The sustainability-linked loan (SLL) market has made progress in addressing key integrity and credibility issues, according to a recent review by the UK financial regulator, the Financial Conduct Authority (FCA). The developments mark significant steps in creating a credible transition finance ecosystem.
The FCA’s observations follow a 2023 review of the SLL market, which highlighted concerns over market integrity that could impede the development of effective net-zero transition financing and increase the risk of greenwashing. Unlike other forms of labelled debt such as green bonds, which are designated for specific green projects, sustainability-linked debt ties financing terms to an issuer’s achievement of specified sustainability targets, allowing for broader corporate use of capital.
Key issues identified in the 2023 review included weak incentives within SLLs, and the selection of low-ambition sustainability targets and indicators. The FCA also noted potential conflicts of interest, where banks might offer incentives to promote SLLs to meet their sustainable finance goals, potentially leading to acceptance of weak Sustainable Performance Targets (SPTs) and Key Performance Indicators (KPIs).
In its update, the FCA acknowledged improvements following engagement with banks active in the SLL market. Since 2023, the market has matured with better practices and more robust product structures, despite facing market headwinds.
One significant improvement noted by the FCA is the increased relevance and ambition of sustainability targets used in SLLs. The regulator found that KPIs are now more closely aligned with borrowers’ business models, with the market focusing on a few key SPTs that are strategically significant to borrowers.
The FCA also highlighted the growing use of multiple sustainability coordinators in syndicated SLLs, which has led to greater scrutiny of KPIs and SPTs. Stakeholders suggest that active debate within larger forums contributes to more challenging SPTs and better alignment with borrowers’ business models.
Furthermore, the FCA noted instances where banks have used the declassification of SLLs as a sanction when borrowers breach sustainability-linked agreements or when loans no longer meet SLL criteria. This indicates that banks are willing to use a full range of measures to maintain higher standards.
Despite improvements in integrity and credibility, the FCA pointed out that the ambitiousness of pricing mechanisms in SLLs remains low, with minimal margin changes for meeting or missing sustainability targets.
The FCA also identified barriers to scaling the sustainability-linked debt market. For small and medium-sized enterprises (SMEs), the high cost of developing internal reporting frameworks, acquiring external assurance, and large required loan sizes were cited as obstacles to using SLL-based financing.
“There are still barriers to scaling the SLL market and some concerns around incentives, but the improvements we’ve observed are important steps in the development of a credible transition finance ecosystem,” the FCA stated.
