Sustainability-linked loans cannot be considered as credible transition financing instruments until the metrics and targets that determine pricing are aligned to borrowers’ transition plans and banks’ own net-zero commitments, according to research by the University of Oxford.
Banks are best placed to drive this change by demanding that the key performance indicators that determine pricing on SLLs are fully aligned with companies’ long-term sustainability strategies and the transformation of their business models towards a net-zero economy.
“Some consider sustainability-linked financing to be a transition financing vehicle. However, I believe that we are still a long way from that,” said Jose Luis Resendiz of the university's Oxford Sustainable Finance Group.
“I think the banks are still learning from SLLs. The best way to improve the integrity of the market will be through the banks.”
Sustainability-linked financing started in the loan market in 2017 and has spread to other asset classes. SLL volume has held steady despite market volatility with US$308bn of SLLs issued in the first half of the year, compared with US$309bn a year earlier, according to Refinitiv data.
The research has classified more than 1,000 KPIs on SLLs issued between 2017 and 2021, and found that less than half are material and more than 30% do not reveal the metrics used. Some borrowers provide the names of external reviewers but more than 80% do not.
While less than one-third of KPIs are linked with borrowers' sustainability strategies, more than half of the greenhouse gas emissions targets are connected to net-zero corporate commitments, the research shows.
New framework
The research aims to create a framework for sustainability-linked finance – including loans and bonds – that will allow banks to assess the materiality and ambition of metrics and targets and alignment with transition plans and Resendiz is starting to work directly with banks.
The framework is based on the Sustainability Accounting Standards Board’s materiality map, which identifies key ESG metrics for 77 different industries that the recently created International Sustainability Standards Board will use to build new global sustainability-related disclosure rules.
Better disclosure and increased transparency in the deeply private loan market will create more credible SLLs that could also link with banks’ net-zero pledges as they start to reduce financed emissions and link material KPIs to their own loan portfolios and credit risk analysis.
“What’s the incentive for the capital providers now to receive less return? Reducing risk exposure is a benefit, but they can only do this if they can prove that the borrowers are using material KPIs,” Resendiz said.
However, bankers admit that it can be tricky to take a tougher line with relationship clients used to calling the shots. "It's quite difficult for banks to get involved in second-guessing the quality and appropriateness of targets for any industrial company," a senior loan banker said.
Needs more work
The research found that the introduction of the Sustainability Linked Loan Principles in March 2019 had no substantial impact on the disclosure or ambition of metrics and targets and has not increased the selection of financially material KPIs.
“I think there should be more progress on the principles, and this can also better guide borrowers. There are two types of greenwashing – intentional and unintentional – and I think that borrowers are quite confused about these ESG trends,” Resendiz said.
The research recommends that provisional principles are created for metrics and targets to align with the interim targets of capital providers’ transition plans, using a "double materiality" approach that covers the financial effects of a business’s practices and its impact on the world.
Metrics and targets should also be included in issuers’ annual reports to improve transparency in the private loan market and third-party verification reports should be included in annual sustainability reports.
Some of the change required will be driven by the emerging role of sustainability coordinators, as banks start to use SLLs to engage on their targets for financed emissions and transition pathways.
But many banks prefer to use second-party opinion providers to avoid relying on their peers, particularly as regulators will also need to develop a similar framework to assess banks' commitments and claims from a financial stability perspective.