The real estate sector has an important role to play in meeting the EU’s climate targets to reduce carbon emissions by fifty-five per cent. by 2030. It accounts for nearly fourty per cent. of Europe’s energy consumption and thirty-six per cent. of energy-related direct and indirect greenhouse gas emissions, leading to increasing attention and pressure from politics and society to improve this footprint. Real estate developers and investors also have a commercial incentive in retrofitting existing buildings to be more sustainable and/or investing in newly built green buildings, as there is increasingly evidence that green buildings attract more prospective purchasers and tenants and therefore yield better rental and sale values. For real estate lenders, mainly European banks, integrating climate-related and environmental considerations in their lending policies may lead to less regulatory scrutiny and potential sanctions given the increased attention paid to such considerations by the European Central Bank.
Against that backdrop, the EU’s legislative bodies have adopted directives and regulations aimed at (a.o.) re-directing capital to more sustainable economic activities in the form of green (or sustainable) finance (as further explained in previous blogs in this series). To this same end, several market initiatives have been undertaken to standardise terms and provisions for loan products with a focus on green or sustainability aspects aimed at lowering the bar for application in practice and increasing the comparability of sustainable loans and their materiality / ambition levels (and thereby increasing the overall credibility of these loan products and mitigating greenwashing risk). Notably, the LMA, in collaboration with the Asia Pacific Loan Market Association and Loan Syndications and Trading Association, has developed (and most recently revised on 23 February 2023) principles and guidance for two commonly used types of loans: (i) the green loan (Green Loan) and (ii) the sustainability-linked loan (Sustainability-Linked Loan). The LMA has further published on 4 May 2023 model form provisions providing a framework for implementation of the Sustainability-Linked Loan Principles (SLLPs) into the LMA recommended form for leveraged acquisition finance transactions into which lenders and borrowers can feed substance on a transaction-by-transaction basis. In the below, we will briefly summarise both the GLPs and the SLLPs and the model form provisions for SLLs, all as published by the LMA. It is worth noting that these LMA publications are a form of self-regulation, intended only as recommendations, leaving it to parties to freely choose whether and to what extent to adopt these recommendations.
Green Loans are any type of loan instruments made available to exclusively (re-)finance new and/or existing eligible green projects. The “use of proceeds” is the fundamental determinant of whether a Green Loan qualifies as “green” or not. Examples of “eligible green projects” in the real estate sector are numerous, and the LMA has listed several examples in a non-exhaustive list attached to the Green Loan Principles (GLPs). However, two broad categories can be identified: (i) the (re-)financing of the acquisition of a green building or portfolio of green buildings and (ii) the financing of a (re-)development of green buildings. While the GLP’s purpose is not to take a position on which green standards are optimal for qualifying projects as “green”, several international initiatives, such as the EU Taxonomy Regulation (as further explained in a previous blog in this series), provide useful guidance to Green Loan borrowers as to what may be considered eligible for a Green Loan. Yet, a uniform international or European definition of a green building is lacking, the introduction of which would likely ease implementation of the GLPs in loan products and enhance comparability.
Other core components of a Green Loan that both borrowers and lenders should take into consideration are the following:
(a) Process for selecting and evaluating eligible green projects: a borrower must clearly communicate to its lender (i) what its environmental and sustainability goals are, (ii) the process by which it has determined whether the green project falls into one of the abovementioned categories and (iii) the selection (or exception) criteria it has used to determine whether the project is green and the process by which it has identified and will manage potential environmental and social risks of the green project.
(b) Management of proceeds: given that the fundamental determinant of a Green Loan is its use of proceeds, the management of said proceeds is an important component of a Green Loan. The proceeds of a Green Loan must be made available by deposit into a designated bank account or otherwise properly monitored in order to maintain transparency and thereby ensuring the integrity of the Green Loan product and avoiding greenwashing.
(c) Reporting: to that same end, borrowers should keep up-to-date information on the use of proceeds and make this readily available to institutions participating in the loan. On, at least, an annual basis until the loan is fully drawn (and in the event of any material development), a report should be drawn up by the borrower including a list of green projects to which the proceeds have been allocated, a brief description of the projects and, where possible, achieved impact. Both qualitative performance indicators and quantitative performance indicators should be measured and reported, including the underlying methodology and/or assumptions used. Borrowers and lenders may agree that reporting should take place more regularly, including during the lifetime of the loan even after it has been fully drawn.
Currently, the market for Green Loans appears mainly focused on the energy performance and carbon emission levels of existing and new green buildings, with less consideration yet given to other green considerations such as water consumption and recycling of construction materials. In addition, there remains a large stock of “brown” buildings (roughly seventy-five per-cent of the total European building stock), which need to be retrofitted to be future proof. Retrofitting can also be considered more environmentally friendly as it avoids the demolition, preparation and construction of a new building and associated emissions. Finally, the real estate loan market is yet to develop into the social and governance components of ESG. The LMA provides a framework for social loans, which is identical to the framework for Green Loans, except aimed at social projects such as affordable housing and alleviating energy poverty. A governance consideration could be diversity across boards, officials, and/or employees.
Sustainability-Linked Loans are any type of loan instruments which incentivise the borrower’s achievement of ambitious, predetermined sustainability performance targets (SPTs). A borrower’s sustainability performance is measured using predefined key performance indicators (KPIs) which measure improvements in a borrower’s sustainability profile. With a Sustainability-Linked Loan, the focus is on incentivising the borrower’s efforts to improve its sustainability profile, by aligning loan terms, often the margin, to the borrower’s performance on its pre-determined SPTs. Hence, unlike a Green Loan, use of proceeds is not a key determinant in the qualification of a Sustainability-Linked Loan.
(a) Selection of KPIs: the credibility of a Sustainability-Linked Loan is dependent on the selection of the KPIs. KPIs should be (i) relevant, core and material to a borrower’s overall current and future business, (ii) measurable or quantifiable on a consistent methodological basis and (iii) able to be benchmarked using an external reference to facilitate the assessment of the SPT’s level of ambition. Poorly selected KPIs can be ineffective in incentivising a borrower to improve its sustainability profile in ways that are relevant and material to its business.
(b) Calibration of SPTs: the process for calibrating the SPTs per KPI is key to a Sustainability-Linked Loan as it will determine and be an expression of the level of ambition of the borrower. SPTs set too low or deemed unambitious can lead to accusations of green washing. To avoid this, SPTs should (i) represent a material improvement in the respective KPIs and be beyond a “business as usual” trajectory, (ii) be comparable to a benchmark or an external reference (e.g. the borrower’s own performance, the borrower’s peers or a science-based scenario), (iii) be consistent with the borrower’s overall sustainability strategy and (iv) be determined on a predefined timeline for the target’s achievement, set before or concurrently with the origination of the loan. SPTs should also make clear reference to the baseline or science-based reference point selected for improvement of KPIs, in what situations recalculations or adjustment to baselines are permitted and how the borrower will achieve the SPTs.
(c) Loan characteristics: a key characteristic of a Sustainability-Linked Loan is the economic reward (or punishment) linked to whether the pre-determined SPTs are met. For example, the margin under a Sustainability-Linked Loan may be reduced (or increased) where the borrower satisfies (or fails) a pre-determined SPT as measured by the pre-determined KPIs.
(d) Reporting: for the Sustainability-Linked Loan, a borrower should, where possible and at least once per annum, provide the lenders participating in the loan with up-to-date information sufficient to allow monitoring of the performance of the SPTs and to determine whether the SPTs remain ambitious to the borrower’s business. More generally, as transparency on sustainability performance is increasingly important in the market, borrowers should also be encouraged to make this information publicly available.
(e) Verification: borrowers are recommended to have an external party verify the borrower’s performance level against each SPT, for each KPI, at least once per annum. As opposed to a pre-signing external review, verification occurs after signing the credit agreement and is performed by an independent external party, such as a qualified expert, an auditor and/or an independent rating agency.
The Sustainability-Linked Loan product for real estate is not as common as the Green Loan product, given that borrowers are typically special purpose vehicles created without any trading history or assets save for the land/property which is subject to the financing. Such borrowers may not have a sustainability strategy or a long-term performance on which KPIs can be benchmarked against, rendering the Sustainability-Linked Loan product unsuitable for these entities. Of course, sponsors in real estate financing can be expected to develop or already have sustainability strategies aimed at improving their sustainability profile, which can be extended to or incorporated by the special purpose vehicle acting as borrower.
The LMA’s recently published model provisions for Sustainability-Linked Loans offers borrowers and lenders a framework for drafting Sustainability-Linked Loan provisions. The framework notably consists of: a mechanism for margin adjustments by which borrowers have a (commercial) incentive to achieve the SPTs, a mechanism for amending any KPI, SPT, calculation methodology or related term during the life of the loan (i.e. a rendez-vous clause), a consequence for a breach of any sustainability provisions leading to the loan being disqualified as a Sustainability-Linked Loan rather than an Event of Default, a reporting mechanism by which a borrower provides regular sustainability information updates through a dedicated compliance certificate, a sustainability report and a verification report to the lender(s) and a (repeating) representation attesting to the truthfulness, accuracy and completeness of the sustainability information provided to the lender(s).
Other blogs in this series
- ESG – Key criteria impacting taxonomy-alignment of real estate
- ESG - How does the SFDR impact the real estate sector?
- ESG - How does the EU Taxonomy Regulation impact the real estate sector?
- ESG - How does the CSRD impact the real estate sector?
In these blogs, ESG experts from the Loyens & Loeff Real Estate and Finance practice group regularly share insights and reflect on ESG topics from a real estate perspective. Together with the ESG focus group with specialists from across our different practice groups and home markets, we combine ESG expertise, project and transactional advice, transaction and litigation experience to enable your success. For more information, please contact one of the members of our Real Estate practice group below.