22 May 2023
Stefano Capacci, Senior Consultant, Sustainable Finance Business Unit Lead, Longevity Partners
Climate change is inherently an economic problem, one caused by the unrelenting pace of the last two hundred years of economic expansion, largely made possible by access to cheap but polluting energy. Its solution, while driven by technological and cultural advancements, is similarly rooted in economics. Longevity Partners, like all actors playing their part in global decarbonisation efforts, seeks to move the needle of capital allocation, from polluting investments to sustainable ones.
The economics of the drive for decarbonisation are simple: sustainable investments – when done well – have lower risk premiums, are more energy efficient, and yield more substantial returns in the long term. As sustainability became a hot topic in the public domain, creating bottom-up advocacy for change and achieving systemic wins like the Paris agreement, the investment world has steadily moved towards addressing this demand by creating investment vehicles for the transparent allocation of capital towards sustainable projects.
The list of products now present in the financial market is too vast to cover here, and the overarching verdict regarding their efficacy is still being debated. Indeed, the number of standards, frameworks, and vehicles now present in the market is greatly varied; these run the gamut from being effective tools for decarbonisation to being empty labels that have marred the efforts of sustainable finance with the taint of greenwashing.
Focusing on the real estate market, one instrument has defined itself as the standard for sustainable financing: the Green Loan.
Real estate investors now face multilateral pressures to sensibilize their portfolios to increasingly stringent ESG standards. Normative requirements, especially in Europe, are increasing risk premiums of older assets, jeopardising their ability to be let and maintain their current valuations. New leasing standards, and this past winter’s proof that overreliance on gas is a risky bet, are demanding that operational efficiency become a primary focus of asset managers, where both standing assets and new developments will be expected to fall in line with the steep downward curve of CRREM decarbonisation pathways. The market has now matured in response and is willing to pay a premium for assets that are demonstrably aligned with sustainability standards. This is best exemplified via the transformation of SFDR, the EU disclosure mechanism, into a green label that funds can employ to attract investors.
The minimum common denominator here is that the real estate world is facing a paradigm shift as the cost of ‘getting up to standard’ is being priced into asset valuation. We cannot escape the transition from the current carbon performance of the global market (50 GTCO2e/year) to where we need to be to achieve the Paris Agreement targets (10 GTCO2e/year by 2050). This impasse stems, in large part, from a global funding gap which inhibits our ability to reduce energy demand and resource use, as well as investing in new infrastructure and technologies.
The real estate sector, contributing to more than 40% of global emissions, needs to decarbonise. It needs to construct more efficient and sustainable buildings and, more importantly, elevate the current stock to meet climate mitigation goals. Consequently, real estate investors need to pursue aggressive strategies to implement these crucial steps. At first glance, the task might look daunting, but as we explored in a previous thought piece, investors have access to a range of services to further incentivise the green transition. A key element of these is Green Loans, a financing vehicle that should be in the toolkit of every real estate investment manager.
Longevity Partners offers multidisciplinary solutions to address the decarbonisation of the real estate sector. We provide services ranging from strategic advisory and building optimisation, to renewable power generation; through these services we work with clients to benchmark their portfolio performance and provide asset-level implementations to meet targets and align with best practices. To help our clients tackle the funding gap we have expanded our offering to include the provision of advice on sustainable financing solutions. We help our clients identify Green Loan opportunities in their projects and acquisitions and service them with Second Party Opinions to ensure their alignment with the principles set forth in the Loan Market Association’s Guidance for Green, Social, and Sustainability-Linked Loans.
What is a Green Loan?
A green loan is a form of sustainable debt financing that can be used to finance or refinance, in whole or in-part, new and/or existing projects that are tied to a quantifiable positive environmental outcome.
Green loans are different from traditional financial transactions in two fundamental ways; the governance of the loan is tied to a Sustainable Finance Framework informed by the LSTA LMA Green Loan Principles, and the outcome of the loan is coupled with environmental targets agreed by borrower and lender.
With the rise of Green and Sustainability-Linked Loans & Bonds, among other products, the debt market has matured to provide solutions that can aid in tackling the climate crisis. Green Loans provide a clear incentive to allocate capital towards decarbonisation projects. Where a project meets the relevant ESG criteria, and a green clause has been written into the transaction, it can be labelled as a Green Loan. This can benefit the borrower in the form of a lower coupon or a variable exit fee based on the project’s performance against a set of targets.
Green debt provides a mechanism for borrowers to benefit directly from improving the environmental and/or social performance of their assets through lower lending costs, and for lenders to allocate capital to more sustainable assets, improving the ESG profile of their loan book. The use of a Green Loan aids the presentation of a project as best-in-class in ESG performance and awards a marginal discount on the coupon or exit fee of the loan.
How does a Green Loan work?
Green Loans and Sustainability-Linked financial transactions are governed with the ICMA & LMA’s Principles. To meet market standards, market participants wanting to issue a Green Loan should draft a comprehensive Sustainable Finance Framework that defines their policies, targets, and governance relating to the following principles:
- Use of Proceeds
- Process for Project Evaluation and Selection
- Management of Proceeds
Every Green Loan needs to make specific considerations of the components above. Its capital needs to be earmarked and allocated in compliance with the governance rules set out by the Framework, and the targets associated with the loan need to be stated and tracked throughout the duration of the loan. Further, Green Loans demand a transparent and recurring reporting mechanism for the drawdown of the loan (use of proceeds) and its environmental sustainability objectives.
Based on the Framework, Green Loan opportunities can be identified, and their progress against targets can then be tracked during both the allocation and post-allocation phases of the project.
What is eligible for a Green Loan?
A wide range of projects that yield a positive environmental and/or social outcome can be eligible for sustainable financing. Green Loans need to tie their Use of Proceeds to environmental outcomes that can be quantified by ESG targets. Some examples include:
- KWh saved
- Scope 1, 2, & 3 CO2e emissions reduced
- Circular economy adapted products used
- BREEAM certification achieved (excellent or above)
- Water/waste management measures included
The applicability of Green Loans is broad, and the instruments can be used to finance:
- Infrastructure projects (e.g., renewable energy)
- Pollution prevention, water and land conservation, and biodiversity projects
More specifically, projects (existing or new) which satisfy the eligibility criteria of the Green Loan Principles can be funded, in part or in full, using a Green Loan. The eligibility criteria provide a selection methodology for green projects; these however are broad in their definition in order to be widely applicable across asset classes. Critics of the Principles argue that the breadth of interpretation allows bad actors to exploit sustainable financing and greenwash projects that should in fact not be considered ‘green’.
Projects material to the real estate sector that can be financed with Green Loans are:
- Renewable energy – including production, transmission, appliances and products;
- Energy efficiency – such as in new and refurbished buildings, energy storage, district heating, smart grids, appliances and products;
- Pollution prevention and control – including reduction of air emissions, greenhouse gas control, soil remediation, waste prevention, waste reduction, waste recycling and energy/emission-efficient waste to energy;
- Sustainable water and wastewater management – including sustainable infrastructure for clean and/or drinking water, wastewater treatment, sustainable urban drainage systems, river training, and other forms of flooding mitigation;
- Climate change adaptation – including information support systems, such as climate observation and early warning systems;
- Green buildings which meet regional, national, or internationally recognised standards or certifications.
What is the Greenium of Sustainable Financing
To reiterate, the debt market has incorporated ESG principles and developed sustainable financing instruments to address the need to fund the green transition. The primary incentive of sustainable financial transactions is the opportunity to access cheaper-than-traditional capital – at the cost of producing a positive environmental impact. The motivating factor for this cheaper capital is the rise of green-labelled funds (like SFDR) and prior to that, the central banks’ release of recovery funds tied to climate change mitigation. These have created a strong demand for green assets, which currently represent only a small portion of the stock available in the market. This interest of investors to build their ‘green’ loan books has allowed issuers to fund projects at a lower spread with respect to conventional funding where the use of proceeds is not earmarked for a green project.
The greenium of sustainable financing has contributed to the explosive growth of the market. In 2020, the Green Bond market reached a record high of $269.5 billion, up from $12.7 billion in 2012. Similarly, the Green Loan market has seen significant growth, with global green loan volumes reaching $183 billion in 2020, up from $24 billion in 2012.
The discount of a Green Loan often comes as a marginal reduction of the coupon. A scenario analysis of interest rate discounts for different types of projects and asset classes is difficult to gauge. As private lending agreements, Green Loans operate in grey markets; ultimately the discount achieved on a green loan depends on the cost of capital, the quality of its environmental targets, and the negotiation with the lending entity.
Our internal market research and experience delivering Green Loans points to these key figures; we estimate an expected discount on the coupon ranging from 12 to 45 bps and step-down mechanisms in exit fees of developments and acquisitions ranging from .2% to 1.5%.
Longevity Partners’ Service Offering?
Longevity Partners offers advisory services and Second Party Opinions for sustainable debt financing. We help clients create the governance structures needed to pursue Green Loan financing and report annually on the progress of transactions against the KPIs set in the green clause of agreements.
- Longevity Partners drafts a Sustainable Finance Framework, defining policies and governance in relation to use of proceeds, process for project evaluation and selection, and management of proceeds, and reporting. This document can be drafted for either the borrower or the lender. When issuing a Green Loan, the two parties need to agree on the governing principles set by the document.
- Longevity Partners tracks Green Loan opportunities across financial transactions and applies the Framework to take advantage of the financial incentives present when issuing Green Loans.
- Longevity Partners issues annual reports on Green Loans which track projects against the progress of the scheme and determines whether the drawdown on the relevant loan(s) has been spent to achieve the selected KPIs.
- Longevity Partners provides independent Second Party Opinions (SPOs) of the transaction’s alignment to market principles, regulations, and best practices in the market. Our SPOs are aligned with the LMA/LSTA guidelines for external reviews, benchmark targets against international frameworks, and assure borrowers and lenders to the quality of a Green Loan.
With our Second Party Opinions, Longevity Partners assesses the project’s compliance with the relevant LMA/ICMA Green, Sustainability-Linked, and Social Loan Principles. We also assess the fitness of its Use of Proceeds against requirements for Project Evaluation & Selection, as well as the Client’s targets, as set out in the relevant Sustainable Finance Framework. Further, we use an independent assessment methodology to determine the project’s fitness against a set of minimum eligibility criteria and map the alignment against the EU Taxonomy.
Sustainable Financing, specifically Green Loans, cater to the need to fund the green transition by providing a clear incentive to pursue decarbonising projects. Green Loans are a form of debt financing where the underlying project is tied to a positive environmental outcome and the impact of the project can be tracked against the drawdown of the loan to determine how the proceeds were allocated. To meet disclosure requirements and align with best practices, Green Loans are expected to report annually and provide updates on the progress of the project and how it is contributing to the environment.
Green Loans come with a wide breadth of benefits. They help funds and assets meet regulatory requirements, yield reputational benefits that attract investors looking for ESG-aligned assets, and, of course, provide clear financial benefits. Beyond the greenium discussed above, which offers lower interest rates to green projects, pursuing a Green Loan benefits the underlying asset. Energy efficient budlings have lower operating costs and ‘green’ budlings have – in general – higher resale value.
As an ESG advisory firm, Longevity Partners services our clients’ sustainability needs, helping them develop fund-level strategies and improve the environmental performance of their assets. Implementing their ESG needs, we create an impact in mitigating climate change and help them play an important role in this century’s stride to meet the Paris goals. With Sustainable Finance we have added an additional means to decarbonise by directly allocating capital to green projects.
To service our client’s sustainable financing needs, we offer Second Party Opinion services to assess Green Loans, assure borrowers and lenders to the transaction’s alignment to market principles, benchmark targets against international frameworks, and align the transaction to the LMA/ICMA criteria.
Reach out to the Sustainable Finance team if you want to have a conversation about Green Loan financing for your business.
 Green Loans are one of the debt labels among the Loan Market Association (LMA) and International Capital Market Association (ICMA) standards. Other popular instruments include Social and Sustainability-Linked Loans and their Bond counterparts.
 Climate Bonds, Green Bonds, Sustainability Linked Bonds and Green Revolving Credit Facilities, and Impact Funds
 International Capital Markets Association (ICMA) and Loan Market Association (LMA)
 Where now different standards are being developed to mimic traditional credit ratings.