Green is the new black: the rise of sustainability in debt

The Bank of England, for example, is set to carry out its first climate stress test this year, creating a further incentive for the UK financial system to focus on green finance and sustainability-linked loans.

Green finance vs sustainability-linked loans 

Green finance focuses on lending against green property or enabling retrofit projects that will lower a building’s carbon emissions.

Sustainability-linked loans, on the other hand, are all about incentivising borrowers to become more environmental, social and governance (ESG)-focused.

A crucial piece of the puzzle 

On its own, green financing might not be enough to incentivise someone to build a green asset, but there are far stronger economic incentives already in place. Increasingly, evidence points towards occupiers prioritising the need for a sustainable workplace in base build and operational life cycle.

Likewise, investors are becoming more focused on sustainability when screening for acquisition, which will clearly drive yields. Green financing is just another piece in what is becoming an increasingly compelling story around returns.

Margin discounts for borrowers 

Since the onset of Covid-19, there has been a marked increase in new lenders offering ESG-linked real estate finance. These lenders, including a number of debt funds, are following the lead of the clearing banks and some global insurance companies, who have been the pioneers of new ESG-linked products.

In an attempt to drive positive change in buildings, many ESG-linked loans now offer economic incentives to borrowers if the asset or borrowing entity in question satisfies a set of pre-defined sustainability KPIs. These financial incentives, often in the form of margin discounts, vary according to the scale and cost of the green initiative.

For example, if a borrower invests heavily in decarbonising the heat provision in a building, taking one or two basis points off a loan margin may not be a sufficient incentive. The more ambitious the measures – and the more they increase over time – the higher the discount on the headline margin.

Measurability of the KPI is a key requirement. KPIs are mapped against a timeframe and assessed on a quarterly basis, often by an independent third party appointed by the lender. The framework doesn’t just apply to shiny new buildings in central London, either. It also applies to older buildings in strong markets such as Cambridge and St Albans, that would benefit from retrofits.

The bigger picture

Sustainability makes up just a third of the growing corporate focus on ESG; the social and governance aspects are influencing the debt market, too.

For example, the Knight Frank Debt Advisory team arranged finance for the development of a purpose-built student accommodation asset. Once the scheme had reached practical completion, the lender introduced KPIs to ensure the mental health and wellbeing of end users was aligned to the strategy of the university nearby.

We’ve also spoken to clients whose entire ethos is around developing products that are focused on the community around them. As time goes by, we believe that borrowers will increasingly concentrate on this social angle.

But if one thing is clear, the debt market is paving the way for a more responsible future.