Demystifying Decarbonisation: exploring green loans and sustainability-linked loans

Financing sustainability: exploring green loans and sustainability-linked loans

While the terms "green loans" and "sustainability-linked loans" have been used in the lending markets for a number of years, there is sometimes some confusion as to the key differences between them. This short article aims to demystify these terms.
 

Green loans

Green loans are loans to fund a specific "green" project, which will have a positive environmental impact. Green projects typically focus on renewable energy generation, energy efficiency improvements, waste management, sustainable transportation, green building construction or retrofitting, and other initiatives aimed at minimising ecological footprints.

The defining characteristic of a green loan is that the funds must be used exclusively for the designated green project and align with strict criteria determined by organisations such as the Loan Market Association, which has set green loans principles to be complied with for the loan to qualify as a "green loan".

When assessing the eligibility of a project for a green loan, the lender will look at factors such as the project's potential to reduce greenhouse gas emissions, conserve natural resources, enhance biodiversity and promote environmental stewardship. Only projects that meet required sustainability standards and demonstrate tangible environmental benefits will be considered eligible for green loan financing.
 

How green loans work

Green loans operate in a similar manner to conventional loans and include similar provisions. What makes them "green" is the requirement for the funds to be used exclusively for the implementation of the green project. Sometimes, a loan can be split into various tranches and include a "green tranche" that is used for a specific green project (e.g. buying and installing some equipment on an asset that will make its operation more environmentally friendly), while the other tranches can be used for other purposes or general working capital.

One notable feature of green loans is their transparency and accountability. Borrowers are required to track and report on the environmental impact of their projects periodically and to demonstrate that the funds are being used as intended. This reporting mechanism not only enhances transparency, but also fosters trust between lenders, borrowers and stakeholders, ensuring that the funds are effectively used for the set environmental objectives.
 

The importance of green loans

The rise of green loans reflects a broader shift towards sustainable finance and can act as a key driver to assist with the transition towards a low-carbon economy. Indeed, green loans offer a structured mechanism to mobilise capital towards environmentally beneficial projects, accelerating the transition to a more sustainable future.
 

Sustainability-linked loans

Sustainability-linked loans (SLLs) are a departure from traditional lending models by linking the terms of the loan to the sustainability performance of the borrower. Unlike green loans, sustainability-linked loans are structured to incentivise broader sustainability improvements across the borrower's operations.

At the heart of SLLs are sustainability-linked targets and key performance indicators agreed upon between the borrower and the lender. These targets encompass a range of environmental, social, and governance metrics ("ESG"), such as reducing carbon emissions, increasing energy efficiency, improving diversity and inclusion, enhancing supply chain transparency, or promoting ethical labour practices. The borrower's ability to achieve these targets directly impacts the financial terms of the loan, with performance-linked adjustments to interest rates or other financial incentives.
 

How sustainability-linked loans work

Under an SLL agreement, the borrower will only earn the financial incentive (e.g., interest rate reduction) if some predefined sustainability targets are met within a specified timeframe. If the borrower successfully meets or exceeds these targets, it will benefit from financial rewards, such as lower interest rates, extended loan maturity periods, or favourable terms for future financing. These performance-based incentives provide motivation for companies to prioritise sustainability initiatives and integrate ESG considerations into their business strategies.

Conversely, and depending on how the loan is drafted, a failure to meet these targets may result in financial penalties, such as increased borrowing costs or covenants.
 

The importance of sustainabilty-linked loans

By linking financial terms to sustainability performance, SLLs encourage companies to embed sustainability into their core business operations, driving progress towards ESG goals. Moreover, SLLs promote transparency, accountability, and continuous improvement, as borrowers are incentivised to set increasingly ambitious sustainability targets over time.

From a lender's perspective, sustainability-linked loans offer several advantages. They allow lenders to enhance their reputation, attract socially responsible investors, and contribute to the transition towards a more sustainable economy. From a borrower's perspective, SLLs also act as an entry into sustainable financing for entities which don't have applicable green projects but are taking steps to improve their environmental behaviours in other ways.
 

Our decarbonisation team

At Stephenson Harwood, we have market-leading expertise in three sectors that will be the key pillars in decarbonising and achieving net zero:
 

• energy,
• transportation and trade, and
• the built and natural environment. 

This gives our clients the benefit of cross-sector insights as we support them on their pathway to net zero.

Our decarbonisation team is international, with specialists spread across eight offices in Europe, Asia and the Middle East. When coupled with our strategic relationships with other key independent law firms, this means we can support our clients wherever their business interests are based.