While environmental, social and governance ("ESG") factors may previously have been background considerations for credit committees, they are increasingly key determinants of capital allocation. The application of ESG to aircraft financing transactions is thus becoming more prevalent as participants are keen to avail themselves of green credentials – although there remain accusations of 'green-washing' in some quarters. In this article we review the current position and future outlook.
To date green financing has tended to fall into two categories: sustainability-linked loans ("SLLs") and 'green loans' (also explored in our previous briefing 'How the grass can be greener in Singapore: green lending in Asia Pacific').
SLLs involve the margin and fees being linked to the borrower's ESG credentials. ESG credentials may be measured by an external evaluator such as a green credit ratings agency. Several mainstream ratings agencies have been active in this market; in 2019 Moody's acquired a majority stake in ESG ratings agency Vigeo Eiris. In other instances, the borrower and lender may agree ESG performance indicators, which must be met in order to avoid increased costs or margin, or, if met, reward the borrower with lower costs and margin. Moreover, the Loan Market Association ("LMA") has recently published the Sustainability Linked Loan Principles ("SLLPs") which in effect links the terms of a loan on offer to a borrower’s sustainability profile, thereby allowing borrowers to achieve more favourable loan terms. The SLLPs, it should be noted, are to be adopted on a voluntary basis and the LMA does not yet set out a clear accreditation system (accreditation has so far been undertaken by ratings agencies). So far, SLLs have been provided for general corporate purposes, rather than specific asset or project financings.
'Green loans' describe a financing in which the proceeds of the loan are to be applied for specific 'green projects' and are more prevalent in asset and project financing transactions. The LMA has produced an analogue to the SLLPs, the Green Loan Principles ("GLPs"), which sets out a non-exhaustive list of ten categories of 'green projects', including for instance, renewable power projects. The GLPs recommend a four-pronged approach to characterisation of a loan as 'green': (i) utilisation of the loan proceeds for 'green projects' (ii), communication of environmental objectives and eligibility criteria to lenders, (iii) management and tracking of proceeds to ensure application for 'green' purposes and (iv) regular and transparent reporting to creditors on the use of proceeds. These elements will necessitate sophisticated monitoring and reporting obligations in finance documentation. European banks have been particularly active in the 'green loan' market, spurred on by environmental regulation and political pressure (currently less prevalent in the US and APAC).
Green financing grew by 46% in 2019 to $460bn. There are various key drivers behind this growth:
Lenders contend that borrowers with better ESG credentials are likely to have better corporate governance and are therefore a lower credit risk. This perhaps seems obvious given the 'governance' aspect of ESG, but given the increasing focus on climate change many believe that companies with better ESG credentials will be inherently better placed and more robust as organisations in the future global business world. Banks are increasingly developing financial modelling on this relationship between ESG and financial performance.
Borrowers are facing significant reputational, political and regulatory pressure to improve their ESG credentials, bolstered by the recent trend towards shareholder activism across markets globally. Sustainable financing will form part of an enhanced and more visible ESG strategy. Moreover, end-users are becoming more conscious of the environmental provenance of the products and services they wish to buy.
Aviation faces particular pressure in this regard, with the industry needing to respond to 'flight-shaming'. Accordingly many major airlines have committed to a radical overhaul of their ESG policies. For example, in February 2020, Delta committed to spend $1bn over the next 10 years to offset its carbon emissions. Major aircraft lessor Avolon has openly discussed the need to improve its ESG performance for bond issuances, even positing the concept of a 'green lease', whereby airlines with better ESG performance would have access to lower rentals. As momentum picks up, aircraft leases may in future contain provisions requiring the airline lessee to be completely transparent with regard to emissions data and fleet composition.
Bank's ESG credentials
Banks (and other financiers such as sovereign wealth funds and pension funds) are also facing mounting pressure to justify their capital flows in terms of ESG criteria (one of the key aims of the Paris Agreement in 2015). Following France, Australia and Singapore, UK regulators announced in early July that banks would soon be subject to climate stress tests. In terms of reputational considerations, a number of major financial institutions have been subject to widespread public and political criticism for their involvement in 'dirty' industries such as coal and gas.
Some banks have sought to self-regulate by imposing environmental disclosure and enhanced performance via voluntary industry schemes. For example, many have already signed up to the United Nations Principles for Sustainable Investment and the Task Force on Climate-related Financial Disclosures. Further, in June 2019, 11 banks holding c.$100bn of shipping loans set up the Poseidon Principles, whereby they have committed to ensuring the environmental viability of shipping debt. An analogous scheme is yet to be seen amongst aviation financiers but might be developed in the coming years.
Regulatory change on the horizon
It is likely that governments and regulators will implement additional measures to benefit those financing environmentally sustainable projects. For example, the European Commission is considering proposals around granting lighter capital treatment to sustainable debt. Banks with sustainability initiatives and processes in place will be better placed to manage these changes.
Application to aviation financing
In December 2019, Deutsche Bank provided debt financing to Singapore-based lessor Avation for the acquisition of three ATR 72-600s to be leased to Braathens Regional Airlines. Vigeo Eiris determined that this financing was aligned with the LMA's GLPs on the basis that the aircraft in question emit 40% less carbon dioxide than a comparable regional jet. This transaction was recognised as the first of its kind for the industry.
However, despite the keen interest of players in the aviation industry in acquiring green credentials, there remain inherent challenges facing aviation financing which may result in long-term incrementalism:
An accusation which has blighted the development of sustainable lending, and one which the aviation industry is particularly susceptible to, is the concept of 'green-washing', whereby loans are labelled as 'green' but are in fact made on identical terms to conventional lending. The use of independent credit agencies in this regard has drawn unwelcome comparisons to some of the practices by ratings agencies undertaken prior to the 2007-8 global financial crisis. Remedial developments in this regard have been threefold:
(1) there is consolidation in the 'green ratings agency' market, which should usher in a uniform set of analytics; (2) the LMA is taking a more active role, as discussed above, in providing documentary guidance to participants on achieving genuine accreditation and; (3) in December 2019 the EU published its 'taxonomy' report, a classification system which should lend legitimacy to projects with genuine ESG credentials.
Ultimately, banks, investors and airlines will need to convince the regulators (and the public) that any ESG financing credentials are genuine.
Whilst new engine, airframe and fuel technologies have allowed the industry to make great strides in reducing the environmental impact of aircraft, the industry remains a significant global carbon emitter (often cited at c.2% of global emissions, and expected to increase as a percentage in the future). Pre-COVID-19, IATA predicted a doubling of global passenger numbers by 2037 to 8.2bn. These forecasts suggest that the aviation industry will find it challenging to significantly improve its environmental record in the medium term.
This creates an inherent difficulty in integrating sustainable financing into financing of aircraft assets, and will, as mentioned, render aviation susceptible to ongoing accusations of 'green-washing'. The exciting development of electric aviation technologies might usher in a revolution in this regard, but this remains a long-term project, with commercial electric flights not expected for many years (largely due to limitations in existing battery technology).
Social and governance considerations
Although the aviation industry’s biggest challenge with respect to ESG factors may be its environmental performance, social and governance factors remain important considerations for ESG ratings and access to ESG financing. From a compliance perspective, ESG principles call for management structures which reflect transparency, accountability and a balance of power, while also enacting fair policies for risk management, compensation, employee relations and decision-making at director and shareholder level. From a social responsibility perspective, many airlines, like other companies, have historically focused on corporate social responsibility initiatives geared towards the environment, community education and social mobility. However, ESG ratings agencies will also focus on diversity and inclusion across the airline’s ranks, human rights considerations (primarily in the treatment of employees and suppliers) and consumer protection.
The outlook for aviation financing
That aviation is an inherently carbon emitting industry has evoked strong views from some that currently it should not be considered for ESG-accredited financing on any terms.
Conversely, the benefits of genuine ESG financing accreditation should perhaps be better viewed as an incentive for the industry to improve its environmental impact. In this way ESG incentives in financing and investment create an opportunity for aviation industry players to strive to improve the status quo, and align with the principle of environmental sustainability over the long-term.
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For further information, please contact: Leo Fattorini, Partner, Bird & Bird firstname.lastname@example.org