Can sustainable companies get a lower cost of capital?
Adapted from State of Green Business 2019, published by GreenBiz in partnership with Trucost, part of S&P Global.
Green bonds have been making headlines in the sustainable finance world the past few years because of their rapid growth. Emerging this year as a rising star in sustainable finance are green and sustainability loans. What has caught the eye of corporate finance and treasury departments is that these loans are often tied to a lower lending rate for companies that can improve their performance on sustainability measures.
Sustainability as a path to lower borrowing costs could be a game-changer.
Green- and sustainability-linked loans reached $36.4 billion while green bond issuance topped $182 billion in 2018 according to BNEF. Since Lloyds Bank’s pioneering effort in 2016, with about $1.27 billion earmarked for loans for greener real estate companies in the United Kingdom, other banks have stepped in (including leaders ING Bank and BNP Paribas) and green loans are spreading to many regions and sectors.
Companies in many industry sectors are taking advantage of sustainability-linked lending, including food and beverage giants such as Danone ($2.5 billion loan), Olam ($500 million) and Wilmar ($200 million), and other sectors such as energy (Iberdrola, $6.7 billion), technology and healthcare (Phillips, $1.25 billion) and materials (Royal DSM, $1.25 billion). BBVA ignited the spread of green lending with the first green corporate loan in Latin America, to Iberdrola, and the first in the United States, to Avangrid ($2.5 billion).
For some companies, lending rates are tied to an improvement in overall corporate sustainability or environmental, social and governance (ESG) performance, while other loans are linked to specific measures such as reducing GHG emissions.
Why are banks offering lower rates to sustainability leaders? Mounting evidence shows that companies with a focus on financially material sustainability or ESG issues outperform others and should represent a lower credit risk. Lenders also note that a company’s focus on sustainability performance can be a measure of innovation as well as an indicator of good management.
For companies, ESG- or sustainability-linked loans, also known as positive-incentive loans, provide a lower lending rate or pricing reward for a company’s sustainability leadership. Unlike green bonds, these sustainability-linked loans can be used for corporate general purpose, not just specific green projects or technologies. The borrower must quantify and report its environmental or sustainability benefits each year to the lender, but in general, these loans are often easier to arrange than bonds and have lower lending thresholds, making them more accessible to smaller companies.
Like many other aspects of green finance, green loans sprouted in Europe. The foundations were laid in March 2018 with the issuance of the Green Loan Principles by the Loan Market Association in conjunction with the International Capital Market Association, which also administers the Green Bond Principles. These organizations collaborated to align the Green Bond and Green Loan Principles, learning from what already had been done on the Green Bond Principles rather than creating a competing framework, as so often has been the case in the sustainability industry. In addition to these standard-setting activities, the EU High-Level Expert Group has included policy recommendations to the European Commission on sustainable finance and green lending.
Credible measures for companies to quantify ESG performance are also fueling growth. To date, most sustainability-linked loans are based on a company’s ESG data or third-party ESG ratings. There are no overarching guidelines or standards for sustainability-linked loans, so banks are moving rapidly to develop their own green lending practices aligned with their performance measures in their business strategies. For companies, this means that they should understand and be able to communicate to their lenders how their sustainability or ESG performances are tied to financial performances, such as revenue growth or lower lending risk.
The emergence of companies quantifying their performance on the U.N. SDGs will create another means for banks to align positive impact lending with companies that are able to show improved SDG performance. Last year, for example, 13 companies from the United States, Europe, Asia and Latin America — Aguas Andinas, AMD, Arm, CLP Holdings, HP Inc., Iberdrola, Ingersoll Rand, Ørsted, ROCKWOOL Group, S&P Global, Spectrum Brands Holdings, Tarkett and Walgreens Boots Alliance — quantified their baseline SDG scores and are poised to track improvements over time.
Early adopters such as ING Bank, BNP Paribas and BBVA continue to break new ground. ING has done 15 green loans and holds 15 percent of its portfolio in "responsible finance," with an aim to double that by 2022. BNP Paribas says interest rates tied to sustainability and ESG performance are where banking is headed. "A transaction that demonstrates that delivering on sustainability will ultimately drive economic performance? Yes, this is the future of banking," says Yann Gerardin, head of corporate and institutional banking at BNP Paribas.
Now that the innovators and early adopters are issuing green loans, getting to a wider scale and reaching the middle market of corporate borrowers will require standardization of terminology and better transparency on ESG. Companies that have invested in sustainability programs, built capacity to manage environmental and social issues across their business functions such as supply chain and risk, and that have taken steps to quantify their performance will be well positioned to take advantage of these loans.