Episode #4: Gaining Altitude: ESG in Aviation Finance (Abigail Carter and Victoria Judd)

Abigail Carter: As many of our listeners will already know, ESG stands for Environmental, Social and Governance. While we focus mostly on the “E” in ESG today, ESG covers a pretty broad set of factors to be taken into account by responsible corporations and financial institutions—including sustainability, climate change, supply chains, consumer rights, diversity and inclusion, and ethical business practices, to name just a few. There has been a twofold increase in emissions from international aviation since the 1990s, and although there has been a six percent decrease in emissions from domestic aviation according to the UK Government’s recent report on Decarbonising Transport, we continue to see an increase in travel. The projected increase in domestic and international aviation from 2018 until 2050 is now a huge 73 percent. But Victoria, why do people seem to be taking this so much more seriously over the last couple of years?

Judd: Well, the ESG focus is not new—it started in the mid-2000s and used to be known as Socially Responsible investment—but the acronym and recent global trends and events (like accelerating interest in climate change and the global pandemic) have most definitely increased the focus on ESG. I would even say that the types of interested stakeholders have extended from investors to employees and communities. We are now seeing not just positive improvements being recognized but penalization of companies that do not comply with ESG factors. For instance, in certain cases shareholders have begun to litigate against banks/pension funds and investments funds for failing to factor climate risk into their decision-making process and for failing to disclose climate risk. Combined with the potential for negative press coverage, it is unsurprising that financial institutions are paying attention to the need not just to monitor but to actively manage their exposure to climate risks in investments.

Carter: And of course, governments are now also taking (and needing to be seen to take) a far more active interest in ESG.

Judd: Right! Take for example the speech by Sarah Breedon from the Bank of England in May this year where she pointed out that even though financial institutions may not have a great deal of emissions themselves, they should be limiting their indirect exposure to companies with higher emissions. And where there is no viable alternative, like in aviation, emissions produced need to be offset.

Carter: We’ll speak a little more about offsetting in a moment, but for now if we take a look at the different financial products available, could you tell us a bit more about what sustainability-linked loans actually are Victoria?

Judd: Sustainability-linked loans (or SLLs, for short) are loans with specific sustainability performance targets. Achieving the performance target results in a margin decrease, by usually 5 – 10 bps. SLLs need not have a green purpose (like a green bond or green loan) and can be used for general corporate expenditure. Key performance targets are determined based on the business of the borrower. They may be emissions for example, or they could be linked to total plastic use or even to an overall ESG score or rating. In any event, they are predefined and apply for the duration of the loan.

Carter: There are a lot of acronyms bouncing around here. I’ve heard about KPIs and SPTs. What are they and what is the difference between them?

Judd: KPIs are Key Performance Indicators and SPTs are Sustainable Performance Targets. The KPI is the item that is looked at—for instance emissions—whereas the SPT is the target that must be reached to be able to get the benefit of the margin reduction.

Targets are bespoke and negotiated between the lender and the borrower on a deal-by-deal basis. As loans are negotiated instruments, there are multiple ways to draft the margin ratchet provisions. Initially, KPIs were tested annually with a single ratchet available for the benefit of the borrower. However, you can now also see a penalty or margin increase if the target is not met, or other alternatives such as having to donate a sum of money to an NGO.

One further point to note is that the targets must be ambitious. If they are not, companies may be accused of “greenwashing.” This would happen if their targets are not ambitious enough or the ESG credentials are perceived to be inflated. A third party can be brought in to confirm that the data evidencing compliance is being reported correctly. That third party then is to some extent “protecting” the borrower and the lenders from accusations of greenwashing.

Carter: We’re starting to see this type of product more now in the aviation market too. Speaking recently about their SLL with JetBlue in 2020, BNP Paribas—who acted as the sole sustainability structuring agent on the deal—reinforced that a borrower can’t simply “sign up” to meeting certain SPTs for the purposes of entering into an SLL; they need to have an ESG strategy in place already, internal mechanisms set up to measure the relevant KPI’s and maybe a dedicated sustainability officer or committee to track compliance and the success of their sustainability metrics. The JetBlue financing included a pricing mechanism tied to the airline’s ESG score or rating. This score was then validated by an ESG research and service provider.

But green loans are a different product from SLLs, right?

Judd: Yes, green loans, like green bonds, are financial products which are made available exclusively to finance or to re-finance new or existing green projects. The LMA Green Loan Principles or the ICMA green bond principles can be referred to for guiding principles which provide an indicative list of generally accepted projects. These principles remain voluntary but are designed to provide a set of parameters which issuers can follow and which encourage transparency. In summary, it is mostly about disclosure and keeping a record detailing how the funds are used and then often a third party will confirm (not least for public disclosure purposes) that yes, the financing has been used towards a green initiative. There has also been some discussion of what have been colloquially called transition bonds which are specifically intended to help those higher carbon industries shift to lower carbon business models.

Carter: Perhaps we might start to see some of these transition bonds in the aviation industry to help airlines or lessors in financing the costs of new technology engines for example. But for now, we are starting to make some progress towards market standardisation—and Victoria, I think this applies just as much in the wider finance market as well?

Judd: I agree—consistent principles and reporting requirements are starting to appear. The EU Taxonomy Regulation, for example, establishes a list of key terms and definitions which is then used to help determine whether certain economic activities are sustainable. There is still some way to go, though, as the taxonomy won’t actually apply in practice until likely early 2022. It is nevertheless helpful guidance in the meantime.

Carter: Definitely. The Aviation Working Group (AWG) has submitted a letter to the EU commission seeking a single international system for classification of green aircraft financing to create a standardized system and avoid conflicting standards across the industry. We are also seeing new developments with carbon calculators launched earlier this year and developed by the AWG and also by IBA Group (who are an asset manager and advisor). These have been developed to help companies calculate their emissions when self-reporting and provide consistency when calculating CO2 emissions data for individual aircraft and for portfolios. The idea is that a ranking can then be given, or that the results are used as a standardized form of evidence which could be used to obtain preferential rates in things like SLLs for example.

Judd: Standardization might also come in through rating agencies who are looking to add ESG factors to their credit rating analysis. Another area where changes are taking place are the Emissions Trading Systems (or ETSs). Obviously, BREXIT has led to a split between the EU ETS and the UK ETS, but emissions trading systems are an important means of monitoring compliance and holding carbon emitters to account, and it will be interesting to see how this is standardized on a global basis.

What are you seeing in the aircraft industry in this respect?

Carter: IATA already has the Aviation Carbon Exchange set up as a centralized marketplace for eligible emissions units to be traded by airlines and other stakeholders. JetBlue has been one of the early airlines to make use of this by purchasing credits in other green initiatives, and there has also been some early discussion about whether carbon credits could be traded alongside a specific aircraft. In terms of other regulation and legislation, this is where CORSIA and qualifying offsets come in, particularly since the EU-ETS regime will taper out the current free allowances for aviation by 2027 to make room for the new CORSIA regulation.

Judd: Hang on. What is CORSIA?

Carter: CORSIA is the Carbon Offsetting and Reduction Scheme for International Aviation. International flights currently account for 1.3% of global emissions, and the purpose of CORSIA is to provide the means for airlines to continue to facilitate tourism and international travel without impacting the efforts to reduce carbon emissions. Under the scheme, carbon credits are purchased in other industries and sectors to offset emissions for international flights. This is only intended as a temporary fix though while emissions are reduced by other long-term measures, including the use of SAF (that’s sustainable aviation fuel, which we’ll touch on briefly in a bit) and improved technologies. Don’t forget, though, that this won’t become mandatory until 2027. The cost of offsetting is therefore only going to increase over time as pressure builds to improve carbon emissions. The question is also whether this is really meeting emissions targets—CORSIA has experienced some early criticism that it doesn’t fully assist in working toward the goal of the Paris Agreement (i.e., climate neutrality) and does not actually encourage a reduction in emissions.

Judd: If you go from the Paris Agreement to what we are seeing in the UK, the UK government has just released its plan to achieve net-zero emissions on domestic UK flights in its Decarbonising Transport Plan. A specific “roadmap” as to how the plan will be achieved is still missing from the proposals, and the results of its industry consultation on net-zero aviation are not expected until later this year.

The European regulators are also now pushing to achieve the ambitious “Fit for 55” EU legislative package announced in mid-July, which aims to reduce emissions by 55 percent by 2030 by removing the current tax exemption for jet fuel and pushing for an increase in synthetic aviation fuels or biofuels. This isn’t a done deal yet though, and the proposals are still subject to approval by the EU council and parliament.

Carter: Interestingly we are also seeing certain governments impose sustainability or environmental targets on airlines as a quid-pro-quo in some cases for government state aid being provided to airlines during the pandemic. For example, the French government, which owns 14.3 percent of the Air France-KLM partnership, has pumped seven billion euros into the airline on the condition that Air France cut its emissions by 15 percent per-seat before 2030.

Judd: The point you make in relation to France is interesting but not surprising. Free money usually comes with some strings attached. The same would be true for government grants or for funding provided by multinationals institutions. They usually impose some ESG-like criteria on the receiver of the funds.

Carter: Let’s not forget though that airlines are also taking their own voluntary steps and measures to implement new ESG strategies, including investments in sustainable aviation companies and initiatives or making pledges to commit funds to carbon offsetting and reducing their emissions—for example, Icelandair just signed an LOI to retrofit its aircraft to switch to hydrogen fuel. Lessors are also making similar investments and have well established action plans and targets, particularly where they are publicly owned or listed. And then there are the manufacturers who are now also publicly committing to reducing emissions—only last month Airbus set a target of bringing a zero-emissions commercial aircraft to market by 2035 using hydrogen as the primary power source.

Judd: You can see why these players are taking such voluntary steps to improve their ESG credentials: There is a financial incentive in having a strong ESG strategy—corporations are viewed as a lower risk (and therefore usually better credit) if they are managed with such a strategy in mind. And that is despite there being an initial capital outlay in setting this up. ESG reporting ensures a certain amount of transparency about corporates’ environmental impact and social responsibilities which could, over the long-term, lead to better investor relations and stock performance.

Abi, how has this fed into leasing companies and their relationships with their airlines?

Carter: So, we saw in the press last year that the CEO of Avolon, one of the top three lessors by number of aircraft, has openly considered offering preferential rates to “greener” airlines. Whether the idea is put into practice, and whether others follow, still remains to be seen. Either way, it is clear that Lessors and other participants in the industry are under increasing pressure from their investors to up their ESG game.

Judd: What about the historic perception outside the industry that aviation can’t be “green” because of increasing travel and carbon emissions?

Carter: Within the industry at least, the view is that great strides have been made in finding new innovations to reduce Aviation’s carbon footprint. SAF is getting a lot of attention at the moment as a means by which emissions can be reduced by up to 80 percent—only this week the Biden Administration has proposed use of SAF as part of its Build Back Better agenda. AerCap and Air Transat also just celebrated the first carbon-neutral A321LR delivery flight, which used a blend of SAF and carbon offsetting. There are still doubts though about whether the use of SAF is enough. Current SAF production levels are insufficient to support more than a small proportion of the industry and SAF is up to five times more expensive than normal jet fuel. Increased demand for SAF could in turn lead to increased cooking oil imports (which is needed to make SAF), and which are ultimately sourced from palm oil, something which we know is heavily associated with deforestation in Southeast Asia. So there is a question as to how environmentally friendly this actually is on a large scale.

Judd: Is the pressure mostly on the airlines themselves to reduce emissions?

Carter: Typically, most pressure has been on the airlines, but an ever-increasing percentage of the worldwide aircraft fleet is now owned by lessors (a trend exacerbated of late with the number of sale and leasebacks we have seen as a way of challenged airlines raising cash during the pandemic), so the days of pushing the responsibility for ESG solely down to the airlines are gone. So, we are now seeing a shift in perception as other participants in the industry provide or make use of green or sustainability-linked financings. We previously saw the now well-publicized 2019 Deutsche Bank financing with Avation, and more recently Etihad worked with Standard Chartered to issue the first transition sukuk in the aviation sector at the end of last year to be used for financing next generation aircraft and development of biofuels.

We have also started to see specific disclosures relating to new generation technology—for example, in a recent Engine ABS issuance, specific attention was placed on the percentage of assets in an initial portfolio which have new generation technology, i.e., using less fuel and with fewer emissions.

Judd: New technology definitely seems to be a driving factor in reducing emissions, whether it is the development of hydrogen in the energy sector or new aircraft models. Can you tell us of an example of this in practice?

Carter: One example is SKY Leasing’s debut aircraft ABS transaction, which closed in June this year, where US$663 million of asset-backed Notes were issued to finance a portfolio of 16 aircraft. The portfolio was made up of particularly young aircraft as well as strong lessee credits with long remaining lease terms—92 percent of the assets were new generation aircraft (which is the highest concentration for an ABS ever issued). Unsurprisingly, this was heavily oversubscribed but even so, there is a lot of focus on new generation technology (whether because of the pandemic or the increased pressure from an ESG perspective, or both). What will be interesting is seeing how those investors and lessors whose business models focus on mid- to end-of-life aircraft and have older generation technology in their portfolios adjust their business models over the next few years, if at all.

Judd: Adjusting business models and having an open mind to new strategies is really what ESG is all about. It’s about being flexible and looking for improvement. That improvement is easily found in the “E” for the aircraft industry, but social and governance matters are also key to a sustainable strategy for any company. That might mean more women on boards or ways in which to have more community involvement. It could also be other forms of innovation.

Carter: I agree. We have seen one lessor consider providing custom engines on a Power by the Hour basis, which could be used to tailor engines for an increased demand for more up-to-date technology. Then, most recently and only in June this year, Avolon also placed a firm order, as the launch customer, for up to 500 electric vertical take-off and landing aircraft (commonly known as eVTOLs).

Judd: I would love to hear more about eVTOLS! So let’s continue that discussion sometime soon. It is certainly interesting to see how the market is evolving and the innovations, whether in terms of technology or in terms of financial products that result from that. With that evolution also comes tremendous growth. If you look at the recent Economist Intelligence Unit report produced with our colleagues Mona Dajani and Sheila Harvey, you can see that even though green bonds still make up only 3.5 percent of the wider bond market, that 3.5 percent is an increase of 81 percent in just one year which is one example of the massive growth, and that is just one financial product. SLLs, green loans and Sustainability Linked Bonds are all following a similar trajectory of growth. We are no doubt only set to see this continue to increase … so let’s maybe talk about this so more sometime.

Carter: I agree!