Growing pains: maintaining credibility in the sustainability-linked loan market

Amidst the growth of sustainable finance, one instrument has achieved outsize prominence; the sustainability-linked loan or SLL, which incentivises a borrower to achieve sustainability targets by linking them to the interest rate payable on the loan.

The prominence and growth of SLLs has brought with it scrutiny; increasing and often negative media coverage of the SLL market observed over the last year has highlighted potential market integrity concerns, underscored by a regulatory probe of the market in the UK which signals further domestic and international supervisory oversight.

In this third edition of Baringa’s annual review (2021 and 2022) of the sustainability-linked loans market and implications for borrowers, lenders and wider stakeholders, we found that across a sample of larger loans:

• An increasing number of loans have both climate and wider environmental and social KPIs, including on nature
• This proliferation of metrics makes it increasingly hard for lenders and stakeholders to assess the materiality and ambition of KPIs
• Despite claims that climate standards are being tightened, fewer borrowers had a documented transition plan
• There was a correlation between borrowers who did have a transition plan, and organisational maturity as measured by existence of governance and progress against targets.

SLLs first started to appear around 2017. Back then, few companies were considering the benefits of connecting their sustainability efforts with their financing strategy. In the intervening years, growing awareness amongst borrowers and financiers as well as a low interest rate environment fuelled the rise of the global sustainable debt markets, with SLL issuance reaching nearly USD 700 billion globally in 2022 according to Environmental Finance data. However, amidst a backdrop of rising interest rates and increasing scrutiny of sustainability claims, issuance has slowed markedly in 2023 and is expected to end the year above 2021 levels, but at potentially half of 2022’s peak.

While there have been recent updates to the sustainability-linked loan principles (SLLP) published by the Loan Market Association, Loan Syndication and Tradition Association, and Asia Pacific Loan Market Association, they have no oversight or approval role in relation to what qualifies as an individual SLL, with banks holding this role and in some cases using second party opinions to give additional comfort to borrowers.

It is this self-policing by loan parties that has exposed the SLL market to greenwashing risks. Investors and others have voiced worries that the targets are often not credible – they are too easy to achieve or not aligned with a borrower’s core business. Against this context, it is perhaps unsurprising that regulatory interest in SLLs has – in conjunction with an ambition for consensus in how to document them – grown with the popularity of the financial instrument. 

Regulatory intervention

During 2023, the UK’s Financial Conduct Authority (FCA) engaged privately with a range of market actors, which culminated in a letter sent to bank Heads of ESG and Sustainable Finance on the findings of its review of the SLL market.

The FCA acknowledges that it does not directly regulate the SLL market but is “keen to ensure that the sustainable finance market works well, and that market integrity is maintained”, making their intervention in a non-regulated market even more noteworthy. Although the letter is directed at banks, FCA-regulated credit fund managers and other lenders active in this area should take note “so that all interested parties active in the SLL market can reflect on its content, whilst drawing attention to a number of observations and weaknesses in the market that were identified”. In short, the concerns highlighted in the letter were:

• The need to strengthen the expectations of sustainability performance targets (SPTs) and key performance indicators (KPIs) with clearer alignment to borrowers' published transition plans
• That borrowers may be deterred from entering into SLLs due to the costs and negotiation time involved in putting them in place
• The potential for conflicts of interest to arise given the linking of remuneration in banks to the achievement of sustainable finance targets which SLLs contribute to, and therefore the potential that banks may accept weak SPTs and KPIs.

While the FCA has no current plans to introduce regulatory standards, it will continue to monitor the SLL market “as part of our wider work on transition finance, with a view to considering the need for further measures to support the development of a robust transition finance ecosystem” and more robust industry codes of conduct are likely. At this stage regulators in other jurisdictions are yet to publicly opine on the SLL market but are known to share the FCA’s concerns.

Market review

Baringa conducted proprietary research on a sample of SLLs, reflecting $13.5 billion in loans from a diversified pool of large, multi-region corporate borrowers. Building on the research we conducted in 2022, this review highlighted that:

• Despite significant growth in awareness and publication of transition plans, including the recommendations of the Transition Plan Taskforce, half of borrowers in our sample did not have a public transition plan
• Progress was more evident amongst those borrowers who had published a transition plan; 70% had made progress against targets compared to only 40% of those lacking a plan. As such, the process of developing a transition plan could be said to aid organisational maturity
• KPIs on SLLs sampled continue to be heavily focussed on climate - either absolute emissions or emissions intensity – with around a quarter incorporating scope 3 emissions, similar to last year
• Climate governance continues to improve, with 85% of borrowers discussing how their board oversees the company's response to climate change, although a quarter still fail to anchor their climate efforts on an approved policy.

There was a sharp drop in the portion of management teams incentivised on targets, halving from 60% in 2022 to around a third of our sample in 2023 despite linking their financing to them.

Rules of the road

As the market continues to evolve, borrowers and lenders can take a range of steps to help the market remain credible and stay ahead of emerging issues:

• Follow the money – sustainable finance is intended to drive enhanced outcomes, or additionality, against a conventional transaction. SLLs can be a meaningful way to encourage clients’ progress in setting, disclosing and delivering on climate and sustainability goals – especially where doing so is central to achieving net zero commitments and financed emissions targets. But the size of the incentive reflected in the interest rate ratchet should reflect this, especially in a context of much higher policy rates.
• Risks must be better managed – there remain instances where KPIs are not core to a business and its’ license to operate, eroding trust as well as incentivising perverse outcomes. As such, when reviewing potential SLLs business and risk teams should make joint decisions and balance between risk, revenue, and client relationship – and use mechanisms such as loan covenants to enforce this over time. This should extend to enhanced transparency by both borrowers and lenders over SLLs that have been issued – much as the equator principles requires banks to publish a summary of transactions each year, a listing by a bank of all SLLs issued in the year with selected deal information incentivises robust outcomes.
• SLLs should be transparent about data behind SPTs and KPIs – borrowers should be clear about the link between metrics, transition plans and credible transition pathways to net zero. The work of the Transition Plan Taskforce (TPT) offers a framework for credible transition plan disclosures that should be leveraged to inform the design of SPTs and KPIs in sustainability-linked instruments and products. This includes not just climate, but nature and social dimensions. Prominent reference to the borrower’s transition plan would be consistent with guidance from the International Capital Market Association (ICMA) in its recently-updated Climate Transition Finance Handbook.
• SLL KPIs should be ambitious – the requirement for ambitious targets is explicitly outlined in the SLL principles, but is not always demonstrated. In addition to verification processes such as science-based targets for emissions, second party opinions have potential to play a growing role in establishing ambition, but are themselves coming under increasing scrutiny by regulators mindful of conflicts of interest.

SLL is an important financing tool but…

The SLL market remains an important financing tool in incentivising sustainability outcomes. If SLLs are to maintain their integrity as an instrument, market practitioners across the world will need to refine practices to ensure SLLs create genuine additionality.

In the interim, focussing on forging a balance between setting targets that are stretching but achievable will be critical, both in terms of motivating companies to accelerate on their ESG ambitions and providing lenders with some comfort that their capital is being used with the right intentions. Importantly, pairing this with more comprehensive disclosures and opportunity for external scrutiny will tackle the transparency problem and help SLLs to reach their full potential.

For more information or to discuss the points raised in this article, please reach out to a member of the team below.