Airlines have long been conscious of the imperative for carbon emissions reduction, with improvements in the fuel efficiency of their fleets also helping to mitigate their exposure to often volatile fuel prices. Their focus was strengthened by the inclusion of aviation within the European Union’s Emissions Trading Scheme (EU ETS) in 2008 and the introduction of ICAO’s new global carbon offsetting scheme, CORSIA, in 2019. At the same time, airlines are keen to improve their green credentials to address passenger concerns about climate-related issues and to counter the ‘flight-shaming’ movement.
However the drivers for further improvements in the carbon footprint of airlines’ operations also come from a different direction – financial institutions and asset managers are increasingly becoming subject to regulatory and public scrutiny regarding the environmental, social and governance ("ESG") profiles of their portfolios. A raft of measures aimed at improving transparency seek to harmonise the classification, standards and financial reporting of ESG projects and investments, including the EU’s Taxonomy Regulation, ESG Regulation and ESG Benchmarks Regulation. Combined with voluntary measures such as the recommendations of the G20’s Task Force on Climate-related Financial Disclosures, the pressure on financial institutions to consider ESG issues in their investments is rising.
These factors have led to the development of a variety of green and sustainable finance products. Some of these products offer pricing benefits to “reward” good corporate behavior whether encouraging environmentally-friendly projects or improving corporate social responsibility more generally, but until now have largely been used in other sectors. This article looks at which products are available and how these might be accessed by the aviation sector.
The origins of sustainable finance can be traced back almost over 30 years, with The Equator Principles, a risk management framework for determining, assessing and managing environmental and social risk, formally established in 2003. It is widely used in project finance, adopted by over 100 financial institutions in 38 countries.
LMA Green Loan Principles and Sustainability Linked Loan Principles
Commercial banks have been entering into “green” loans for several years, with a number of European and Asian banks particularly active in sectors including agriculture and industry, and increasingly moving into transport. This follows the success of the green bond market, which has generated demand for an equivalent debt product from the banking market. Green bonds were created to fund projects that have environmental and/or climate benefits, and the Green Bond Principles were introduced in 2014 in order to provide some transparency for subscribers by establishing a framework of rules for what could constitute a green project, as well as the monitoring and reporting on eligible projects and use of proceeds. Green bonds typically involve additional transaction costs as a result of issuers needing to track, monitor and report on use of proceeds, but these may be considered to be offset by other corporate benefits including positive marketing and diversification of their investor base to a broader investor class.
Demand has risen as financial institutions and corporates seek to enhance their perceived green credentials and anticipate increased reporting and regulatory oversight in this area. Green loans can provide a means of demonstrating both commitment to good environmental practices and awareness of climate-related risks to a business.
Based on the Green Bond Principles, the Loan Market Association (LMA) launched the Green Loan Principles in March 2018. This has been followed by the Sustainability Linked Loan Principles in March 2019, which in turn has been followed by the Sustainability-Linked Bond Principles in June 2020. Please find our article on this topic here.
The Green Loan Principles aim to promote consistency in the methodology used across the green loan market. They comprise voluntary recommended guidelines clarifying the instances in which a loan might be categorized as “green,” essentially on a ‘use of proceeds’ model, based on the underlying characteristics of the transaction. A non-exhaustive list of eligible “green projects” include energy efficiency, pollution prevention and control, clean transportation, climate change adaption and renewable energy. The Principles require that the funds are ring-fenced for “green projects” and their use tracked, something relatively easily satisfied by the purchase of an asset using funds drawn down once for that purpose, provided that the relevant asset can be categorized as a “green project.” The updated Guidance published by the LMA in May 2020 clarifies that the Green Loan Principles can be satisfied by a green project identified as such at the outset or by the establishment of a framework under which green projects are identified as eligible during the life of the loan (for example under a revolving credit facility).
By contrast, the Sustainability Linked Loan Principles deviate from the traditional “use of proceeds” model typically used for green financing. Unlike the Green Loan Principles, the Sustainability Linked Loan Principles do not require the loan monies to be used in a particular manner. Instead they measure the borrower’s wider performance against a set of sustainability performance targets (SPTs) and reward, or possibly penalize, it accordingly. This is typically done by way of a margin ratchet – either one-way, so that the reduction in margin is simply not applied if the target is not met, or two-way, so that the borrower enjoys a reduction in margin if the target is met, but suffers a margin hike if not. The latter has been criticized as resulting in the lender benefitting from the borrower’s poor behavior. In any event, unlike the Green Loan Principles, the Sustainability Linked Loan Principles expressly contemplate these financial levers, with the intention that borrowers are thereby incentivized to make improvements to their sustainability profile over the term of the loan.
The Green Loan Principles do not expressly contemplate a pricing impact – the updated Guidance from May 2020 only directs the parties to “give due consideration as to whether or not a failure to apply the proceeds of a green loan towards a Green Project will trigger an event of default” and makes it clear that the loan should not be considered green from the date of occurrence of such event, subject to any cure rights. However, in practice the lenders’ rights generally include a margin ratchet allowing lower pricing for the relevant Green loan. In some instances a loan could be structured as both a Green loan and a Sustainable loan, however this is rare in practice.
In both cases, third-party specialist or expert opinions are often employed to confirm that the relevant criteria for the use of proceeds or meeting of targets, as applicable, have been satisfied. While internal verification is permitted, external review is recommended under the Principles where lenders do not have a broad working knowledge of the borrower, or the borrower lacks internal expertise to self-certify.
The table at the bottom of this article sets out a summary of the key differences between these two loan products.
To what extent are these products suitable for aviation?
The Sustainability Linked Loan Principles are likely to be more suited to a general use corporate facility, if the timing coincides with a sustainable overhaul of the relevant borrower’s business. An overhaul might include a refleeting to more fuel efficient aircraft, investment in biofuel technology or sustainable improvements in an airline’s real estate portfolio or procurement, operational or maintenance arrangements. Example Sustainability Performance Targets listed in the Sustainability Linked Loan Principles include increases in energy efficiency or the amount of renewable energy generated or used by the borrower and reductions in greenhouse gas emissions or water usage.
A number of airlines have already accessed sustainability-linked loans, of varying types.
Although appetite for green and sustainability-linked products has traditionally been lower in the United States than in Europe and Asia, in February 2020, JetBlue Airways was announced as the first airline to arrange a sustainability-linked loan. The sustainability-linked feature was added to their existing US$550m revolving credit facility with BNP Paribas, and includes a two-way interest rate ratchet depending on whether ESG targets are achieved.
In December 2019 Etihad was announced as the first airline to fund a project with a commercial loan based on the United Nations Sustainable Development Goals – in this case receiving 100 million euro to fund a number of projects, including the expansion of an “eco-residence” cabin crew apartment complex. The financing included a two-way interest rate ratchet, and specifies a range of eligible projects to be linked to one or more of the UN Sustainable Development Goals. These include Green Buildings, Investment in Women, Biofuels, Reduction of Carbon Footprint, Waste Management and Recycling, Humanitarian Efforts, and Wildlife Protection.
Structurally a typical aviation finance transaction which ring-fences the use of proceeds for the purchase or refinancing of a specific asset would tend to lend itself to the use of the Green Loan Principles. Indeed, green loans and green bonds are already being used in the shipping sector, for example, to fund the purchase of LNG-powered vessels which produce much lower levels of emissions than traditional shipping fuel. Similarly it could be anticipated that the Green Loan Principles might be applied to a loan for the purchase of next generation or new technology aircraft which produce reduced emissions, certified by an independent third party.
In December 2019, Singapore-based lessor Avation acquired three ATR 72-600s to be leased to Braathens Regional Airlines on the basis of financing by Deutsche Bank which was stated to be the first ever commercial aircraft financed with a Green Loan.
Vigeo Eiris, the ESG ratings agency which acted on the transaction, confirmed that replacing ageing regional jets with new ATR 72-600 aircraft was aligned with the LMA's Green Loan Principles, on the basis that ATR 72-600s aircraft create significantly less environmental impact than other jets and turboprops, emitting 40% less carbon dioxide than a comparable regional jet. However it remains to be seen whether green loans will be made available more widely to finance larger commercial aircraft using classic aviation finance structures, amid the risk of receiving criticism for green-washing.
The updated Guidance to the Green Loan Principles (GLP) published by the LMA in May 2020 clarifies that projects that significantly improve the efficiency of utilisation of fossil fuels are potentially eligible, as long as the relevant project is aligned with the four core components of the GLP, and the borrower has “committed to an ambitious decarbonisation pathway reasonably considered to be aligned to the Paris Agreement”. The Guidance states that “observed market practice is that such projects may be labelled as “light green” or “transition”.”
However the EU’s Taxonomy Regulation, which introduces an EU-wide classification system (or taxonomy) to determine which products can be marketed to investors as environmentally sustainable, currently does not include aviation. Notwithstanding this, the EU Technical Expert Group (TEG) on Sustainable Finance recommended that aviation ‘should be addressed by the Taxonomy Regulation in the future given the significance of emissions from the sector’. However it might be expected that any inclusion of aviation would attach stringent criteria, beyond refleeting to more efficient but still traditionally-powered aircraft.
In addition to traditional asset financing structures, there are a number of projects which airlines are increasingly looking at, for which the Green Loan Principles and the Sustainability Linked Loan Principles could each be available although transactions which comply with both are rare in practice. A number of airlines have already announced investments in alternative fuels. In August 2019, British Airways announced a partnership with renewable fuels company, Velocys, to build a facility which converts household and commercial waste into renewable sustainable jet fuel to power its fleet, committing further funds to the project in May 2020. In addition Virgin made its first symbolic flight partly fueled by biofuel in October 2019. In February 2020 Delta Air Lines pledged to invest $1 billion in becoming "carbon neutral" with an ambition to reach that target by 2030 by investing in advancing clean air travel technologies, accelerating reductions in waste and emissions, and establishing new offsetting and natural carbon sequestration projects. Although it may be difficult to justify the use of a green loan to purchase aircraft, airlines could make use of them to refinance other assets which comply with the Green Loan Principles, such as energy efficient office buildings.
ICAO’s new global carbon offsetting scheme, CORSIA, may also act as the driver for green projects funded by airlines. CORSIA requires airlines to buy and surrender offsetting credits known as “emissions units” on a three-year compliance cycle in respect of the number of emissions attributed to routes flown by them between participating states during that period. Until 2026, only flights between the voluntary participating states are covered, but from 2027, emissions units must be bought in respect of all international flights. A number of airlines such as IAG, easyJet and Air France-KLM have committed to voluntarily offset all domestic emissions too. While emissions units can be bought from carbon trading companies, larger airlines are likely to look to set up their own offsetting schemes and may sensibly look to green and sustainable financing to do so.
With regulatory changes and increased public focus on environmental matters driving change in the aviation industry and certain capital providers available and looking to finance that change in new markets, there is scope for the right projects to receive financing at the right price. While the industry must be alert to accusations of green-washing, there are a number of developments which deserve being labelled as Green Loan Principles or Sustainability-Linked Loan Principles financings. If this mixture of regulatory impetus and technological and financial ingenuity leads to a greener and more sustainable aviation industry, we will all benefit.
||LMA Green Loan Principles
||Sustainability-Linked Loan Principles
|Aim of product
||Create a high-level framework of guidelines to ensure consistency in which loans can be recognized as “green.”
||Create a high-level framework of guidelines to ensure consistency in which loans can be recognized as “sustainable.”
|What is it?
||Four stage voluntary set of criteria applied to loan instruments made available exclusively to finance or refinance, in whole or in part, new and/or existing eligible “Green Projects.”
|Four stage voluntary set of criteria applied to loan instruments and/or contingent facilities (such as bonding/guarantee lines or letters of credit) which incentivize the borrower’s achievement of ambitious, sustainability performance targets (SPTs).
|Restrictions on use of proceeds?
Yes. Proceeds must be used for “Green Projects” - a non-exhaustive list includes:
- Energy efficiency
- Pollution prevention and control
- Clean transportation
- Climate change adaption
- Renewable energy
Proceeds credited to a dedicated account/tracked, to ensure they remain separate.
No required use of proceeds specified. Targets are instead linked to borrower’s wider Corporate Social Responsibility (“CSR”) strategy.
Therefore a loan could be a general corporate facility.
|Impact on pricing?
|None prescribed/contemplated, but in practice a margin ratchet may be included.
|Yes, this is a key component of the product. The borrower’s performance against pre-determined SPTs is rewarded by the loan terms, for example a reduction in margin.
Process for Project Evaluation and Selection Borrower to communicate to its lenders:
- Its environmental sustainability objectives
- Process and criteria by which its projects have been determined eligible as green projects
- How it will identify and manage any associated material environmental risks
Target setting – Measuring sustainability of Borrower:
SPTs to be set by lenders against borrower’s recent performance, possibly with assistance of “Sustainability Structuring Agent.”
Borrowers may be encouraged to seek a third party opinion re their SPTs as a condition precedent to the loan. Where no third-party opinion is sought, borrower should have the internal expertise to verify its methodologies.
|Use of proceeds information (brief description and expected impact) to be renewed annually until fully drawn and in the event of material developments thereafter. Information need only be provided to lenders.
|Information relating to SPTs (such as any external ESG rating) should, where possible, be provided to lenders at least annually. Borrowers encouraged to publicly report information relating to SPTs.
|External review is recommended “where appropriate” but not required.
External review to be negotiated on transaction-by-transaction basis, but encouraged where SPT information is not made publicly available.
For publicly traded companies, it may be sufficient for lenders to rely on the borrower’s public disclosures.