Green financing: a fast-growing trend

Tuesday 21 November 2023

Carmen Peli
Peli Partners, Bucharest

Delia Lepadatu
Peli Partners, Bucharest

Green financing, also known as sustainable finance, is a rapidly growing field that aims to channel financial resources towards projects and initiatives that have positive environmental and social impacts. As the world faces pressing challenges – such as the climate crisis, resource depletion and social inequality – green financing has emerged as a powerful tool to accelerate the transition towards a more sustainable and inclusive economy.

In recent years, there has been a significant shift in mindset as governments, businesses and individuals recognise the urgent need to address environmental, social and governance (ESG) issues. Green financing provides a framework that aligns financial decisions with sustainable development goals, encouraging the flow of capital towards projects that promote renewable energy, energy efficiency, sustainable agriculture, clean water, biodiversity conservation and social welfare.

Green loans versus sustainability-linked loans

When considering an ESG-related loan, one must first determine if the funding is designated for projects that have a positive environmental impact (ie, green loans) or if it can be used for sustainable purposes (ie, sustainability-linked loans).

Green loans are dedicated to funding environmentally sustainable projects, whereas sustainability-linked loans are related to predefined sustainability performance targets, offering financial incentives based on achieving or exceeding those targets.

The proceeds from a green loan are marked for a specific green project and the borrower is obliged to use the funds solely for environmentally friendly purposes, as defined by the loan agreement.

Sustainability-linked loans are more flexible in terms of their use of proceeds. The borrowed funds can be used for general corporate purposes or any project deemed as sustainable. This allows borrowers to align their financing with their overall sustainability strategy, rather than being limited to specific green projects.

Green loans often have specific eligibility criteria to ensure the borrower’s project aligns with the lender’s defined environmental standards or certifications. Sustainability-linked loans are tied to key performance indicators (KPIs) to be achieved over the loan term; these can be tailored to the borrower’s specific sustainability goals.

Specific loan provisions in green financing

Loan agreements have been adapted to ensure that borrowers observe the ESG requirements. The inclusion and specific details of ESG provisions in loan agreements can vary significantly and are typically negotiated between the lender and borrower based on their specific ESG goals, industry practices and regulatory requirements. Some common provisions related to ESG included in loan agreements are:

  • Use of loan proceeds: loan agreements may restrict the use of funds to ensure they are directed toward ESG-friendly purposes;
  • Interest rates and incentives: green loans may offer more favourable terms, such as lower interest rates or longer repayment periods, as an incentive to support environmentally sustainable initiatives, whereas sustainability-linked loans often incorporate financial incentives or adjustments to the loan’s interest rate based on the borrower’s performance against the agreed-upon KPIs;
  • ESG commitments: borrowers may be required to make specific commitments such as implementing sustainable practices, reducing carbon emissions, improving workplace safety, promoting diversity and inclusion, adopting robust corporate governance principles, etc;
  • Reporting requirements (common for green loans): lenders may require borrowers to provide regular ESG reports, disclosing relevant metrics, targets and performance indicators. These reports can cover areas such as energy consumption, waste management, employee turnover, community engagement and board diversity;
  • ESG KPIs (common for sustainability-linked loans): lenders may establish specific ESG performance metrics and targets that borrowers must observe during the term of the loan;
  • Compliance with applicable laws and standards: loan agreements may include provisions that require borrowers to comply with relevant laws, regulations and industry standards related to environmental protection, labour practices, human rights and/or corporate governance; and
  • Remediation and default: in the event of a breach of ESG commitments, loan agreements may include provisions for remedial actions that the borrower must undertake. Failure to meet ESG requirements could also trigger default provisions, allowing the lender to accelerate the loan or take other appropriate actions.

Greenwashing – a risk for lenders and borrowers alike

Greenwashing in loans refers to the practice of promoting loans as environmentally friendly or sustainable without genuine adherence to green principles. In such cases, the loans may not actually contribute to significant environmental benefits or may even support environmentally harmful activities.

Greenwashing can occur for instance when: (1) a loan is marketed as supporting environmentally friendly projects or initiatives, but the funds are not exclusively used for such purposes; (2) lenders do not rigorously verify the environmental impact or sustainability credentials of the projects or activities being financed by the loan; or (3) using unclear or ambiguous language to describe the environmental benefits of a loan without providing specific details about the loan's actual impact on the environment. To prevent greenwashing the following measures can be considered:

  • Third-party certification: lenders can collaborate with independent organisations and require the borrowers to provide third-party certification to validate the green credentials of the loan;
  • Robust due diligence: lenders should conduct due diligence to ensure that the funds are being used for genuinely sustainable purposes. This involves verifying the environmental impact of projects, assessing their alignment with sustainability goals and monitoring their progress over time;
  • Clear loan terms and monitoring: lenders should clearly define the terms and conditions of their green loans, including the eligibility criteria, specific environmental targets and reporting requirements. Regular monitoring of the loan's environmental impact helps ensure transparency and traceability of loan proceeds; and
  • Green insurance: green insurance products provide coverage for environmental risks and losses associated with sustainable projects (ie, insurance for renewable energy installations, climate-related risks, director liability related to governance issues etc). Green insurance helps mitigate the financial impact of environmental hazards and encourages the financing of sustainable initiatives.

By adopting effective measures to combat greenwashing in loans, lenders can mitigate greenwashing in loans and provide borrowers with genuine opportunities to support environmentally sustainable projects. This approach encourages transparency, credibility and accountability in the financial industry's efforts towards promoting sustainability.