Green loans vs sustainable loans: what you need to know

1. What is the difference between green loans and sustainability linked loans?

The key difference between the two types of loans comes down to the use of the proceeds of the loan.

In the case of a green loan, the loan proceeds must be applied towards a "green project". At this stage we do not have an agreed definition of green projects. However, guidance jointly published by loan market industry bodies spanning Asia Pacific, Europe, North America and beyond provide a non-exhaustive list of green project categories, such as projects investing in renewable energy and pollution prevention.

On the other hand, the proceeds of a sustainability linked loan are typically used for a borrower's general corporate purposes, which do not need to be green or sustainable in nature. Instead, certain economic characteristics of these loans (such as the applicable interest rate) are tied to the achievement of key performance indicators and sustainability performance targets. If achieved, those economic characteristics are typically adjusted in favour of the borrower.

2. How common are green loans and sustainability linked loans?

Both green loans and sustainability linked loans have existed for a number of years. However, the prevalence of these types of loans both in Australia and globally has grown significantly since 2021, reflecting the market's commitment to responsible and sustainable lending.

In 2022 the green and sustainable loan market peaked at over US$700 billion. The latest market data indicates a decline of approximately 25% in the volume of green loans and sustainability linked loans in the first half of 2023. However this is in the context of a decline of approximately 21% in the global loan market as a whole.

As between the two types of loans, green loans represent a smaller portion of the sustainable loan market as opposed to sustainability linked loans. This is likely due to the flexibility of sustainability linked loans which can be implemented across a broader range of industries and for a variety of purposes.

3. What stage in the lifecycle does a borrower need to decide to pursue a loan that is green or sustainability linked?

Green loans and sustainability linked loans can be established at any time: when documenting a new loan, as an amendment to an existing loan or as part of a refinance.

In the case of a green loan, a borrower must identify the proposed green project to ensure it meets the eligibility requirements. Accordingly a borrower will typically determine whether to pursue a green loan at the outset when deciding to seek finance for a particular (green) project. Similarly, sustainability linked loans require the identification of key performance indicators and sustainability performance targets that represent a genuine commitment to advancing sustainability measures across the borrower's organisation. In each case, lenders must be satisfied that the loan meets relevant criteria, which may include the appointment of third parties to provide an independent assessment. These steps can add complexities when documenting such a loan, so the key is to allow sufficient time to discuss and agree the operation of the relevant loan. However, it is possible for borrowers to establish loans which include the mechanics for a sustainability link, but provide for the key performance indicators and sustainability performance targets to be agreed later (if at all).

Although organisations such as the APLMA have released some suggested drafting for sustainability linked loan provisions, at this stage there is no one market standard or precedent approach to documenting either green loans or sustainability linked loans. This does present advantages, as it allows for greater flexibility in tailoring the terms of a loan to best suit the particular needs and requirements of borrowers and lenders.

4. What is driving lenders' participation in green loans and sustainability linked loans?

Demonstrating a commitment to environmental, social and governance objectives is important for both borrowers and lenders alike. The broader community, not to mention shareholders and investors, are looking for key organisations in the market to lead by example and set ambitious goals for the future. It is also becoming more common for lenders to identify and publish a sustainable finance target. A failure to participate in and evolve with this process may have reputational impacts on those organisations.

5. What do borrowers need to be aware of in an environment where there is heightened scrutiny around greenwashing?

As the prevalence of green and sustainable branded products in the market has increased, so too has scrutiny of the promotion of these products to ensure it is done in an accurate and measured way. ASIC in particular has been active in its monitoring of claims related to green and sustainable products, and between July 2022 and March 2023 made 35 interventions ranging from corrective disclosure outcomes to the commencement of civil penalty proceedings.

In the case of green loans, both borrowers and lenders need to ensure the green project continues to meet the green project criteria if either party wishes to continue advertising the loan as green. To protect both borrowers and lenders, it is advisable that loan documents make clear that communications referring to the loan as green or similar should cease if the project is no longer classified as a green project or there are any other concerns regarding the green credentials of the loan.

On the other hand, the key performance indicators and sustainability performance targets in sustainability linked loans should be sufficiently ambitious and material, benchmarked against an agreed position, such that they represent a meaningful and impactful goal to work towards.

ASIC has published Information Sheet 271 which provides tips on how to avoid greenwashing when promoting sustainability related products, with which all parties to a green loan or sustainability linked loan are recommended to be familiar.

6. Are there any other risks for borrowers to address when considering a green loan or sustainability linked loan?

A key point to consider is the intended consequences of any failure to comply with the relevant green or sustainability linked provisions. A common position is that a failure to comply with such provisions will not result in a default under the loan documents. However it is important that this is discussed and the agreed position is clearly stated in the loan documents.

In addition, in the case of a sustainability linked loan, a failure to achieve the specified key performance indicators and sustainability performance targets may result in an adjustment of the economic characteristics of the loan which are against the borrower's interests, such as an increase in applicable interest rate.

Ultimately, a well-documented green loan or sustainability linked loan will be tailored to the needs and capacity of the borrower and lenders, and, in the case of a green loan, the underlying green project. As part of this process, additional risks arising in respect of these loans should be identified and mitigated by the parties.