Sustainability linked loans are an integral part of transition finance, and aim to economically incentivise a borrower to meet key sustainability targets. These targets may include reduced water consumption or energy use, and a common incentive is to decrease the loan margin. Other firms are incentivised by demonstrating to stakeholders that they are taking sustainability seriously. Unlike green loans, the loan itself doesn’t have to specifically support environmental activities making them applicable to a wider range of applicants. On paper, sustainability linked loans sound great, but in practice they need some fine tuning.
What’s the FCA review all about?
Sustainability linked loans are a key enabler of the transition to a green economy. Following market concerns and negative press, the FCA worked with key stakeholders earlier this year to:
- Establish how the sustainability linked loan market works
- Gather additional insight from stakeholders
- Consider how to improve sustainability linked loan integrity and address key concerns
- Think about how further develop the sustainability linked loan market to support transition finance
The FCA has since published its findings in a letter to the market and through direct engagement with participating firms.
What’s the problem with sustainability linked loans?
Credibility is the biggest issue. This can lead to greenwashing and erode trust in the sustainable finance market. The problem is two-fold:
1 Sustainable performance targets (SPTs) just aren’t robust enough and don’t stretch the borrower to drive meaningful changes in behaviour.
2 Key performance indicators (KPIs), to track performance against those targets, are too weak.
This raises the question of whether sustainability linked loans are working as intended and actively supporting transition finance goals. Arguably not, according to the FCA. The regulator spoke to one firm that felt that only 30% of its 250 sustainability linked loans were fit for purpose and half of them didn't have robust enough KPIs. With the majority of banks counting these products as part of their sustainable financing targets, this is big problem.
The next issue is one of margins. With sustainability linked loans, depending on the specific product design, a borrower that meets their sustainability targets should see a decrease in the loan margin. If they miss their target, that margin should increase. In practice, the FCA found that increases in the margin were minimal at 2.5 base points and generally capped at 5 base points. Riskier leveraged or lower-rated loans carried higher increases of around 25-30 base points.
There could be a conflict of interest
Conflicts of interest could arise in relation to sustainability linked loans, for example, some banks receive additional remuneration for meeting ESG financing targets regardless of customer performance. Combined with a desire to satisfy clients, this could incentivise banks to issue sustainability linked loans with easy to achieve targets and weak key performance indicators. Targets should always be challenging to avoid rewarding borrowers for typical business activities.
So, what’s next?
The FCA has highlighted the need to create more ambitious goals, and strengthen the link between those targets and KPIs. To achieve this firms can draw on the upcoming disclosure framework from the transition plan taskforce, due in Autumn, which will help firms demonstrate their sustainable transition plans. In the meantime, issuers should check the recent revisions to the Sustainability linked loan Principles, from the Loan Market Association to make sure they continue to meet best practice.
There are also some quick wins. For example, firms can review key roles and responsibilities, accountability processes and escalation routes for any problems. This will strengthen reporting processes, and make it easier to act if customers don’t meet KPIs. Good oversight of data can also help, and it’s important for both parties to agree the KPIs at the start of the contract, with full disclosure throughout over the underlying data and assurance processes. Both KPIs and SPTs should be linked to science-based targets for improved credibility, and firms need to be clear on how they link to transition plans.
Making these changes will improve the quality of sustainability linked loans, reduce the risk of greenwashing and support transition finance. Staying up to date with regulatory output is also important as the FCA will continue to monitor the market and may consider further measures in future.