ESG Lending: Towards Sustainability Linked Finance

Background

“If you fail to plan, you are planning to fail” Benjamin Franklin

Global warming is here with us and everyone has witnessed its effect in just a very short time. It, therefore, behoves all sectors of the economy to drive a narrative and implement policies that seek to reverse the adverse climate changes.

Environmental Social Governance (ESG) and ESG Lending are a set of standards and sustainable finance initiatives that are taking the world by storm, and they aim at dealing with the effects of climate change. Woe to organizations that are not aligned or planning to align themselves to the sustainability initiatives, as they run the risk of being overlooked by the stakeholders in favour of organizations that are contributing towards mitigating the effects of climate change.

Despite bank loans being the primary source of debt financing for firms around the world, little is known about their role in the rapidly evolving ESG-contingent financing space.

As our first part in a series on ESG Lending, we delve into an introduction to the concept of ESG Lending and how we got here.

The State of the Climate in Africa 2020 Report (issued by the World Meteorological Organization)[1] indicated that climate change could lower gross domestic product (GDP) in Sub-Saharan Africa by up to 3 percent by 2050. Further, climate change poses a systemic risk to the financial sector with the potential to destabilize the normal functioning of the system. Such risks include:

a)????Physical risks associated with frequent severe weather events and environmental change.

b)????Transition risks posed by the policy and technological changes necessary to achieve a greener economy.

c)????Liability risks arise from financial institutions being sued for financing companies that harm the environment.

Financial institutions are therefore leaning towards environmental social governance lending in a bid to play their part in achieving a greener economy. Sustainability can be achieved by organizations incorporating Environmental Social Governance (ESG) issues in their investments.

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ESG refers to a set of standards measuring a business's impact on the environment, and society and how accountable it is. The environmental aspect of ESG is a measure of how a company safeguards the environment. The social aspect measures how a company manages relationships with employees, customers, contractors and the communities in which it operates. The governance aspect measures a company’s performance in terms of audits, board diversity, internal controls and shareholder rights. These factors help investors and other stakeholders to measure the performance and ensure the accountability of companies.

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ESG Lending

ESG Lending is a type of lending which focuses not only on profits but also on environmental and social governance performance to achieve sustainability.

Why opt for ESG Lending?

ESG Lending has various benefits including building trust and integrity, which in turn attracts investments. It also provides access to new markets for green loans, sustainability-linked loans, blue loans and green sukuk which attracts key stakeholders in different fields. ESG Lending also serves to reduce systemic risks to financial institutions as comprehensive risk assessment surrounding social and environmental issues is conducted ensuring well-informed decisions are made with a key focus on sustainability.

There are various types of loans under ESG Lending:

a)????Sustainability-linked loans;

b)????Green loans;

c)????Blue loans; and

d)????Green Sukuk.

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a)??????????????Sustainability Linked Loans

The Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA) have developed Sustainability-Linked Loan Principles (SLLP) which are voluntary guidelines that provide the key characteristics of sustainability-linked loans. Under the SLLP, sustainability-linked loans are defined as any type[s] of loan instruments and/or contingent facilities which incentivize the borrower's achievement of ambitious, predetermined sustainability performance objectives.

Sustainability-linked loans are therefore general-purpose loans whose terms are contractually tied to ESG performance and have a pricing incentive to the intent that the interest rate margins may be reduced if the borrowers meet the key performance indicators and if they do not the interest margins would increase.

Sustainability-linked loans are flexible as the proceeds can be used for non-green purposes, broadening the scope for borrowers and lenders concerned with sustainability issues.

The Sustainability Linked Principles developed by the LMA, APLMA and LSTA set out the following guiding core components used to measure sustainability-linked loans:

1)????selection of Key Performance Indicators (KPIs) that are relevant, core, and material to the borrower’s sustainability and business strategy;

2)????calibration of sustainability performance targets (SPTs);

3)????loan characteristics (typically spreads) linked to meeting SPTs;

4)????reporting of detailed SPT performance; and

5)????independent and external verification of performance against SPTs.

Data by the International Finance Corporation (IFC) a member of the World Bank Group shows that since their inception in 2017, over $809 billion of sustainability-linked financing has been brought to market, of which 85 percent were sustainability-linked loans.

In Kenya, strides have been made towards sustainable financing. The Kenya Bankers Association 2015 developed the Sustainable Finance Initiative-Guiding Principles whose aim is to guide financiers on how to optimize the balancing of their business goals with the economy’s future priorities and socio-environmental concerns.

Further, the Central Bank of Kenya (CBK) issued Guidance on Climate-Related Risk Management (2021) which aims at enabling banks to integrate climate-related risks into their governance, strategy, risk management and disclosure framework.

b)??????????????Green loans

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Green loans are loans or investments that support activities that have a substantial contribution to an environmental objective such as purchasing environmentally friendly goods and services or building environmentally friendly infrastructure.

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Unlike sustainability linked-loans, green loans have a clear requirement for proceeds to be used for a green purpose or project, for example, to finance pollution prevention and control, infrastructure for clean energy vehicles or sustainable water management. Further, there are no pricing reduction elements for green loans or sustainability linked-loans.

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In March 2018, the LMA, APLMA and the LSTA published the Green Loan Principles (GLP) which have since been adopted by the International Finance Corporation (IFC). The Green Loan Principles are voluntary guidelines that set out the following key components in determining whether a loan qualifies as a green loan:

1.????use of proceeds-100% of the proceeds must be used to fund green projects;

2.????process for project evaluation and selection, to be developed by borrowers and lenders.

3.????management of proceeds- the proceeds of a green loan should be credited to a dedicated account to maintain transparency; and

4.????reporting-preparation of qualitative and quantitative performance indicators, which indicator should be verified by auditors or independent ESG rating providers.

The World Bank notes that there has been a rapid growth of green loans globally. In 2021 IFC issued Africa's first certified green loan of up to $150 million to Absa Bank Ltd (South Africa).

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In Kenya, KCB Group is one of the leading banks offering green loans and in 2020 it was accredited by the United Nations Green Climate Fund as the first financial intermediary for the implementation of green financing in East Africa. Further, KCB Group was advanced $150 Million by the IFC to fund the growth of the bank’s climate finance portfolio, with a specific focus on financing the development of energy efficiency projects, renewable energy, climate-smart projects, and green buildings. KCB Bank granted its first Kenya Shillings Five Billion green loan to an infrastructure firm in Kenya in 2022.

c)????Blue Loans

Blue loans are innovative financing instruments that earmark funds exclusively for ocean-friendly projects and critical clean water resources protection. ?They are a subset of green loans but focus on financing marine and ocean-based projects that have positive environmental, economic and climate benefits.

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The European Commission alongside other key industry players developed the Sustainable Blue Economy Finance Principles in 2017 which aim at enhancing responsible investment in aspects of the blue economy and to further the implementation of the Sustainable Development Goals (SDGs) which contribute to the conservation and sustainable use of the oceans, seas and marine resources for sustainable development.

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In advancing blue loans, financial institutions should take into account the Blue Economy Finance Principles which should be aligned with the core components of the Green Loan Principles.

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In Kenya, the Government has made deliberate focus on the blue economy through the involvement of various stakeholders. This is seen as a key sector in the creation of employment and a source of livelihood for the many young people living in the coastal as well as western counties which largely depend on the water bodies for their economic activities. It, therefore, presents an ideal opportunity for the finance sector to evaluate its involvement in the conversation to ensure that key policies and legislation are developed and aligned to facilitate the blue loans.

d)????Green Sukuk

Green Sukuk are Shari’ah-compliant investments in renewable energy and other environmentally friendly projects backed by specific assets. They address Shari’ah concern for protecting the environment.

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The key requirement for green sukuk is that the loan proceeds must be used for environmentally friendly projects. Green Sukuk is therefore similar to green loans in conventional banking.

Conclusion

Having established that ESG lending will play a critical role in ensuring responsible practices by financial institutions and all related stakeholders, it is our considered view that the widespread use of general-purpose loans that are designed to incentivize firms across industries to improve their overall sustainability profiles, rather than achieve narrower objectives tied to specific projects, will help ensure the growth of ESG contingent financing.

And banks, much like institutional investors, are uniquely positioned to effectively monitor firms’ progress on ESG considerations.

However, they – and other stakeholders more broadly – need to develop mechanisms and policies that enable them to monitor the implementation of the ESG consideration to avert deceitful reporting. Transparent disclosures regarding ESG-related contract terms will therefore play an important role in alleviating such concerns.

We, therefore, propose that the banks and related authorities need work closely in evaluating and developing a framework that ensures that the ESG concerns are reflected in loan contracts and provide guidance for regulating and instituting sustainable finance.

Catch us in the next part of the series as we explore the Regulatory Framework for ESG Lending in Kenya and the role of financial institutions in compliance.

[1]https://www.uneca.org/sites/default/files/ACPC/State-of-the-Climate-in-Africa/WMO_State%20of%20the%20Climate%20in%20Africa%202020_Report_en.pdf

Authors: Isaiah Mungai Kamau and Mary Mwai