The Bank: Green- and ESG-based Lending

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As uptake of reducing carbon emissions grows, some lenders are further incentivizing it with green and sustainability-linked loans (SLL) that come with a rate discount.

Throughout the U.S., loans related to environmental targets—and, at times, social and governance metrics—grew by about $52 billion in 2021, representing a staggering 292% year-over-year increase, according to Bloomberg data.

And earlier in 2021, Bank of America (BofA) said it would deploy $1 trillion by 2030 to expedite a transition to a lower-carbon economy.

“We will meet our commitment by working with clients to provide lending, capital-raising, advisory and investment services, and to develop financial solutions and drive innovation to ensure the transition to a sustainable economy,” BofA vice chairman Anne Finucane, who leads its ESG efforts, said in a statement.

Some banks have launched “green energy desks” to lend—with ESG strings attached.

“We see local and regional community benefits in the types of projects that we finance. And under current statutory framework, there’s an economic incentive for the bank to do so.” —Max Vernier, Live Oak Bank

Pittsburgh-based PNC Financial Services Group announced in August 2021 that it would commit $20 billion throughout a five-year period to support environmental finance, including environmental sustainability-linked bonds (SLBs) and SLLs.

“PNC recognizes that environmental issues, including climate change, are impacting our business, our clients and the communities in which we operate,” Richard Bynum, PNC chief corporate responsibility officer, said in a statement.

“We acknowledge that the transition to a low-carbon economy presents both risks and opportunities, and we are committed to balancing financial priorities, responsible risk management and environmental considerations in ways that benefit our varied stakeholders.”

In 2018, Michigan-based utility CMS Energy Corp. became the first U.S. company to enter an SLL, getting a reduced interest rate for $1.4 billion in credit facilities in exchange for hitting environment-related targets.

Earlier that year, the company said it planned to eliminate coal in its power generation operations, estimating this will reduce its carbon emissions 80% and result in more than 40% of renewable content—all by 2040.

“We are excited to be a trendsetter in the United States, entering an innovative credit facility where sustainability and financial results go hand in hand,” said Patti Poppe, CMS Energy’s CEO at the time.

Nomenclature

While “green loans” typically finance or refinance environmentally friendly projects, SLLs usually involve a borrower that isn’t in the green space, setting performance targets that dictate whether the borrower will receive and continue to receive a lower interest rate.

In June 2021, Canada’s Enbridge Inc. announced the closing of its first SLB. The $1 billion, 12-year senior note included goals: reducing greenhouse-gas (GHG) emissions, greater gender and ethnic diversity and more women on its board.

“Our sustainable financing framework provides transparency to our stakeholders and positions us well to succeed in leading our industry to a more sustainable and inclusive energy future,” Enbridge CFO Colin Gruending said in a statement.

In April 2021, Singapore-headquartered energy trader Trafigura Group Pte. Ltd. raised $203.5 million in a privately placed sustainability-linked financing. The deal requires third-party assessment annually of Trafigura’s carbon emissions.

“We were pleased to incorporate the sustainability-linked mechanism into the transaction [in 2021],” Christophe Salmon, Trafigura’s CFO, said in a press release, “taking another opportunity to demonstrate leadership in this field, whilst our investors participate in this journey alongside us.”

The company’s first SLL closed in March 2021 for $1.85 billion, oversubscribed from a target of $1.5 billion. Among Trafigura’s environmental goals is the use of green ammonia in marine shipping. Penalties or discounts kick in, depending on hitting targets.

RNG lending

North Carolina-based Live Oak Bank began reviewing renewable energy projects in 2015 and made its first loan to the sector in 2016.

“We felt like there was an opportunity to create jobs in rural America with infrastructure revitalization, and we can accomplish that by also building environmentally friendly technologies,” said Max Vernier, Live Oak Bank vice president of bioenergy.

The company does not have an oil and gas loan desk but does work with oil and gas companies in their renewable portfolios. Among them are BP Plc, Chevron Corp. and other majors, as well as midstream and downstream operators.

Of its $1.2 billion in loans to the solar and bioenergy industries to date, one is to an Arizona dairy farm that is collecting and selling the emitted methane into a local distribution pipeline. Opal Fuels uses the renewable natural gas (RNG) to fuel long-haul trucks, creating environmental credits that it then sells to Chevron and others.

“In that regard,” Vernier said, “we’re working directly with companies like Chevron because we are financing projects that produce RNG for use in the transportation sector, and Chevron is purchasing the carbon credits associated with that gas to fulfil annual compliance requirements.”

Although the bank sees monetary benefits from such partnerships, that’s not the only reason for the collaborations. “More strategically, and for brand and moral reasons, we feel that similar biorefineries that produce carbon-negative fuels can provide a number of ancillary benefits,” he said.

Among them: improving watersheds and air quality in communities, sequestering and repurposing GHG, recycling nutrients back into soil and helping counterparties such as dairy farmers find a use for something that, like GHG, was seen as a societal waste with no value.

“We see local and regional community benefits in the types of projects that we finance. And under current statutory framework, there’s an economic incentive for the bank to do so.”

Loan or PE?

Buddy Clark, who co-chairs law firm Haynes and Boone LLP’s energy practice group, said green lending to the oil and gas industry has a hurdle: finding bankable loans.

“You could make the argument that it impairs the borrower’s ability to repay the loan if you put structural provisions in a credit agreement to meet ‘green criteria’ that make it more expensive for a producer to do business,” said Clark, author of “Oil Capital,” a history of law in energy finance beginning with the Iron Age.

“If it makes it more expensive for the producer to conduct its business, does that make the bank more likely to be repaid—or less likely?”

“With the potential for greater returns in excess of banks’ interest rates, private investors can afford to be more willing to risk their capital.” —Buddy Clark, Haynes and Boone LLP

Whereas bankers have fiduciary obligations to shareholders and regulatory obligations to depositors to make prudent loans, private equity firms have more flexibility to take a chance on green lending, especially if that is the stated purpose of their fund.

“You’ve got to differentiate between investors and bankers because bankers have a much lower tolerance for risk and require a higher assurance of getting repaid,” Clark said. “With the potential for greater returns in excess of banks’ interest rates, private investors can afford to be more willing to risk their capital.

“In the [oil and gas] lending work that I’ve been doing, I haven’t seen banks imposing covenants to encourage reductions in CO₂ or methane emissions yet. I wouldn’t be surprised to see it.

“But when you think about it, it doesn’t guarantee that the producer is going to be able to repay the loan any faster or with greater certainty if they reduce their methane emissions at the cost of increasing production expenses.”

It’s not to say green desk loans are completely unheard of in Clark’s circle. He has seen one private non-bank debt provider that included a decrease in pricing in connection with the borrower meeting certain ESG goals.

The loan to an oil and gas producer was initially going to be prime plus 5%, but it offered a reduced rate to incentivize the producer to reduce flaring by a set amount.

“The borrower-producer could receive lower pricing if it met certain metrics that were to be evaluated by a third-party, green assessment company, [which provides] consultants who will certify whether or not a company is meeting thresholds on targets for reduction of emissions,” Clark said.

Despite his concerns, Clark said green loans have potential under the right set of circumstances. Within the oil and gas industry, he said, there are companies working to reduce emissions or capture energy in a non-polluting, profitable way that might qualify.

For example, Austin, Texas-based startup Geothermix. Founded by a University of Texas petroleum engineering professor, Mukul Sharma, the company’s idea is to inject water into deep, horizontal wells. The heated water and steam would then generate electricity at the surface.

“That’s a renewable use of oil and gas assets that would qualify as a green investment,” Clark said. “That’s the kind of example where a bank with exposure to the oil and gas industry can find ways to make green loans.”

Oil and gas companies are working to minimize their environmental impact whether there’s a financial incentive to do so or not, he has observed. But despite the industry’s best efforts to operate in an environmentally sustainable fashion, producers still face hurdles in receiving green loans, he added.

“Fundamentally, I don’t see how producers can overcome the fact that they’re in the business of producing hydrocarbons which, when burned, are going to result in CO₂ emissions,” he said. “Most oil and gas is sold as fuel for energy, and the byproduct is carbon dioxide.

“At the end of the day, it is a chemical reaction that isn’t going to change.”