Sustainable finance in aviation: what future?
While environmental, social and governance (“ESG”) factors may have previously been substantive considerations for credit committees, they are increasingly key determinants of capital allocation. The application of ESG to aircraft finance transactions is therefore increasingly widespread as participants are eager to avail themselves of green credentials – although accusations of “green laundering” remain in some quarters. In this article, we review the current position and the way forward.
To date, green finance has tended to fall into two categories: sustainability-linked loans (“SLL“) and” green loans “(also explored in our previous briefing”How the grass can be greener in Singapore: green loans in Asia-Pacific‘).
SLLs imply that the margin and fees are tied to the borrower’s ESG credentials. ESG benchmarks can be measured by an external assessor such as a green credit rating agency. Several traditional rating agencies have been active in this market; in 2019 Moody’s acquired a majority stake in the ESG rating agency Vigeo Eiris. In other cases, the borrower and the lender may agree on ESG performance indicators, which must be met in order to avoid an increase in costs or margin, or, if met, reward the borrower. with lower costs and margin. In addition, the Loan Market Association (“LMA“) recently published the Principles of Sustainability Lending (“SLLP“) which effectively ties the terms of a proposed loan to a borrower’s sustainability profile, thereby enabling borrowers to obtain more favorable loan terms. Note that SLLPs should be adopted on a voluntary basis. and the LMA does not yet establish a clear accreditation system (accreditation has so far been undertaken by rating agencies).
“Green loans” describe financing in which the loan proceeds are to be allocated to specific “green projects” and are more prevalent in asset and project finance transactions. LMA has produced an analogue of SLLPs, the Green Loan Principles (“GLP“), which lists a non-exhaustive list of ten categories of” green projects “, including, for example, renewable energy projects. GLP recommends a four-pronged approach to qualifying a loan as” green “: (i ) use of loan proceeds for “green projects” (ii), communication of environmental objectives and eligibility criteria to lenders, (iii) management and monitoring of funds to ensure application for “green” purposes “And (iv) regular and transparent reporting to creditors on the use of funds. These elements will require sophisticated monitoring and reporting requirements in financial documentation. European banks have been particularly active in the” green loan “market. , stimulated by environmental regulations and political pressures (currently less prevalent in the United States and Asia-Pacific).
Green finance increased 46% in 2019 to $ 460 billion. Several key drivers are behind this growth:
Lenders argue that borrowers with better ESG credentials are likely to have better corporate governance and therefore have lower credit risk. Perhaps this seems obvious given the ‘governance“ESG aspect, but given the growing attention to climate change, many believe that companies with better ESG credentials will be inherently better placed and stronger as organizations in the future global business world. more and more financial modeling on this relationship between ESG and financial performance.
Borrowers face significant reputational, political and regulatory pressures to improve their ESG credentials, reinforced by the recent trend of shareholder activism in markets around the world. Sustainable financing will be part of a stronger and more visible ESG strategy. In addition, end users are increasingly aware of the environmental provenance of the products and services they wish to purchase.
Aviation is facing particular pressure in this regard, with the industry having to respond to “flight-shaming”. As a result, many major airlines have embarked on a radical overhaul of their ESG policies. For example, in February 2020, Delta pledged to spend $ 1 billion over the next 10 years to offset its carbon emissions. The major aircraft rental company Avolon has openly discussed the need to improve its ESG performance for bond issues, even posing the concept of a “green lease”, under which airlines with better ESG performance would have access at lower rents. As the dynamics accelerate, aircraft leases may in the future contain provisions requiring the airline tenant to be fully transparent with respect to emissions data and fleet composition. .
ESG references of the bank
Banks (and other financiers such as sovereign wealth funds and pension funds) also face increasing pressure to justify their capital flows in terms of ESG criteria (one of the key objectives of the Paris Agreement in 2015 ). After France, Australia and Singapore, British regulators announced in early July that banks would soon be subjected to climate stress tests. In terms of reputational considerations, a number of large financial institutions have been the subject of much public and political criticism for their involvement in “dirty” industries such as coal and gas.
Some banks have sought to self-regulate by mandating environmental disclosure and performance improvement through voluntary industry programs. For example, many have already adhered to the United Nations Principles for Sustainable Investment and the Task Force on Climate-related Financial Disclosures. Additionally, in June 2019, 11 banks with approximately $ 100 billion in maritime loans implemented the Poseidon Principles, by which they committed to ensuring the environmental sustainability of maritime debt. A similar pattern has not yet been seen among aviation financiers but could be developed in the years to come.
Regulatory change on the horizon
Governments and regulators are likely to implement additional measures to benefit those who fund environmentally friendly projects. For example, the European Commission is considering proposals for granting a lighter treatment of capital to sustainable debt. Banks that have sustainable development 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 for lease from Braathens Regional Airlines. Vigeo Eiris determined that this funding was aligned with LMA’s GLP on the assumption that the aircraft in question emits 40% less carbon dioxide than a comparable regional jet. This transaction was recognized as the first of its kind in the industry.
However, despite the keen interest of aviation industry players in acquiring green credentials, there remain challenges inherent in aviation financing that can lead to long-term incrementalism:
One charge that has hampered the development of sustainable credit, and to which the aviation industry is particularly sensitive, is the concept of “green-washing”, whereby loans are labeled as “green” but are in fact granted on terms. identical to loan. The use of independent credit agencies in this regard has drawn unfortunate comparisons with some of the practices of rating agencies undertaken prior to the global financial crisis of 2007-2008. The corrective developments in this regard were of three types:
(1) there is a consolidation in the market for “green rating agencies”, which should inaugurate a uniform set of analyzes; (2) LMA takes a more active role, as noted above, by providing documentary advice to participants on obtaining true accreditation and; (3) in December 2019, the EU published its “taxonomy” report, a classification system that should confer legitimacy on projects with real ESG references.
Ultimately, banks, investors, and airlines will have to convince regulators (and the public) that all ESG funding credentials are genuine.
While new engine, airframe and fuel technologies have enabled industry to make great strides in reducing the environmental impact of airplanes, the industry remains a significant global emitter of carbon (often cited at around 2% of global emissions, and is expected to increase as a percentage in the future). Before COVID-19, IATA predicted the number of passengers worldwide to double by 2037 to 8.2 billion. These forecasts suggest that the aviation industry will struggle to significantly improve its environmental performance in the medium term.
This creates an inherent difficulty in integrating sustainable financing into the financing of aviation assets and, as mentioned, will make aviation susceptible to constant accusation of “green laundering”. The exciting development of electric aviation technology could usher in a revolution in this regard, but it remains a long-term project, with electric commercial flights not expected for many years to come (largely due to limitations in the existing battery technology).
Social and governance considerations
While the aviation industry’s biggest challenge with regard to ESG factors may be its environmental performance, social and governance factors remain important considerations for ESG ratings and access to ESG finance. From a compliance perspective, ESG principles require management structures that reflect transparency, accountability and balance of power, while adopting 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 focused on the environment, community education and social mobility. However, ESG rating agencies will also focus on diversity and inclusion in the airline’s ranks, human rights considerations (primarily in the treatment of employees and suppliers) and consumer protection. .
Prospects for aviation financing
The fact that aviation is an inherently carbon-emitting industry has sparked strong opinions from some that it should not currently be considered for ESG accredited funding under any conditions.
Conversely, the benefits of a true accreditation of ESG financing should perhaps be better perceived 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 long-term environmental sustainability.