Green Loans or Sustainability Linked Loans?

Following a period of uncertainty in the investing landscape, during which the sustainable finance market saw decreased activity, ESG priorities are starting to gain traction once again. With the re-emergence of environmentally and socially conscious investing, many fund managers may be unclear on the sustainable finance options.

Whether investing in private equity, real estate, infrastructure or debt, investment funds looking to link financing to their ESG targets and outcomes need to understand which options are most suited to their needs. It’s worth, therefore, taking time to explore the two main options: green loans and sustainability linked loans (SLLs).  

Green loans versus SLLs: what's the difference?

Simply put, green loans are for funding projects with an environmental benefit; while SLLs are more suitable in cases where proceeds are used to fund other types of sustainable impacts.

Green loans are made available by lenders solely to finance or refinance new or existing environmental projects – for example, eco-efficient products and processes, pollution prevention and control measures, or biodiversity conservation. Use of proceeds is limited to projects with clear environmental benefits that can be assessed – and ideally quantified, measured and reported – by the borrower.

“Under the umbrella of sustainable loans you also have the social loan, because ESG financing support is not just E-centric,” says Holly Faulkner, Head of Climate & ESG at RBS International. These are loan instruments specifically for projects with clear social benefits, such as access to healthcare and sanitation, affordable housing, or food security programmes.

By contrast, SLLs are related to KPIs in the form of predefined sustainability performance targets using metrics such as improvements in the energy efficiency ratings of buildings or increases in the amount of renewable energy generated by an installation. SLLs offer financial incentives for achieving or exceeding those targets.

“The benefit of this is dual-sided, as the cost of the facility decreases in line with these goals being met, while the client simultaneously achieves milestones such as reducing their carbon footprint, improving gender equality at board level, and demonstrating strong corporate governance – all of which are examples of measurable sustainability KPIs,” explains Holly.

The fall and rise of sustainability lending volumes

An extended period of market uncertainty created competing priorities for funds, with ESG pushed to a back burner for some. “Higher interest rates, falling asset valuations, challenging fundraising and other factors have been dominating the agenda for fund managers,” reports James Hamelin, Director, Institutional Banking at RBS International. “In the interest of getting deals done and over the line quickly, the integration of ESG into facility documents have been parked for a later date.”

Demand for sustainable finance has fallen in consequence, but volumes should recover as stability returns. “As the market begins to normalise again, I would fully expect ESG to move up the agenda, with a focus on ESG becoming the norm in the alternative investment space,” predicts James. “Already, more impact funds are being launched, and even for those who aren’t tagging themselves as impact or ESG, it is still forming part of their investment decision-making and how they go on to manage assets.”

A positive direction of travel is apparent. In 2024, over one-fifth of all private capital fundraising has been allocated to ESG-labelled funds, reports Preqin. Green lending has been particularly linked to investment activity in sectors driving real-world transaction activities, such as real estate and infrastructure, with infrastructure themed ESG funds accounting for 32% of ESG fundraising.

“We need to get to a position where the ESG team and investment managers are on the same page and pushing in the same direction, then we will see an increase in green loans and SLLs,” says James. The ratio of global sustainable lending volumes between green loans and SLLs is also shifting, with data from Dealogic showing the share of green loans steadily increasing since 2021. “To date, most clients have tended to use SLLs, but we are seeing that beginning to change, particularly in the real estate space.”

The applicability of green labelling has also increased in recent years to a broader spectrum of fund financing instruments. “Initial sustainable lending volumes in the funds space was utilised for subscription facilities but we are now seeing greater uptake across NAV facilities too,” says Rahel Haque, Climate & ESG Capital Markets Lead for Private Markets at NatWest. Alternative investors have increasingly focused on the commercial ESG opportunity, which in turn has grown the pool of eligible green projects. “We recently closed a green NAV facility for a European Real Estate investor who were looking to facilitate their ESG ‘value-add’ investment strategy.”

Is a green loan or SLL the right choice?

To decide whether a green loan or SLL is appropriate, funds can compare the Loan Market Association Principles to which each product is aligned. These provide frameworks to structure green loans and SLLs on a deal-by-deal basis to support environmental projects and ESG-focused economic activity and growth. Both products also have reporting requirements associated with obtaining the pricing benefit, which should be reviewed when determining the most appropriate finance route for a fund.

“Both types of loans have merits and challenges,” says James. “It depends on the situation as to which product may be more appropriate for the underlying client. Equally, some may not be at the point where either product is appropriate because they haven’t developed out their ESG strategy.”

Green loans focus on project evaluation and selection; management of proceeds; and reporting; and tend to have lower costs compared to SLLs. “For clients in the renewables space, for example, a green loan is suitable because the fundamental determinant of the product is the utilisation of the loan proceeds for green projects,” says Holly.

SLLs, meanwhile, focus on selection of KPIs; calibration of sustainability performance targets (SPTs); loan characteristics; reporting; and verification. “SLLs are intended to complement and enhance a borrower’s existing sustainability strategy, as well as incentivise the achievement of ambitious, predetermined SPTs,” adds Holly.

“New funds might look to focus on ESG-readiness KPIs, while more established, mature funds might focus on impact-orientated metrics.” A number of investors are utilising programmatic financing structures to enable their ESG investment strategy.

“We have worked with a number of clients in defining a portfolio of KPIs that can be leveraged across a range of funds or across their Portfolio Companies,” says Rahel. “Setting up KPI structures in this manner offers an investor another catalyst to execute their value creation plan systematically across their portfolio.”

There are also options for a combined green loan/SLL, offering flexible support for funds’ ESG journeys. “We’ve recently looked at a number of deals which are a hybrid of green and SLL: clients don’t necessarily need to choose one or the other,” says James. 

A maturing sustainable finance market

There are signs that the sustainable finance market is moving into a maturing phase as investors navigate out of a period of hype beset by the risk of greenwashing into one where ESG targets are set with modified, more realistic expectations. Greater confidence in sustainability investing should have a stabilising effect on ESG-linked loans.

“Key to this is understanding that ESG is a multifaceted consideration,” says Holly. “Clients are no longer looking exclusively at climate-related metrics such as carbon emissions. Under the umbrella of ESG there are complexities associated with responding to nature and biodiversity requirements, for example. With climate-related regulations and frameworks increasingly incorporating nature-related risks, these factors will become progressively more relevant as fund managers look to address ESG as part of their strategies.”

The market is also increasing its focus on transition financing and how to mobilise capital to support decarbonisation efforts. “The majority of assets in the real economy are not green so there is a sizeable opportunity in moving assets from ‘brown’ to ‘green’,” says Rahel. “Whilst SLLs partially achieve this objective, lenders recognise a broader taxonomy is needed and are working through the requirements of borrowers.”

There is still education that needs to occur outside of the ESG teams between the lender and borrower, James adds. “It feels like people are currently a little scared about signing up to something which may increase costs and add administrative burdens. We have a responsibility as a lender to work with clients, educate them and ensure that ESG goals and targets are sufficiently stretching while not making them unachievable.”

Interested in hearing more?

If you’d like to talk about any of the themes discussed in this article, please contact your relationship team or read more about our sustainable banking business.