3 November 2022 by and Finance & Banking Alert

Sustainable finances vs green loans: Key differences to look out for

Environmental, social and governance (ESG) is not a new concept in South Africa but has of late become something of a buzzword, with funders and governments alike making a shift towards a more environmentally sustainable way of investing.

The worldwide commitment to sustainable investing was cemented by the Paris Agreement in which governments all over the world (including South Africa) agreed to implement a 40-gigatonnes reduction in greenhouse gas emissions levels by 2030.

The European Union (EU) Taxonomy has also played a big role in advancing sustainable financing through the introduction of a classification system. This clearly outlines the activities that can be regarded as environmentally sustainable for investment purposes across the EU and provides market participants and consumers with a common understanding and language regarding environmental sustainability in their business endeavours. Certain local funders, such as Nedbank, have also developed their own internal classification system, based to an extent on the EU Taxonomy.

Although South Africa has not formally implemented its own legal classification system, the South African National Treasury is working towards this, having issued a draft South Africa Green Finance Taxonomy in March 2022 and a media statement to that effect on 1 April 2022.

General principles

To give effect to the commitments undertaken in the Paris Agreement, investors have implemented various framework funding provisions geared towards sustainability, the most pertinent of which are sustainability-linked loans and green loans.

Sustainability-linked loans are debt instruments made available to a borrower for general corporate purposes but which provide an economic benefit to the borrower for achieving negotiated sustainability performance targets. Green loans,

on the other hand, are debt instruments whose proceeds are used for a pre-specified green purpose or project which is beneficial to the environment. Key identifiers for environmental betterment include reduced greenhouse gas emissions, improved energy efficiency ratings, efficient water use, socio-economic advancement and empowerment, the use of recyclable materials, the conservation and protection of biodiversity, and the achievement of a recognised ESG certification.

Key differences between sustainability-linked loans and green loans

Sustainability-linked loans

As alluded to above, sustainability-linked loans mirror standardised loans advanced to corporations for general corporate purposes. The major distinction is that when a sustainability-linked loan is advanced to a borrower, it generally contains certain ESG targets which, if met by the borrower, may induce a certain economic benefit in its favour. The pre-determined targets are not a contractual obligation but rather an incentive for the borrower to advance the ESG sustainability cause. 

The benefit accruing to the borrower in the event of meeting such targets is often a margin adjustment in line with the borrower’s performance insofar as environmental sustainability is concerned. There is, however, no penalty imposed should the borrower not meet its targets.

Green loans

Conversely, green loans are advanced for a specified green purpose which benefits the environment and typically emanate from sectors with heavy capital expenditure requirements in green areas, such as the renewable energy sector. The proceeds of the loan must be used for clearly identified sustainable objectives and failure to use the proceeds accordingly attract a financial penalty for the borrower or project company in question.

The obligation to meet pre-determined sustainability performance targets is embedded in the loan agreement itself, making the fulfilment of such targets a contractual obligation and not merely an incentive, as is the case with sustainability-linked loans.

Market developments

The first ever African sustainability-linked bond was issued by the South African water utility Rand Water, as advised by CDH, which was the largest South African rand denominated sustainability-linked bond issued to date.

CDH also advised Harmony Gold Mining regarding its green loan of R1,5 billion to fund Phase 2 of its Solar PV Strategy (up to 137MW of peak generation capacity).

Although the South African sustainability-linked debt market is still in its developmental phase, we are seeing a rise in the demand for sustainability-linked corporate financing at an accelerated rate, especially amongst corporations in South Africa.

Benefits of sustainable finance

The benefits of sustainable finance are undeniable. The accelerated growth in sustainable finance has prompted many investors to reconsider their investment theses and borrowers to adapt their operations to be more sustainable. Some of the benefits of sustainable finance for lenders and borrowers alike include:

  • the establishment of a more meaningful and positive impact on the world at large;
  • cost saving and efficiency considering the return received on the usage of recyclable materials, for instance;
  • innovation;
  • competitiveness as sustainable practices advance the investor and borrower as compared to non-sustainable counterparts; and
  • risk mitigation.

Conclusion

In conclusion, with countries across the world facing an energy crisis, ESG and similar sustainable financing initiatives are having a significant impact on not only economies, but also the environment. We anticipate that green loans and sustainability-linked loans will continue to shape investment theses, drive the switch towards a more sustainable way of conducting business, and contribute to the emergence of new regulations aimed at improving sustainability. The prospect is an exciting one where a new breed of environmentally conscious corporates will emerge, and this will benefit the world at large.

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