Sustainable or “ESG” (environmental, social and governance) financing is becoming embedded in lending, particularly in the bond market as investors seek ethical investments on long-term debt. Finance is being used to push the sustainability agenda in two ways: (i) “use of proceeds” funds are provided by reference to sustainability criteria, typically in application of green or social projects, or, (ii) finance terms are “sustainability-linked” i.e. a margin adjustment is applied depending on whether pre-agreed sustainability-linked KPIs or objectives are met. With HM government’s transition to net zero being driven through capital, financial institutions are under pressure to decarbonise their loan books and think carefully as to where they invest. Approximately 21% of the UK’s carbon emissions are from buildings so private developers will sooner or later be a key stakeholder in the transition process.
Given the built environment has such a significant environmental and/or social impact, developers are already familiar with regulatory pressure to deliver “green” and “social” developments, particularly through EPC criteria and planning requirements. This has led to a natural and inevitable focus to pursue sustainable finance through green or social use of proceeds finance to fund specific development. Doing so, doesn’t require a drastic a change in business model so the appeal of use of proceeds funding, particularly where borrowers are already undertaking green or social developments, is clear. To date, some borrowers may have been able to do so without committing to do more than their existing regulatory requirements but financial institutions are becoming increasingly scrutinised in making sustainable investments. Funders are therefore making it clear that green / social parameters need to be stretch-targets to avoid allegations of “green-washing”. Business as usual will not be enough.
The challenge of SPVs in sustainable finance
In development finance, the use of SPVs makes sustainability-linked financing challenging. SPVs won’t have embedded sustainability strategies with business models, data collection and reporting to back them up. That doesn’t however make sustainability strategies redundant. Business planning and strategy will still be needed to take advantage of use of proceeds funding. This means developers should be looking at their business models: what projects will need to be funded? Is there an embedded sustainability strategy in the business which can support this? Do they even have the data collection, monitoring and management resources to evaluate ongoing compliance with targets? Do businesses have the organisational capacity to commit to KPIs in long-term funding? As with financial reporting, disclosure and transparency on ESG reporting will become vital to access funds, together with the necessary organisational structure around this. As sustainable financing becomes the norm, there may come a point in the not too-distant future where a business might struggle to access finance if they have not aligned their business with these requirements.
Funders appreciate this will raise huge challenges for businesses but are willing to support their customers in making this transition. They ultimately don’t want to stop lending to the built environment purely to decarbonise their loan books and don’t want any margin gain for implementing a sustainability strategy to be disproportionate to the cost of doing so. Funders are therefore willing to work with businesses to identify appropriate terms for them. The key starting point will be data collection with at least 3 years of data being an ideal baseline to monitor ongoing performance. This, in turn, means having the buy-in to sustainability and support of the executive teams. It will be for the businesses, themselves, to identify what their sustainability priorities are and taking these to funders.
Sustainable finance is here to stay
Ultimately, sustainable finance won’t go away but is developing quickly from a “nice to have” to a fundamental feature of investment. The drive to net-zero will accelerate this further to the extent that some financial institutions envisage that within five years, sustainable finance will be the norm. Borrowers will therefore need to justify opting-out rather than in of seeking finance on sustainable terms. In order to do so, businesses will need to ensure they have the data, systems and organisation to back sustainable reporting up. This isn’t an overnight process but a journey which needs to be engaged with in line with medium to long-term business goals.