Sustainable Financing

Sustainable financing and regulatory challanges

10-11-2022
As a result of the changing political landscape, changed opinions and new financial ESG regulations, companies are being confronted with various financing challenges and opportunities.

Climate risks and transition risks are putting pressure on companies’ results, which often involve their financing partly from financial institutions (credit providers). From a financing perspective, a sustainable business model is indispensable for a company to be viable and maintain its cash flows.

But non-financial institutions are seeing a decrease in the financeability of their activities due to increasing ESG regulatory pressure for financial institutions. Financial institutions are increasingly being forced to finance only sustainable business models. Moreover, this issue is high on the agenda of the regulatory authorities.

In this chapter, we will first address the crucial role that credit providers play in achieving sustainability goals. Then, we will discuss the European sustainability legislation and the role of the regulatory authorities. Finally, we will look at several forms of sustainable financing, from which companies could benefit.

The role of the credit provider

To achieve the ambitious climate goals set by the Paris Agreement, there is a considerable need for capital and financing in order to facilitate the transition to a sustainable economy. In addition to public funds, it is essential to rely on private flows of funding as well.

For that reason, this transition cannot be realised without the commitment of the banking and financial sector. The European legislator believes that it is necessary to encourage financial institutions to be transparent and to engage in long-term thinking about the sustainability issue in order to achieve these goals. In addition, sustainability must be a permanent element of the risk management of financial institutions. New regulations, which mainly focus on financial institutions, are constantly being announced. Those regulations also indirectly impact regular companies and (private) investors. Lack of clarity as to what activities are sustainable is one of the reasons that investments in sustainable initiatives are still inadequate. The European legislator has introduced standards to qualify the extent to which an activity is sustainable. The introduction of transparency is to avoid 'greenwashing' and to encourage investors to engage in sustainable investments.

The introduction of transparency is to avoid 'greenwashing'.

Initially, legislation focused on realising environmental goals, but the social and governance aspects of ESG are increasingly becoming the subject of these regulations.

As investors and providers of financing, financial institutions play a crucial role in society. Climate goals cannot be achieved without them. EU laws and regulations mainly focus on financial institutions. In addition to these regulations, interest groups point out the role that they see financial institutions should play in the transition.

As providers of funding, financial institutions can encourage their customers to develop sustainable initiatives. Part of the objective is for these institutions to contribute to the sustainability transition. They can decide to no longer finance non-sustainable initiatives. That would mean that the parties receiving financing will be impacted by the changing regulations as well.

As financiers of the economy, banks are exposed to credit risks, reputational risks, legal risks, operational risks and market risks. These potential risks are impacted by public opinion in general, and climate issues in particular. The changing opinions and preferences of their customers have also caused financial institutions to place sustainability high on the internal agenda.

Banks are exposed to these potential risks, not only directly but also indirectly through their credit portfolio. A financial institution's credit portfolio can be overrepresented in certain economic sectors or geographic areas. It is important for banks to consider these risks and their scope internally. EU financial regulations and the monitoring of compliance force financial institutions to look at the activities they finance from a different perspective.

Within the existing risk models, which traditionally focus on the credit file level, sustainability risks are not considered, or to a limited extent at best. For a bank that traditionally has a large share in the financing of greenhouse horticulture, the increased risk of storm and hail damage should be considered in a broader assessment of a financing application than it is now. These risks, too, must be weighed and quantified.

Expectations are that financial institutions will make their credit portfolios ‘greener’ in order to mitigate these climate risks. Therefore, it is likely to become increasingly difficult to obtain financing or re-financing of less sustainable activities. In any event, that financing will be obtained on less favourable terms.

A bank’s starting point when providing financing is to mitigate risks. This means that innovative parties without any solid cash flows that use new technologies often have to seek solace from other sources of liquidity than a bank loan. Since climate risks must be borne by society, the government will have to play a prominent role in the transition to more sustainable economic activity. Support can be provided by way of subsidies or state-guaranteed loans.

European sustainability legislation

The European Union pays a great deal of attention to regulations designed to make our economy greener and more sustainable. The capital flows are rerouted to more sustainable forms of investment. The set of EY ESG legislation includes the Taxonomy Regulation , the Sustainable Finance Disclosure Regulation (SFDR), the Non-Financial Reporting Directive (NFRD) and the proposals for the Corporate Sustainability Reporting Directive (CSRD) and the Corporate Sustainability Due Diligence Directive (CSDD).

Taxonomy Regulation

The Taxonomy Regulation provides a uniform classification system to establish clarity about sustainable investments. The Taxonomy Regulation makes clear whether economic activities qualify as environmentally sustainable.

The Taxonomy Regulation applies to financial market participants, namely banks, certain investment companies, fund managers, insurers and developers of certain pension products. It defines certain investment products and pension products. It requires the financial market participants to provide information on those financial products to demonstrate that they qualify as sustainable. The information must be posted, inter alia, on the website and be included in the fund prospectus, the annual report, the investor information, the marketing documentation and periodic reports.

The Taxonomy Regulation is to establish clarity about sustainable investments.

The climate mitigation and adaptation goals as set forth in the Taxonomy Regulation already apply and already have to be included in the information to be disclosed. The rules on the other goals, such as pollution prevention and protection of ecosystems, will take effect on 1 January 2023. Therefore, it is advisable for the financial market participants that come under the Taxonomy Regulation to make preparations now in order to meet the new requirements.

NFRD

The NFRD requires financial market participants with more than 500 employees to disclose what share of their turnover and expenditure is in line with the aforementioned Taxonomy Regulation. They may do so in an annex to the annual financial report or in a separate annual sustainability report.

SFDR

Another directive that sets further rules for the disclosure of information on sustainability in the financial sector is the SFDR. The starting point for this disclosure regulation is environmental sustainability in the economic market. Investors must be well informed of the sustainability impacts of the investment policy and the investment decisions of financial market parties.

In principle, the SFDR applies to all financial market participants, irrespective of whether they offer sustainable financial products. The SFDR defines financial market participants in the same way as the Taxonomy Regulation, namely banks, certain investment companies, fund managers, insurers and developers of certain pension products.

The SFDR contains a classification system divided into three main categories. The first category of financial products includes all classic products without any sustainability characteristics. Category two regards financial products with some sustainable characteristics. The third category of financial products regards products specifically aimed at sustainability, for which sustainability is a binding and mandatory part of the investment process.

The rules on disclosure of information mainly relate to considering adverse sustainability impacts in the investment policy or advice, at entity level as well as at product level. Furthermore, these disclosure rules regard the integration of sustainability risks, the courses of conduct in terms of sustainability risks, and the remuneration policy relating to the integration of sustainability risks.

CSRD

On 21 April 2021, the European Commission approved a set of rules on sustainable financing. This set includes a proposal for a directive on corporate sustainability reporting, the CSRD.

The CSRD further expands the scope and disclosure requirements for ESG information as set in the existing NFRD. The CSRD contains several additional requirements. For example, companies are required to disclose information that is needed to understand how sustainability factors impact the company. Furthermore, information that is needed to understand the company's own social and environmental impacts must be disclosed.

In addition to the information as required under the NFRD, the companies will be required to disclose information on their strategy and goals, the role of the board and management, the key adverse effects relating to the company and its value chain, intangible assets, and how they have identified the information that they disclose. Companies will also have to disclose their green financial indicators in accordance with the Taxonomy Regulation to demonstrate which of their activities are sustainable. The report pertains, therefore, also to (potential) impacts that the company's activities may have on sustainability.

CSDD

The European Commission published the proposal for the CSDD as a complementary to the CSRD. The proposed directive will apply to companies with more than 500 employees and a (net) worldwide turnover of more than 150 million euros. The CSDD will also apply where there are more than 250 employees and a (net) worldwide turnover of more than 40 million euros if 50% of that turnover is generated in certain sectors. The obligations under the CSDD include integrating due diligence in the company's policy and investigating (potential) adverse human rights and climate impacts. The adverse human rights and climate impacts must be stopped and mitigated. In addition, prevention measures must be taken. Procedures must be set up for complaints processing and handling. Furthermore, the company's activities and the measures taken must be monitored. Finally, findings from the foregoing investigation must be reported under the CSDD, and a plan aligning the business model and the company strategy to the Paris Agreement must be drawn up. This directive is likely to have considerable impact on the companies that will come under its scope. For more detailed information, see Chapter 1.

Role of the regulatory authorities

As investors prefer sustainable investments, financial institutions must make sure that the information that they disclose about these products is correct, clear and not misleading.

The AFM and the DNB consider enforcement of sustainability regulations to be the prime focus of supervision.

In their role as regulatory authorities, both the Authority for the Financial Markets (AFM) and De Nederlandsche Bank (the Dutch Central Bank - DNB) have indicated that they consider enforcement of sustainability regulations to be the prime focus of the supervision of financial institutions.

The DNB regards the climate risk as a potential system risk for the financial sector. The consequences and risks attached to climate change applicable to financial institutions in this respect are subdivided into physical risks, transition risks and liability risks. Physical risks are understood as climate-related damage, such as damage caused by flooding or storm. Transition risks are risks occurring as a result of a gradual change in the direction of an economy with less climate impacts. This includes technical progress (such as the transition from oil and natural gas to solar and wind energy), changes in preferences of more aware consumers and the introduction of sustainability regulations, but also changing public opinion. Financial institutions must be aware of these risks and weigh them in their internal risk control. The credit portfolio is expected eventually to become more sustainable, which will reduce the risk at macro level as compared to the existing credit portfolio.

The DNB focuses on climate and environmental risks, aiming at raising awareness and addressing sustainability risks within the financial sector. Climate and environmental risks may have a material financial impact on the financial solidity and reputation of funds. To control these risks, the DNB has drawn up a document containing guidelines for integrating climate and environmental risks in the strategy, governance, risk control and information disclosure of fund managers. In addition, the DNB assesses policymakers and co-policymakers of certain financial institutions before they take up office. As part of this assessment, the DNB examines the knowledge and experience of the candidate in the field of climate and environmental risks.

The AFM monitors whether financial institutions disclose reliable and accessible information on sustainability factors. The regulated institutions must integrate sustainability aspects in their business operations, product development, risk management and investment decisions. Consumers and other customers must be adequately informed and advised to support their financial decisions, and receive a product that fits their needs.

Forms of sustainable financing

In recent years, as a result, among other things. of the increasing relevance and popularity of forms of sustainable financing, several sustainable financing instruments have been developed for both loans and bonds. For loans in the international financing market, the 'Green Loans' and 'Sustainability-Linked Loans' are the most popular. Although this publication will not address the documentation standard for green bonds, particularly the standard for Green Loans has been inspired by the Green Bond Principles that have been under development since as early as 2014. In addition to these international standards and initiatives, there are also national forms of green financing, such as the scheme for green banks and growth funds , which will not be discussed in this publication either.

Green Loans are based on the Green Loan Principles (GLP) as issued by Loan Market Association (LMA) together with the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA). The GLP were first issued in 2018 in order to promote consistency in the financial markets in the field of green loans. The most recent version of the GLP and the related ‘manual’ date back to February 2021.

Sustainability-Linked Loans are based on the Sustainability-Linked Loan Principles (SLLPs), as also issued by the LMA, APLMA and LSTA. The most recent version of the SLLP and the related manual date back to March 2022.

Both the GLP and the SLLPs are principles that market parties can voluntarily apply on an individual basis for each loan that provide direction through certain characteristics as to when a loan qualifies as a Green Loan or a Sustainability-Linked Loan. The GLP and SLLPs merely provide a framework within which such products can be further developed. Meanwhile, the GLP and SLLPs are frequently used and have been embraced by several large banks in the Netherlands. Incidentally, in addition to the GLP and SLLPs, the LMA also has several other initiatives in the field of ESG, such as the Social Loan Principles from 2021, which provide direction for the provision of loans for 'social projects’ .

As regards the contents of the 'green credit documentation' based on the GLP and SLLPs, it should be noted that these are often not all that different from non-green credit documentation.

GLP / Green Loans

According to the GLP, a green loan can only be provided for 'green projects'. An indication of what may qualify as a green project can be found in annex 1 to the GLP. According to the GLP, a green loan must in any event satisfy the following four core components:

1. Goal: the loan (or tranche) may only be used for a green project, and this use is sufficiently safeguarded and recorded in the financing documentation.
2. Process for evaluation and selection: the borrower is expected to provide clarity to the lender as to its environmental sustainability goals and the basis on which the borrower concludes that the financed projects qualify as green.
3. Use: the borrower is expected to have a system in place which enables the lender to verify whether the proceeds of the loan are being used for the relevant green project.
4. Reporting: the borrower must keep the lender informed annually of the use of the funds - in any event until the loan is fully drawn.

SLLPs / Sustainability-Linked Loans

According to the SLLPs, the borrower must set specific and ambitious goals - the sustainability performance targets (SPTs) - in combination with meaningful key performance indicators (KPIs). Based on the SPTs and KPIs, it should then be possible to assess whether the borrower is on its way to meeting its sustainability targets.

The KPIs may be linked to internal and external goals. For example, a borrower may request an external agency for a sustainability rating for the company or the borrower and the lender may agree what internal sustainability targets will be used as KPIs. The latter may include: (i) reducing the company's carbon emissions or a specific production process; (ii) building of, or renovating buildings into, sustainable homes; (iii) reducing food waste; (iv) the use of recycled materials in the production process; or (v) promoting biodiversity.

If the KPIs and SPTs are met, the borrower will usually be rewarded with a lower interest rate. In some cases, the converse applies as well: if the SPTs are not met, the borrower is required to pay a higher interest rate. This bonus-malus system usually does not apply to Green Loans, although borrowers under Green Loans usually lose the green qualification of their loan if the four core components cannot be satisfied.

It may be concluded that Green Loans and Sustainability-Linked Loans are fundamentally different. Where Green Loans are used to finance a green project, Sustainability-Linked Loans are used to encourage the borrower to meet the SPTs and KPIs set and, thus, to contribute to a greener planet.

SLL or GL?

When selecting a green financing instrument, the borrower should ask itself whether the funds can be fully used to finance a green project and whether it can satisfy the four core components. If not, a Sustainability-Linked Loan is the way to go. Moreover, Green Loans are often provided as term loans that can be linked to a specific green project, while Sustainability-Linked Loans are usually revolving credit facilities that serve to support the overall business operations and, thus, the borrower's broader green strategy.

Qualification under the Taxonomy Regulation

The classification for economic activities as developed under the Taxonomy Regulation requires parties to disclose the share of their turnover that ensues from sustainable activities. If a borrower uses a Green Loan or a Sustainability-Linked Loan to invest in making its economic activities more sustainable, this may improve the borrower's sustainability profile, and may be counted in the required reporting.

To what extent the GLPs and SLLPs fit the context of the Taxonomy Regulation in a broader sense is still unclear. It will be up to the legislator and market parties to provide clarity on this point in the future.

Conclusion

ESG and the related provision of information play an ever-growing role in the financing practice. The existing regulations already entail far-reaching duties to provide information, but those rules will be considerably expanded in the near future. This will not only impact the financial market participants, but also other large companies. Attracting financing for non-sustainable activities from financial institutions is likely to become more difficult in time. On the other hand, financing of sustainable activities will become cheaper. It would be wise to anticipate this development in time.

Tips & Tricks

• Review whether the company comes under the scope of the new regulations.
• Make sure that sustainability aspects become a permanent part of strategy and governance.
• Realise that a future-proof business model will make the financeability of a company easier/more advantageous.
• When financing 'green projects' consider financing through a Green Loan.
• When financing investments to make the overall business operations more sustainable, consider financing through a Sustainability-Linked Loan.