder of the core components of the GLPs by:

  • explaining the process by which they have and will continue to evaluate the environmental sustainability of selected project(s);
  • providing information on the processes by which the perceived, actual or potential environmental and social risks associated with the selected project will be managed;
  • agreeing to ring-fence and track the monies so that, when required, customers can demonstrate how it has been used; and
  • providing a report, not less than once a year, to their financiers which covers the list of projects financed and "a brief description of the projects, the amounts allocated and their expected and, where possible, achieved impact."

There may a small economic benefit to customers in the form of a reduction on the profit rate but customers are more likely to see indirect benefits (such as their properties being more attractive tenants who are willing to a pay a premium to rent their properties). However, these benefits need to be weighed against the additional reporting and management burden.

With 'sustainability-linked' finance customers can use the money for any agreed purpose and there is a clear direct economic benefit as financiers seek to promote sustainability by offering a reduction in profit rate where customers meet material, ambitious, pre-determined, regularly monitored and externally verified sustainability objectives through Key Performance Indicators (KPIs) and Sustainability Performance Targets (SPTs). 

In addition to the margin reduction which must be assessed on an on-going basis, the finance must align with the other four core components set out in the SLLPs:

  • Selection of KPIs – which must be the KPIs must be material to the customer’s core sustainability and business strategy, and address relevant ESG challenges of its industry sector;
  • Calibration of SPTs – SPTS must be set in good faith and remain relevant (so long as they apply) and ambitious throughout the life of the loan;
  • Reporting – at least once a year, customers must provide up to date information allowing the bank to monitor performance of the SPTs and to determine that they remain ambitious and relevant to the customer's business; and
  • Verification – the customer's performance level against each SPT for each KPI for any date/period relevant for assessing the SPT performance must be assessed regulator and a sustainability confirmation statement must be provided with verification report.

As with 'green' finance, the additional burden of the reporting and verification requirements needs to be measured against the direct and indirect benefits which may accrue to a customer when utilising this type of finance but if, like many landlords, you are faced with significant costs to retrofit your property portfolio you may want to take advantage of these new and innovative products that are designed to help you meet the challenges ahead.