Friday 29 Mar 2024
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This article first appeared in Forum, The Edge Malaysia Weekly on April 4, 2022 - April 10, 2022

Sustainability-linked lending, where the terms of loans are linked to environmental targets, is catching on fast. The volume of these loans surged more than 300% in 2021 to hit a record US$717 billion, according to Refinitiv data, with increased activity coming from every region and every industry.

This kind of rapid growth has justifiably raised excitement around the role of sustainability-linked loans (SLLs) in the transition to a low-carbon world. As the market deepens, however, it is crucial that participants remain focused on quality. Lenders will always compete to offer attractive borrowers the best terms, but they should resist the temptation to go soft on sustainability goals. That risks undermining the value of the product to all involved — and to the climate.

We all know that financial institutions have a responsibility to support the transition to net zero carbon emissions, and the banking industry is coming together to make this happen. The Net Zero Banking Alliance represents over 40% of the world’s banking assets, for example, and the Glasgow Financial Alliance for Net Zero has gathered commitments from firms holding an incredible US$1.3 trillion of assets under management.

SLLs are perhaps the most powerful instrument in any bank’s net zero toolkit. By connecting the cost of capital directly to sustainability performance targets, such as the proportion of renewables in their overall energy mix, lenders effectively incentivise borrowers to do the right thing — or penalise them for failing to take action.

Target shopping

Unlike “green” loans, SLLs are also available to borrowers in any industry and do not place restrictions on the use of proceeds. The ability to incentivise borrowers to make progress with their transitions is an important form of engagement for banks that are working to align their own portfolios with a net zero trajectory. The challenge for banks, however, is to ensure that these financings contribute to positive outcomes for the planet.

This is particularly relevant in competitive, borrower-friendly markets like Asia. Strong borrowers can take their pick from multiple sources of liquidity, and plenty of banks are keen to offer a sustainable label to enhance their own marketing efforts.

This raises the risk of greenwashing as the market grows and borrowers go “target shopping” in search of a sustainability label that requires the least amount of effort. We believe the loan market can avoid this by sticking to the internationally recognised principles laid out by the Asia Pacific Loan Market Association and its sister organisations, the Loan Market Association in Europe, the Middle East and Africa and the Loan Syndications and Trading Association in the Americas.

The Sustainability-Linked Loan Principles call for performance targets to be material, measurable and ambitious. Material targets must be core to a borrower’s business and its sustainability strategy, with a meaningful impact on its operations. Measurable targets need to be benchmarked against independently assessed or scientific standards.

The level of ambition is especially important: SLLs are not designed to reward borrowers for continuing to operate their business as usual. The Principles also call for targets to be time-bound, with a commitment to regular reporting to allow lenders to track progress. And they call for external reviewers to verify the relevance and level of ambition of the targets, as well as mandate third-party verification of a borrower’s performance against its targets.

For a practical illustration, a financing that offers a lower interest margin if the borrower cuts its carbon emissions by a meaningful amount — say, 25% over three years — is clearly aligned with the spirit of an SLL. On the other hand, market participants could question the level of ambition for a borrower that targets only a modest improvement or, worse, commits only to maintaining the status quo, for example, by keeping its current environmental, social and corporate governance (ESG) rating.

All of this, of course, is voluntary. Ultimately, it is up to the capital providers (the banks) to set the right incentives and hold companies accountable if they fail to meet their targets.

Carrot and stick

The significance of the SLL format lies in the link between sustainability targets and economic outcomes. It is this mechanism that makes it such a powerful catalyst for change and an important tool in the transition to net zero.

Given the range of steps required to move the world to a net zero future, a one-size-fits-all approach is not desirable or practical. Some borrowers need to completely transform their businesses to a lower-carbon model while others must take more incremental steps. Lenders also have their own policies around what qualifies as sustainable and what incentives are within their budget.

Two-way pricing mechanisms in SLLs are particularly interesting, in contrast to the bond market, which has historically provided for step-up coupon adjustments only. Banks, for instance, could offer a discount to the interest margin if all key performance indicators are met, and add a penalty if none of them are. The decrease and increase to the margin need not be mirror images of each other to add greater weight to the “carrot” or the “stick”.

There are also a variety of compensatory mechanisms, such as carbon credit purchases or contributions to social charities instead of additional interest payments. In some circumstances, these may be more appropriate and avoid the perception that banks are profiting from bad behaviour.

In time, we expect banks to explore more ways to protect their own reputations, including imposing an event of default where borrowers fail to report on their sustainability progress or make material changes to their plans — for example, building a new carbon emitting facility.

With the right incentives and penalties in place, SLLs have the potential to influence corporate behaviour across every industry and in every region, and accelerate the transition. For this promising tool to become standard practice and embedded into mainstream financing, we cannot afford to let standards slip.


Rosamund Barker is head of legal at the Asia Pacific Loan Market Association. This column is part of a series coordinated by Climate Governance Malaysia, the national chapter of the World Economic Forum’s Climate Governance Initiative (CGI). The CGI is an effort to support boards of directors in discharging their duty of care as long-term stewards of the companies they oversee, specifically to ensure that climate risks and opportunities are adequately addressed.

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