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In this episode of Sustainability Breakthroughs, our podcast series with the Aldersgate Group, we’re joined by Bevis Watts, CEO of Triodos Bank UK, to discuss what’s holding the market back and what changes are needed to help encourage more sustainability-linked lending.
How to make sustainability KPIs more effective
Where we’re seeing the bulk of existing loans, and how they’re being used
The dangers of short-term thinking
Opportunities to raise awareness of green finance and improve access to data
The need for standards, not just principles, to improve integrity and robustness
Josie Murdoch, policy principal at the Aldersgate Group (chair)
Imogen Benson, managing associate at TLT
Bevis Watts, CEO at Triodos Bank UK
Follow the rest of our series on environmental sustainability in business on the TLT website, or subscribe to Sustainability Breakthroughs on your podcast app.
Hello, and welcome to this podcast from the Aldersgate Group and TLT. I'm Josie Murdoch, policy principal at the Aldersgate Group, specialising in green finance. And in this episode, we'll be discussing an emerging financial instrument in the field of green finance, sustainability linked loans, and look at what's holding the market back.
So there has been a major boom in green finance activity in the past few years; investors and companies alike are thinking more about climate change and sustainability when they make financial decisions. Research from TheCityUK found that the global green finance market has grown from $5.2 billion in 2012 to more than $540 billion in 2021, but that still only accounts for 4% of the global financial market.
So, we've seen an increase in regulatory and fiscal policies from the government designed to increase this share. We've had the introduction of climate-related financial disclosures – often referred to as the TCFD – and the announcement that net zero transition plans will become mandatory to report from 2023. And we're also seeing a growing toolbox of financial instruments in both the public and private sector with, for example, green bonds seeing a real boom in the last five years.
But today we're going to do a deep dive into one specific financial instrument: sustainability linked loans. So before we dive in, I'm delighted to introduce our guests today. We are joined by Imogen Benson, managing associate in the banking team at UK law firm TLT, and Bevis Watts, CEO at Triodos Bank UK. Thank you both for joining.
So it's probably helpful to start by defining what is a sustainability linked loan. So, Imogen, over to you.
Okay. So yeah, good starting point. A sustainability linked loan is one that includes a margin adjustment. It ties the margin to performance of a specific set of KPIs. Now, this allows a gradual improvement for any company against those KPIs and allows non-notionally green businesses, like a normal business, to just become gradually more sustainable and improve their performance. It either reduces their impact on the planet or gradually changes the way they operate to become more sustainable.
Great, thank you. And just to clarify, with the margin rate adjustment, that's a change in the interest rate essentially?
That's right, yeah. So essentially, it does just adjust the interest rate that a borrower pays for money, so it can become cheaper the more sustainable a business becomes.
Great, that's super clear. Thank you Imogen. And there's been a lot of debate about what the KPIs should be for sustainability linked loans. Bevis, what are your thoughts on those? What's some examples of some KPIs and what are your reflections on what they should be?
Yeah, well, I think it's important firstly, just to add to Imogen, to differentiate green loans and sustainability linked loans because a lot of people perceive them as the same thing. And green loans are financing of wind turbines or specific assets. The sustainability linked loans are about transition, as Imogen was saying.
So how do you measure that transition in sustainability terms? Well, it's a very broad spectrum we're talking about because we've done these sorts of things for many years, and done them at a very small business level – so we've worked with organisations like the Sustainable Restaurant Association, the Green Tourism Board and others, that if people move through those accreditations, then their interest rate will move down (so if you move from silver to gold, for example, you get a lower interest rate); so, you can do it in specific, very targeted ways like that – but what you're seeing at the larger end of sustainability linked loans is specific performance targets set around carbon emissions, and sometimes broader sustainability metrics.
What I'd like to see is that really much more holistically embraced to focus on the sustainable development goals, because I think that's where we really need to get to, is a much more holistic understanding of sustainability. But if you look at some of the big corporate loans that have been publicly available, they're largely around greenhouse gas emission reduction.
Yeah, I can only echo that. We're seeing the same kind of thing, and I'd love to see a more holistic approach, but I think Bevis is bang on the money. We're seeing a huge variation of KPIs, but probably the most consistent is greenhouse gases. I think probably the type of business varies the KPIs that anyone can use. So, if businesses are listening, it's about looking at your business and seeing what data you have, and what you can think of that will change and make your business more sustainable. So reduction in water usage, increasing recycling percentages, increasing percent of renewable energy that you use, reduction in fossil fuel, gradual switch to electric vehicles, reduction in supply chain mileage. All of those things, it's worth just thinking about any specific business, what can be done.
Really interesting. I know that the UK Infrastructure Bank, for example, which has a net zero mandate, its KPIs will be greenhouse gas emissions avoided and also jobs supported. So there’s two there, but obviously it doesn't also have, for example, a nature mandate and nature is one of its KPIs. So we're seeing similar limitations in both public and private investment. Would you see that there's a risk of too many KPIs potentially becoming a barrier for investment, for example?
There's a huge, huge option here. And yes, there's a lot of flex, and yes, there can be a lot of KPIs. There's a huge risk, if we look at KPIs and people invest in the wrong infrastructure, they look short term, not long term.
But I like the aspect of sustainability linked loans because they're flexible. They allow a business to do what's right for their business, to develop in their own way, to build on what they have and use the sustainability tools that they can use for their own business. And it gives them a chance to transition in their own way because they can analyse their data and measure the impact of behavioural changes that's helpful to them.
I mean maybe…I think we have to move to an era where we've got common metrics and common methodologies. So, if you were aligned to the sustainable development goals and there was an understanding of how you would meaningfully measure progress against each of those, then you can still have a lot of flexibility within how you apply the money, and which one you prioritise within a business depending on what your own impacts are.
But I mean, if you just look at greenhouse gases at the minute, you've got huge variations on whether people are measuring all of their Scope 3 emissions, whether they're one and a half degree aligned or two degree aligned, and whether they've actually even sought Science Based Targets initiative verification or not. So just within that one, which is the most prominent, is an enormous variation of what people are claiming, what they're targeting and therefore what sustainability linked loans will apply to. So, we have to bring in some harmonisation really to avoid greenwashing.
That's a really interesting point. Thank you. I want to talk a little bit about timeframes here. Imogen, you've mentioned that businesses report against their KPIs annually. Can you see any implications of that with regards to a business's ability to become more sustainable? For example, could that lead to short-term fixes rather than long-term business strategy changes?
Completely. There's a huge, huge risk of that. I think we do need to start looking slightly more longer term. I mean, if you look at banks – well, all lenders perhaps – a lot of them aren't looking more than five years in the future.
Now, TCFDs and various other changes have required boards to consider scenario analysis. Now, the further we look into the future, the more likely we are to have sustainable changes and sensible long-term goals. If we look at the future, there is an element of crystal ball gazing. There is. And the problem is, we are trying to look and guess what is going to happen. And we're going to guess what needs to happen in order to become more sustainable in the future. So I mean, Back to the Future suggested I would be on a hoverboard by now, and I'm gutted about the fact that I am not.
However, scenario analysis now has got a little bit more accurate. It is based on facts and likelihoods, and weather patterns that have been pored over by actual experts who are brilliant at this. So I think we are getting more useful scenario analysis, the more we've done it and the more data is available. So we are more likely to be able to get sustainable and sensible changes rather than short-term wins if we focus on a slightly longer scenario analysis.
Yeah. And on that point, I suppose my understanding of sustainability linked loans is, as you've said, they give businesses a lot of freedom. So, do you see them using sustainability linked loans more for operational expenditure or more for capital expenditure and investing in some of the huge infrastructure changes that may be required for some of these to decarbonise?
Yeah, I mean, I think it's a variety and it depends on that flexibility and what the transition the company is looking to make. If you look at the big corporate end, and some of the high-profile loans that have happened, like Tesco and Kingfisher Group and so on, they've taken out revolving credit facilities. So that would imply that there's a huge amount of flexibility in what that can be used for, and maybe they are deploying some new assets and some CapEx is involved to change operations and so on. But probably there's a significant amount of OpEx there to support them through a transition.
So, I think there’s huge amount of flexibility and what it applies to, and it looks like most of the larger corporate loans are very much geared in that flexible way. They're being built as revolving credit facilities, where it's at the company's discretion as to what they need to do to achieve their targets, they're just measuring on the ultimate target.
If you look at the smaller SME end that I was talking about earlier, then that will be a different kettle of fish. And we're seeing a lot of those transition loans that we get involved with much more around transformation of a building or transformation of an operation, which lends itself more to senior debt and CapEx.
That's really useful to hear, especially given that green bonds are obviously brilliant for raising capital for specific projects. So it's really interesting to see that sustainability linked loans will fill a gap in operational expenditure, which that brings me onto growth in the market. Green bonds, for example, have seen a huge growth of 49% over the last five years. How is it looking for sustainability linked loans in comparison?
Now, huge, huge growth again. Now, in 2019, we saw $143 billion in sustainability linked loans. And in 2021, that increased to $428 billion. So huge, huge growth just in two years. However, I would just bring that back a little bit because we're seeing a lot of sustainability linked loans at the top end of the market, at the high-value transactions. So there may be not too many more transactions, but each one is of slightly higher value.
And so that leads me onto barriers, I suppose. So, if they're most suited for bigger companies, what's the best way of raising awareness for perhaps smaller organisations with regards to being able to access sustainability linked loans? And what are indeed some of the barriers for bigger companies as well, or opportunities for raising awareness?
So, we've talked about a couple of barriers, awareness being one of them. If every business has heard of a sustainability linked loan, and I mean, a lot of businesses are already doing these things, they're already changing their ways to become more sustainable just because of public pressure and because they want to be seen as sustainable, particularly for the younger consumer.
So an awareness point of view, if every business knew about these, they might be using it, they might be getting cheaper money from a bank. Now, that can be fixed by a number of different ways. But generally, I think everybody that knows about them has that requirement to speak about them. So, the Dear CEO letter, the membership organisations, all of that, just getting it out into the market so that everyone knows that there is an option to have a cheaper margin, have cheaper money, if you are doing the sustainability things that the vast majority of businesses are.
And we've spoken about data at length as a barrier, and we have been for years. I mean, it is improving, and with the TCFDs becoming mandatory, then hopefully data will become even more prevalent as it trickles down from larger companies to small companies.
I mean, I think we'll only get real change in business and industry when banks are mandated in a different way. So it's really helpful that we've had TCFD and mandatory disclosures of risks related to climate change. But until we have mandatory transition plans and mandatory reporting against the sustainable development goals, you're never going to see a real systemic shift in how money flows.
So, the first barrier, and we've signalled in the UK that we're going to move to those mandatory plans that happened at COP26. But what we need now is a real increase in the knowledge and expertise around what sustainability means within the finance industry. You need those common metrics and methodologies agreed across a range of different KPIs, not just on greenhouse gases and how you measure the carbon footprint of your portfolios. And if we don't have that, we have what we have now, which is there's a Wild West in green finance. And there's a very broad spectrum of what defines a green bond and what defines the sustainability linked loan and a green loan and everything else.
So that Wild West will continue for a few years until you've got those definitions and standards. And we need to move to standards, not just principles, which are currently what we have with the Loan Market Association defining principles for all of those products. But that's the biggest thing because otherwise you will have a real deterrent to real, genuine, deep products with integrity and loans with integrity.
I mean, I've seen an engineering company take out a sustainability linked loan that one of the measures was all of their staff would receive health and safety training by the end of the following year, or something. And that's one of the metrics, and that's publicly available. And you scratch your head and you think, "Well, okay, but that's not what we really should be talking about."
Yeah, completely agree. I'd love to see a market standard set, if nothing else, just to be more efficient so that everyone doesn't have to keep renegotiating a set of documents and keep reading them because if there’s a market standard, we know the flex within that drafting. So I completely agree.
And when we were looking at government impact and what we're needing from the government, it's perhaps that regulation, but also, I think…TLT surveyed the FS market last year and asked what the best support we could receive is. And 61% said tax incentives, and 52% said subsidies and grant schemes. So government input is being requested. The market is crying out for, saying, "Okay, give us some guidance here. Give us what we need to do and we are happy to do it."
Really interesting. And it's great that the government has mandated that net zero transition plans should be published from 2023 for the largest companies, and a standard’s being developed at the moment for what those should include. So it'd be really welcome to see reporting against the SDGs, for example, being included there, and hopefully some more standards and beyond just principles being developed.
I want to come onto my final question, which is: you've alluded to some of the other solutions already, Imogen, but what other solutions are there for especially smaller businesses to access green finance in the way that they need it, and especially in this flexible way that sustainability linked loans offer?
Now, we talked about the market standard set of documents, which would be really, really helpful. We've talked about tax incentives and subsidies. We've talked about data availability. So there are a lot of solutions in the works.
And larger companies have sustainability teams to help them monitor the sustainability goals, where smaller companies may struggle with that a little bit. But as we get more and more data available, that will trickle down into the smaller companies. As TCFDs become mandatory, further down the chain, again, more data is there. And say, for example, a company has 25 different real estate assets with 25 different landlords, and they're giving them 25 different sets of data, that's not going to be possible for them to collate that, and provide one holistic group set of data. So, if we standardise a lot more, then it will open up the whole market for even more companies to be using any of the green finance products.
Yeah, I mean, my view is we need much more ambition. I think we are too busy celebrating growth in fairly tenuous products, in green bonds and sustainability linked loans at the minute. We need much, much more scale of ambition.
And this needs to become part of the DNA of every financial product. So if you look at the domestic market in other countries, green mortgages are quite common, where the interest rate is geared to the sustainability of the property and so on. I think banks are asleep at the wheel in not doing that for their corporate mortgages now because one of your biggest issues is that around 50% of all of the balance sheets of UK banks are lent to property. So why on earth wouldn't you quickly switch all of your products now for any new money to have that incentive to decarbonise those buildings?
And so that's just one small example for me, how I think this needs to become the DNA of every product, and not something unusual that we're talking about really. And as I say, that will only happen when banks are pushed to own much more – not just climate risk on their own balance sheet, but own the responsibility for net zero targets and transition plans towards the SDGs more broadly.
And I'd love to see things like PACE mortgages really come into their own here, whereby a borrowing is actually against the property itself rather than against the borrower. So if you sell the building, that mortgage taken out in order to retrofit and make a building more energy efficient can be passed onto the next owner. So we're looking at the cost of transitioning a building and the cost of retrofitting not only being born by the current person, the current organisation that has the building. So yeah, I'd love to see a little bit more flex there.
Really helpful, thank you both. I want to end on perhaps a summary of what we've just discussed. So we've talked about mandatory reporting for banks and companies, we've talked about data and standardisation of reporting, and we've talked about longer timeframes. And we've also talked about some of the solutions that may fill the gap in if businesses can't access sustainability linked loans, for whatever reason. If you both could pick one thing that you thought would really help move this along?
If there's one thing that I think would help move sustainability linked loans forward particularly, is to move beyond principles to some standard definitions of measurement. And as I say, I think what that does, it brings integrity and robustness to what companies are actually setting targets around. And then all banks can then compare and contrast those measures. And I think that would just really set a different landscape to be all clear on what it is we're trying to shift and do together.
Now, one of the key things for me, there's a margin upside and margin downside for meeting KPIs or not meeting KPIs. And that money, there isn't really a market position on what needs to happen to that. So if a lender is paid more in terms of interest because KPIs are not met, is it morally viable for them to receive that money? Do they need to use that money for particularly sustainable projects? Does it need to be a charity donation? Are there any tax implications?
It's worth considering that there's a quagmire here and that many, even from a company's perspective, a borrower's perspective, when they receive a cheaper margin, is there anything that needs to happen to that additional cash? Does that need to be used for an investment in a sustainable project? Does it need to be a charity donation? We don't have a market position on this and I think it would be really helpful.
That's really interesting, thank you. Well, thank you both to our speakers. Thank you, Bevis, and thank you, Imogen, and thank you everyone for listening today.
21 September 2022
Publications 05 OCTOBER 2022