Essential ESG: Episode 12 – Emerging trends in sustainable finance - Fund Finance

In the latest episode of Corrs' Essential ESG podcast, Adam Stapledon, Alison Morris and Emmanuel Georgouras discuss emerging trends in sustainable finance for 2023 and beyond.

As corporates take action to stay up-to-date with global developments and meet increasing stakeholder expectations, sustainable finance is becoming much more mainstream. Adam, Alison and Emmanuel discuss a number of emerging trends in the area, including the use of sustainability-linked loans and green financing.

Essential ESG is a podcast series presented by Corrs that breaks down topical issues affecting the rapidly evolving environmental, social and governance landscape in Australia and beyond.

TRANSCRIPT

Adam Stapledon, Partner and Head of Banking and Finance

Alison Morris, Special Counsel, Banking and Finance

Emmanuel Georgouras, Associate, Banking and Finance

Emmanuel: Welcome to another instalment of Corrs' Essential ESG podcast. My name is Emmanuel Georgouras and I'm an associate in the banking and finance team and a member of our sustainable finance working group. I'd like to begin today by acknowledging the traditional custodians of the land on which we meet, being the Gadigal people of the Eora Nation, and pay my respects to their elders past, present and emerging. Today we're going to be speaking with Adam Stapleton and Alison Morris. Adam is the national head of our banking and finance practice group at Corrs and Alison is a special counsel in the banking and finance group and also a member of our sustainable finance working group. Welcome Adam and Alison. Today we're going to be talking about all things sustainable finance, what it is and what we expect to see over the next few years. So to start us off today Adam, could you please provide a quick introduction into sustainable finance?

Adam: Thanks Emmanuel. Very happy to be here. According to the World Bank, sustainable finance is the process of taking due account of environmental, social and governance considerations when making investment decisions in the financial sector, leading to increased longer term investments into sustainable economic activities and projects. Sustainable finance really reflects an increasing integration of ESG issues into corporate activity. Corporates today are looking to meet new global requirements for emissions reduction targets, human rights and integrity. As corporates take action to stay up-to-date with global developments and increasing stakeholder expectations, sustainable finance is becoming much more mainstream across global markets. The two key types of sustainable financing that we advise on at Corrs and which are really the main forms in the market are sustainability-linked loans and green financing. Sustainability-linked loans are probably a broader category, so we'll start with those. They are loans that incentivise the achievement of predetermined sustainability performance objectives, utilising predefined key performance indicators or metrics to link economic outcomes to sustainable practice.

Emmanuel: Can you tell us a bit about each of those?

Adam: For sustainability-linked loans, proceeds don't need to be used for a specific project or a green project. Rather they provide an incentive, often in the form of interest rate adjustments, for borrowers to improve their overall sustainability performance in the relevant sustainability domains. As with many things, the UK and the EU are leading markets for sustainability-linked lending, but it's increasingly prevalent in the Australian market. And they're a really great option for borrowers who don't necessarily have a specific green project or who need more flexibility than is available in green financing. It gives borrowers an opportunity to commit to improve their sustainability profile with more latitude in how they can then apply the proceeds.

Emmanuel: Could you give us an example of what that might look like?

Adam: So for example, Stuart Robertson – one of my partners – and Alison, my co-panellist today, worked for RSK Group on a £1 billion+ facility, which was the largest private credit sustainability-linked loan at the time. And the metrics on that are focused around carbon emissions reduction, but also ethics training and improvements to health and safety. A slightly narrower example is green financing, either in the form of loans or bonds. A green loan is a form of financing that enables borrowers to use the proceeds to fund projects that make a substantial contribution to an environmental objective. So that could be, for example, funding the development of a renewable energy project, it could be clean transportation, environmentally sustainable agriculture, or the development of green buildings which meet recognised standards or certifications. A key difference between the green and sustainability-linked loan framework is that green bonds must be used exclusively for green projects.

Emmanuel: There is some guidance in the form of principles around green bonds, isn't there? Could you outline them for our listeners?

Adam: The four main components of the green loan principals are: that the proceeds must be used for designated green projects that provide clear environmental benefits; that there is a clear process for project evaluation and selection including disclosure by the borrower of how it will manage environmental and social risks for their relevant projects; management of proceeds to ensure they're applied in the right way; and finally reporting which is both qualitative and quantitative reporting covering things like energy capacity, the level of generation and contribution to emissions reductions. A good example of a green loan is a transaction that Corrs acted on recently for lenders to First Sentier Investors Global Diversified Infrastructure Fund. The facilities provided to First Sentier included a green tranche facility, which must be used exclusively to fund projects and assets necessary for the transition to a low carbon and climate resilient economy. The facilities established a green financing framework which sets out how proceeds from the green tranche must be used and managed. The eligible categories are defined under the climate bonds initiative standards and the EU taxonomy and include renewable energy, energy efficiency, waste management, clean transportation and sustainable water management. This is an example of a facility where the green tranche sits alongside a tranche which is available for other purposes.

Emmanuel: So Adam there seems to be quite a lot happening in the space and you specifically mentioned a need to integrate ESG into operations and mainstreaming of sustainable finance. Alison, could you give us an overview of some of the specific drivers of sustainable financing, both globally and also in Australia?

Alison: Thanks Emmanuel. Businesses are increasingly incorporating ESG-related targets and commitments into their decision-making operations, not just in connection with their debt funding, but more generally. And the rise of sustainable financing reflects the logical integration of these targets and commitments to secure funding for businesses to meet their ESG objectives. The drivers for borrowers and lenders have some overlap, but for borrowers, market pressure is pushing companies to commit to monitor and disclose their sustainability-related actions. And corporates are also looking to address their climate change and other operational risks. And this means they'll need funding for resilient infrastructure projects in the short term, increasing demand for sustainable financing and mainstreaming the use of sustainable finance products. Obtaining sustainable financing supports the achievement of ESG-related targets, particularly where companies are looking to measure and report on their achievements. For example, in the energy space, a company with net zero emissions targets can leverage sustainable financing options to fund the decommissioning of their GHG emissions intensive liabilities or to construct a renewable energy project. Sustainability-linked loans and other green financing may also offer savings and incentives for borrowers seeking to access financing in an uncertain economic climate.

Emmanuel: Are there savings to be made by borrowers if they take a sustainability-linked loan?

Alison: Sustainable financing may enable companies meeting their objectives under the conditions of the loans, to potentially save on interest costs and lower the overall costs of their financing.

Emmanuel: And are the drivers the same for lenders?

Alison: The drivers are slightly different for lenders. As with the rest of the market, financial institutions have made their own public commitments to sustainability. Lenders are facing heightened reporting obligations and stakeholder scrutiny of how they're implementing and achieving their commitments. While sustainable financing options incentivise borrowers to achieve measurable ESG results, they also enable lenders to use their capital and resources to support their own sustainability initiatives. For example, Blackstone's ESG policy focuses on the priority ESG topics of climate change, mitigation, resilience and adaptation, diversity, equity and inclusion, and good governance. By providing sustainability-linked loans to companies with KPIs addressing these same topics, Blackstone is ensuring that its acting in line with its own ESG commitments and lenders are increasing favouring borrowers who have clear and meaningful ESG metrics which drive their sustainability efforts.

Emmanuel: So it seems it's actually a big item on many company's agendas. How are we seeing this shift to SLL's play out in the Australian market specifically?

Adam: There's obvious pressure from investors on all participants in markets on using ESG and sustainability as a lens to consider their businesses. In fact, a global investor survey that PWC published in 2022 showed that 82% of investors surveyed were facing demands from their clients for their portfolios to apply an ESG lens. And it's not surprising given that and the trends that Alison's just been talking about, that the use of sustainability-linked loans is rapidly increasing in Australia and the Asia-Pacific region more generally. In fact, on one measure in 2022 about US$119 billion of sustainability-linked loans were provided within the Asia-Pacific region, which was an increase of something over 40% on previous years. In terms of the nature of the loans, we're seeing an increase in their coverage of broader issues beyond those addressed by traditional green financing options.

Emmanuel: Can you tell us what you mean by that?

Adam: So when sustainability-linked lending first came into the market, a lot of the focus in the key performance indicators, KPIs, was a reduction of scope 1 and 2 emissions. Borrowers and lenders are increasingly agreeing a broader range of KPIs reflecting broader ESG priorities and recognising that sustainability extends well beyond purely environmental targets. So for example, we've acted on a sustainability-linked loan facility for Pact Group provided by CBA, which included KPIs covering scope 1 and 2 emissions reduction targets, but also covering recycling and gender pay equality. A recent sustainability-linked loan provided to an infrastructure owner included a KPI linked to improved opportunities for First Nations people and prioritising procurement from contractors with a defined percentage of Aboriginal or Torres Strait Islander employees. Similarly, a recent very large corporate facility for a major retailer included targets relating to reduction of greenhouse gases, but also diversion of waste from landfill and a KPI linked to the percentage of women in leadership positions in the organisation. Overall what we're seeing is that sustainability-linked loans are increasingly popular in the Australian market because of the ability to use the funding for general corporate purposes while the sort of pricing incentives remain tied to meeting specific sustainability performance targets and criteria and an adoption of broader ESG-focused KPIs beyond just environmental. So the activities and projects normally covered by green lines are often now also attached to sustainability-linked lending, alongside KPIs focused more on the social and governance aspects of ESG.

Emmanuel: What social and governance metrics are you seeing?

Adam: In particular, we're expecting that KPIs linked to outcomes for Australian First Nations people will become increasingly important, along with KPIs focused on mental health and diversity.

Emmanuel: Thanks Adam. So, Alison, it's obviously interesting to see now that there's an increasing inclusion of social performance metrics in SLLs. What are some of the challenges in drafting sustainability key performance indicators for these SLLs?

Alison: Thanks Emmanuel. There are challenges for lenders and borrowers in setting meaningful and credible KPIs to be used within their finance documents. For borrowers, the challenges include designing, implementing and the reporting on their KPI frameworks to achieve the set targets. And also ensuring that the KPIs are in fact relevant and credible for their businesses. For lenders, once the provisions are drafted into the loan documents, they then need to ensure that they can appropriately monitor the achievement of the relevant KPIs and where relevant ensure that those KPIs are aligned with their own sustainability-related targets and commitments.

Emmanuel: Is there a best practice for how these commitments are incorporated?

Alison: It is a developing area, so to date there's no standard practice in the Australian market on how KPIs and pricing incentives should be drafted. There are other sustainability-linked loan principals which are published by the Loan Syndications and Trading Association, and these offer an example of guidance, but domestic standards and regulations take a more piecemeal approach and are often based on previous transactions which have been done by that particular financial institution. It can be difficult with more socially-focused targets such as mental health, how can borrowers draft a commitment so it's achievable and measurable while still being ambitious and ensuring that their achievement of the target creates some positive sustainable benefit. It's a balance between ambition to create positive change and being realistic to ensure the financing can be secured and maintained and the KPIs measured.

Emmanuel: Thanks Alison. That's really good from the transactional focused side. Adam, how do you see that playing out from the risk side?

Adam: Picking up on one of the points that Alison just made, there is a bit of ambiguity and lack of standardisation in sustainability loan principles. And that can lead to both commercial and legal risks of being accused of misleading and deceptive conduct through green or bluewashing through the use of a sustainability-linked loan framework. In fact, 87% of investors surveyed in PWC's global investor survey in 2022 thought that company reporting on sustainability contains greenwashing, showing that there's a lack of trust in companies monitoring and disclosing against sustainability targets and scrutiny on the reporting that they're providing. And we've seen that in Australia recently as well as internationally, with regulators coming down quite hard on claims that are vague and use terms such as green or sustainable or ethical without clear tangible measurements and actions to back up their claims. In the end, the risk for participants in this market is really coming through a lack of a uniform standard and uniform reporting and disclosure requirements.

Emmanuel: We've definitely seen these words greenwashing and bluewashing blow up in the media over the past six months or so. Alison, would you say that the lack of regulation is changing and it's going to continue to change?

Alison: Absolutely Emmanuel. We think that the introduction of regulations is probably the biggest item that lenders and borrowers need to have on their radar for sustainable financing. In terms of general regulation for sustainable financing, the EU as always is leading the way. They've had the implementation of the sustainable finance disclosure regulations and they've developed the EU Eco label for certified green retail financial products. There's growing regulation by the SEC in the US to crack down on misleading ESG claims by investment funds.

Emmanuel: And what's happening back home?

Alison: From an Australian perspective, the Australian Government has also proposed a new sustainable finance strategy and taxonomy, which aims to improve market transparency and provide verifiable data for investors alongside other initiatives to reduce greenwashing. We'll be covering this in the next podcast in our sustainable finance series, with a particular look at taxonomies.

Emmanuel: Thanks very much Adam and Alison. So I guess the next part of our conversation should be about what's expected over the course of 2023 and also the next few years. And I guess the big ticket items that our clients should be aware of, would you say these items would definitely – the top one would be increased regulation. What opportunities do you see for our clients Adam?

Adam: In terms of future trends, there's no doubt that regulation and formalising frameworks is a key and increasing trend in this space. And the formalising of a sustainable finance taxonomy for Australia is an important first step in that. And people looking to participate in the market should really be anticipating the regulation that is coming in and trying to future-proof what they're doing now with one eye on what is likely to come in in the future. So definitely dial-in to the next of our series which focuses on that.

Emmanuel: And Alison, just to go on from what Adam said, what would you view as the big opportunities?

Alison: We consider there are opportunities to pursue sustainable financing beyond projects and infrastructure, through sustainability-linked loans. And we also think that parties should not be shying away from green bonds. The benefit is their precision in being specifically used for green development. More generally with sustainability-linked loans, we think that there is scope to include a broader range of KPIs and sustainability-linked loans. It's important though for borrowers and lenders to ensure that these are precise and ambitious and secure a positive benefit to society and the environment. So they have to be authentic to the particular borrower and the industry in which they operate. And we expect that corporate borrowers who don't position themselves appropriately and implement respectable ESG targets may encounter difficulties in obtaining finance or may have to obtain finance on less favourable terms in the short term. For borrowers operating in more high meaning industries and looking to achieve transition finance to comply with net zero climate change policies, these borrowers will need to consider how to ensure that ESG and sustainability targets are sufficient to meet lender's increasing standards otherwise they too will face barriers to accessing finance. Overall we're expecting to see a greater push towards sustainable finance in 2023, with sustainability-linked loans being the leading form of financing. We expect that the mainstream and sustainable financing result in mandatory ESG green clauses being built into an increasing number of finance documents. Although there's risk and difficulties for borrowers, there remains adequate preparation time for corporate Australia to prepare for a new financing model and focus on developing their ESG initiatives.

Emmanuel: That's actually a great place for us to wrap up, because as a part of our series on sustainable finance, there will be upcoming podcasts including one on sustainable finance taxonomies, regulatory developments and also litigation in this ever-changing space. I want to thank you very much Alison and Adam for your time and please tune into our next podcast. It will be released soon.

This podcast is for reference purposes only. It does not constitute legal advice and should not be relied upon as such. You should always obtain legal advice about your specific circumstances.

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