Sustainability Linked Loans: Catalysts for a Greener Future?

Jean-Baptiste Vaujour is a Professor of Practice at emlyon business school where he teaches about consulting and green finance. He is an energy economist and a registered expert at the EU Commission and for the World Energy Council. He has recently published a book on the decarbonisation of the economy.

 

Sustainability Linked Loans (SLLs) have emerged as a dynamic financial instrument that aligns corporate financing with sustainability objectives (source). Unlike traditional loans, SLLs are tied to the borrower’s achievement of pre-determined sustainability performance targets (SPTs). As corporations increasingly prioritize ESG criteria, SLLs offer an opportunity to integrate these considerations into their financial strategies. This article explores the fundamentals of SLLs, their benefits, and the considerations necessary for maximizing their potential.

What are Sustainability Linked Loans?

SLLs are designed to incentivize borrowers to improve their environmental performance. Unlike green bonds, which are earmarked for specific environmentally friendly projects, SLLs can be used for general purposes. The constituting feature of SLLs is their linkage to specific environmental performance indicators (KPI). These are typically aligned with the borrower’s broader impact strategy and can encompass a range of metrics, such as reducing GHG emissions or improving energy efficiency.

The actual interest rate the borrower is going to pay on its credit is influenced by its ability to meet these previously defined targets. Achieving the target performance leads to a decrease in interest payments, while falling short or delaying results in a premium on the interest rate. This way, there is an alignment of interests between management and shareholders to improve the environmental performance of the company.

Benefits of Sustainability Linked Loans

SLLs provide a reputational benefit to companies that use them as they embed their ESG commitments within their financial strategy, providing a long-term incentive to improve their environmental performance. It acts as a signal to all stakeholders about the seriousness of the commitment, but it could also result in improved valuation for the stock of the company as it would attract impact-minded investors such as article 9 investment funds.

Aside from the direct financial incentive resulting from the improved financial performance, there are many co-benefits to the implementation of SLLs in the financial structure of a company. Focusing on environmental footprint reduction in operations often leads to better, less wasteful behaviors and cost savings. The increased scrutiny on variables such as energy and water consumption, GHG emissions, waste production can lead to significant savings.

In order to demonstrate their compliance with the predefined KPIs, companies also have to produce and report a steady information stream to the lenders. That information often has to be audited and/or certified by independent third parties. While clearly an additional administrative burden, this increased scrutiny can help improve operations on the one hand and also contribute to the company’s compliance with CSRD disclosure requirements.

Considerations and Limitations

On the other hand, the main limitation of SLLs comes from their very nature. At its core such a loan is a commitment to reach specific environmental targets with a financial incentive attached to it. However, this raises questions about the way these targets are set. The first obstacle is linked to the timing of the lending and reimbursement process. The targets are set ex ante during the initial negotiation phase and they have to reflect industry standards and the current situation of the borrowing company. A delicate balance must be found between environmental ambition and operational realism as unattainable KPIs will be detrimental to both the financial health and environmental commitment of the company. Conversely, too conservative targets will not provide long-term impetus for continuous improvement.

This initial difficulty is compounded by the long-term nature of debt commitments. Reimbursements will stretch out over many years and the situation of the company will ineluctably change. This may lead to suboptimal outcomes where the KPIs are no longer compatible with the structure of the business – for example if it purchased a competitor whose environmental track-record is less pristine. This in turn leads to complex definitions for the KPIs that have to accommodate such possibilities from the beginning.

From the bank’s perspective, SLLs also raise questions. Most boil down to a profitability issue when compared to standard loans. In order to issue a SLL, the bank has to run thorough due diligences on the borrower, in order to assess its current environmental performance and then set the appropriate targets. This process is both time-consuming and expensive as external expertise is required. Once the loan is issued, if the borrower complies with the targets, then the reduced interest rate conversely means that the bank is going to earn less money on the operation. Cumulated, both factors lead to significant pressures on the overall profitability of the operation for the bank. More pervasively, the issuance of SLLs is nearly impossible to industrialize because of their tailored nature. A one-size-fit all is by nature impossible and these financial products are hence reserved for a limited number of specific clients.

Conclusion

Sustainability Linked Loans represent a powerful tool for integrating sustainability into corporate finance. By linking financial performance with sustainability outcomes, SLLs incentivize companies to pursue meaningful environmental improvements. However, to maximize their potential, it is essential to set appropriate targets, ensure robust measurement and verification, and navigate the associated risks and challenges. There are however significant limits to their contribution to a wider shift of the economy towards a more sustainable pathway.