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29 May 2024 | Comment | Article by Dominic Marshall

The increasing role of finance in transitioning towards a Net Zero future

Climate finance – both public and privately sourced

Climate related considerations have, for some time now, been a focus of funding agreements aimed at making long-term investments in sustainable economic activities and projects. Climate finance from both public and private sources is provided through a range of mechanisms such as loans, guarantees, grants, sovereign green bonds issued by national governments and the trading of carbon credits. The UK government has committed to providing £11.6 billion of International Climate Finance (ICF) between the financial years 2021/22 and 2025/26. Private climate finance also has a role in amplifying the effectiveness of government climate policies and will be pivotal in driving our switch to a low carbon economy. UK banks including Barclays, HSBC, NatWest, and TSB are among the 144 signatories to the Net Zero Banking Alliance looking to increase their green and sustainable lending and ‘transition the operational and attributable greenhouse gas (GHG) emissions from their lending and investment portfolios to align with pathways to net-zero by 2050 or sooner’.

Private climate finance will also provide investment to enable emerging markets and developing economies to reduce their greenhouse gas emissions. Banks and investors such as pension funds and insurers as well as other private finance providers, motivated not only by legal requirements and the need to discharge their fiduciary obligations, but also by the need to manage risk and protect their reputations, are increasingly focusing on sustainability considerations. Private finance will help all companies realign their business models for net zero by funding the initiatives and innovations of the future whilst driving economic growth.

Does the law require investing for sustainability impact?

Society’s most basic expectation of the finance sector is that it provides reliable and effective financial products that support growth and investment in all forms of economic activity. Products have therefore traditionally focused on the prioritisation of financial goals and returns to meet investors’ duties to shareholders and to the companies they manage. Investors looking to invest in sustainability linked outcomes may feel that such aspirations conflict with the financial gain purpose. However, climate change poses very real risks to all our social systems (including financial), so the connection between climate and economic (and wider societal) resilience cannot be ignored. This is supported by a growing body of climate-related regulation, both in the UK and internationally, which aims to highlight the connection between climate risks and financial performance.

Key risks to the financial sector from climate change include physical risks (such as flooding, droughts and storms), transition risks, which arise from a transition towards a low carbon economy and which drive changes in the value of assets and liabilities for banks and insurers (such as changes in policy, market sentiment, new technologies) and liability risks where parties who have suffered loss from physical risks and transition risk factors associated with climate change may seek to recover these losses from those they consider responsible (such as ‘greenwashing’ claims).

In 2021, the report ‘A Legal Framework for Impact’ was published, which provides a detailed analysis of the legal duty owed by investors when considering what it describes as ‘investing for sustainable impact’. The report broadly finds that ‘if an asset owner or investment manager concludes, or on the available evidence ought to conclude that one or more sustainability factors poses a material risk to its ability to achieve its financial investment objectives, it will generally have a legal obligation to consider what, if anything, it can do to mitigate that risk (using some or all of investment powers, stewardship, policy engagement or otherwise) and to act accordingly’. The report also notes that existing legal standards of care that investors must apply in performing their duties (the standards of the ‘prudent’ or ‘reasonable’ investor) are inevitably somewhat backward-looking and tend to discourage some investors from stepping too far ‘out of the box’ and taking more innovative approaches to sustainable investment, where this is pursued as a goal in its own right, even where it might result in reduced financial performance or outcomes. A call for more innovative approaches will, however, likely increase as younger generations increasingly take up positions and influence in the finance sector and as a general response to wider societal and consumer demand.

What does sustainable finance look like in practice?

Sustainable finance is still finance, so involves the fundamental elements of all financing activity: capital allocation, investing, diversification, risk sharing, and value maximisation. It does, however, have a different focus when we consider these fundamentals. For example, capital allocation decides how best to distribute a company’s money. In a sustainable finance context, the goal is investing for long-term social and environmental sustainability. Diversification means allocating portfolio resources or capital to a mix of different investments to spread the risk. Sustainable finance encourages diversification by broadening investment horizons by considering ESG (environmental, social and governance) factors. Value maximisation traditionally emphasises financial value for shareholders. In a sustainable finance context, the goal is to also maximise the welfare of stakeholders, including the environment and wider society.

There are a range of investment products used by financiers to achieve these objectives. At a basic level, these include:

  • Green Bonds are any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance, in part or in full, new and/or existing environmentally sustainable activities. The Green Bond Principles, a voluntary code of best practice developed by the International Capital Market Association (ICMA), provide a non-exhaustive list of ‘Green Projects’, including renewable energy, energy efficiency, pollution prevention and control, environmentally sustainable management of living natural resources and land use (which includes sustainable agriculture and animal husbandry practices), terrestrial and aquatic biodiversity conservation, clean transportation, sustainable water and wastewater management, climate change adaptation, eco-efficient and/or circular economy adapted products, production technologies and processes and finally green buildings.
  • Green loans – these are described by the Green Loan Principles (GLP), further voluntary best practice guidelines developed by the ICMA, as ‘any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible Green Projects’ (the definition mirrors the projects described above in relation to green bonds; the GLP are based on the ICMA’s Green Bond Principles with the aim of promoting uniformity across financial markets). The proceeds of the loan must be used for a specific environmental project or purpose.
  • Sustainability-linked bonds are bonds where the proceeds from the issuance are not ring-fenced to green or sustainable purposes (unlike ‘use of proceeds’ green bonds, above) and may be used for general corporate purposes. These bonds are, instead, linked to the performance of certain key performance indicators (KPI) in achieving pre-defined sustainability performance targets. These bonds are therefore a ‘forward looking’ performance-based product. The ICMA has published Sustainability-Linked Bond Principles (SLBP) which are also voluntary in nature and constitute recommended market best practice in order to promote market integrity and transparency in sustainable finance. SLBPs are based on five ‘core components’ with guidance on the following:
  1. how KPIs are selected so that they are measurable, verifiable and materially relevant to the issuer’s overall business
  2. how targets are calibrated to ensure they are both ambitious and realistically achievable and capable of external validation
  3. as the bond’s underlying structural or financial characteristics may vary depending on whether the selected target is reached, any such variation e.g. a variation in interest rate, should be ‘meaningful’ relative to the original characteristics of the bond
  4. reporting – bond issuers should regularly publish and keep available up to date information relevant to the selected KPIs and performance against the targets, as well as other relevant information to investors, for example an update in the issuer’s sustainability strategy, and finally
  5. verification – bond issuers should seek regular, independent and external verification of the KPIs’ performance against the targets by a qualified external review, including for periods relevant for assessing whether a particular target has been reached.

Sustainability linked bonds complement ‘use of proceeds’ green bonds and are an opportunity for issuers to attract new capital linked to key performance indicators and targets that are in line with their material ESG strategies, driving overall strategic sustainability as opposed to furthering one-off projects.

What are the benefits to businesses using green finance products?

Businesses with a positive impact on society can capitalise on business opportunities related to climate change (and other societal trends). Many advertised tender opportunities (within both the public and private sector) require data and/or confirmation on a bidder’s current ESG credentials. And while the sustainable finance market has predominately focused on larger corporations, small and medium-sized enterprises are increasingly being described as the ‘new front’ in the battle against climate change. Major banks are now offering a range of funds to provide loans to SMEs which invest in green and sustainable activities. Green loans to SMEs are typically restricted to funding sustainable business activities such as investment in renewable energy, green buildings, and pollution prevention. Many banks have also launched sustainability assessment tools to provide insights and resources to help businesses transition to net zero.

SMEs with a strong sustainability ethos will attract more customers, open access to greater procurement opportunities and prove attractive employers. According to the British Business Bank, 11% of smaller businesses have accessed external finance to support net zero actions so far, which equates 700,000 businesses and 22% are prepared to access external finance to support net zero actions in the next five years, equating to 1.3m businesses. The Bank is also developing a green finance offer. Its report Small Business Finance Markets 2023/24, states that it will pursue collaboration opportunities with its delivery partners, supporting initiatives which enable small businesses to become more environmentally sustainable and will work alongside finance providers to create a modern green economy.

Lenders will now consider the savings generated from installing green technologies and apply them to the overall assessment of finance affordability. Green finance options are becoming increasingly attractive for businesses wishing to look beyond the short-term cost to take advantage of the opportunities offered by ‘going green’. It is clear that businesses should prepare themselves when considering approaching banks or other lenders for green or ESG funding. Businesses now need to understand that finance providers apply certain criteria before granting such funding and must also understand the information they need to provide to meet these eligibility requirements and unlock the efficiency and value gains provided by green financing opportunities.

Author bio

Dominic Marshall


Dominic is a partner and head of the banking and finance team. Dominic is a vastly experienced banking and finance lawyer who, since joining Hugh James in 2010 has grown and developed the banking team into a leading player, acting for high street banks, challenger banks, financial institutions and building societies.

Disclaimer: The information on the Hugh James website is for general information only and reflects the position at the date of publication. It does not constitute legal advice and should not be treated as such. If you would like to ensure the commentary reflects current legislation, case law or best practice, please contact the blog author.


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