The rise of ESG finance

ESG (Environmental, Social and Governance) finance remains a hot topic and continues to grow rapidly, with Bloomberg predicting the $2.2 trillion ESG debt market to hit $11 trillion by 2025, based on the rate of growth during the past five years.

Green finance first emerged as a solution for funding environmentally friendly projects, such as renewable energy plants.  However, in recent years, with an ever increasing social and political demand to tackle social issues alongside environmental issues, we have seen green-lending evolve more broadly into ESG finance which, along with environmental concerns, also takes account of wider social and governance targets and KPIs.  

ESG finance encompasses a broad range of products, but in terms of debt, there are two main types of ESG lending products available to borrowers; (1) green loans and (2) sustainability linked loans (SLLs).  An important distinction between green loans and SLLs is to do with the use of proceeds and the pricing of the loan.  The proceeds of green loans must be used for environmentally focused projects (such as the development of a recycling plant). SLLs do not have specific requirements as to use of proceeds, instead the ESG-aspect is seen through the linking of pricing to the borrower's performance against specific ESG metrics.  In early versions of SLLs, borrowers would be incentivised with lower margins if they hit their ESG targets, however now SLLs will often have a two-way pricing mechanism, where the borrower pays less if it hits its targets and more if it fails to reach them.  

The development of SLLs has opened up the world of ESG financing to borrowers across different industries, not just those involved in environmentally focused projects.  

Once previously available only in institutional markets, ESG financing is now more widely available, with Virgin Money releasing SLLs in March 2021 in its commercial banking offering, making it the first bank in Europe to offer SLLs to commercial customers.  The growing industry is not only borrower driven with an EY report conducted in 2020 finding that 52% of banks view environmental and climate change as a key emerging risk over the next five years, up from 37% in 2019.  

Cheaper pricing is an obvious incentive for borrowers, however another benefit of ESG financing is the positive PR credentials it can bring. 

The benefits of being able to show ESG targets, commitments and credentials are clear to see with public sentiment for environmental and social issues being stronger than ever.  Consumers are not only more interested in ESG issues, they are also becoming more knowledgeable and more aware of corporate green-washing.  Borrowers accessing ESG financing will need to prove performance against their ESG targets not only to access cheaper pricing, but also to retain their consumers.  An April 2020 consumer study conducted by Kearney showed 83% of respondents said they consider environmental impacts when making purchasing decisions, up from 71% in 2019.  Borrowers will also need to consider how business is conducted emerging from the covid-19 pandemic, with the same Kearney study showing 48% of respondents said the pandemic has made them more concerned about the environment.  Utilising ESG-linked facilities could be a valuable tool for borrowers to show their ESG commitment to consumers.

On 9 June 2021, the Green Taxonomy Advisory Group was launched by the UK Government; an independent expert group established to oversee the delivery of a common green investing framework and to crack down on green-washing.  This is focused at green investing rather than lending; however, it is an example of the growing demand for ESG claims to be substantiated and the need for borrowers to be squeaky clean in their ESG claims. 

Lenders also have PR considerations, particularly in the context of charging increased margins for poor performance against ESG metrics.  If the goal of ESG finance is to promote sustainable development, then lenders can be in a difficult position if they are seen to be benefiting from a borrower's poor ESG performance.  We may see lenders ringfencing proceeds from increased margins and applying them towards ESG-focused initiatives.