The UK’s Financial Conduct Authority (FCA) says it is “encouraged” by improvements in the integrity of the sustainability-linked loan market, despite ongoing challenges around pricing.
Sustainability-linked loans, where terms such as pricing are linked to the borrower meeting certain targets or KPIs, are the most widely used sustainable finance product.
More than half are structured as investment-grade revolving credit facilities (RCFs), with utility and energy companies traditionally the largest users, Natixis data shows.
However, the sustainability-linked loan market grew rapidly in a relatively unregulated environment, and the FCA wrote to bank executives in 2023 expressing concern that widespread adoption may be held back by a lack of trust.
Following a market review, the regulator said lenders or bank staff may be incentivised to set weaker sustainability targets for their borrowers, that participation could be discouraged for reputational reasons, and that for borrowers that fail to meet targets, step-ups in margins appeared relatively small.
In a letter sent to sustainable finance heads at UK lenders last week, the regulator says the sustainability-linked loan market appears to have matured since then, with participants exhibiting “better practice and more robust product structures”.
“There are still barriers to scaling the [sustainability-linked loan] 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 says.
The regulator acknowledges that pricing “remains a challenge”, with margin adjustments for meeting or missing targets still minimal.
But it says KPIs are now generally more closely aligned to borrowers’ business models, and facilities tend to focus on a smaller number of core targets.
Syndicated sustainability-linked loans increasingly involve multiple sustainability coordinators, resulting in greater scrutiny of KPIs at the structuring stage.
And although there are cases of borrowers missing targets, the regulator says this trend “may indicate that the market is maturing”, noting that some have continued to seek a sustainability-linked loan structure when refinancing.
“Where [targets] are ambitious, we would expect to observe some instances of borrowers not meeting them and this should not unequivocally be regarded as failure,” the FCA says.
Globally, the volume of sustainability-linked loans issued totalled €650bn last year, up from €513bn in 2023 but still below the 2022 peak of €761bn, according to data published by Spanish bank BBVA.
The slump in 2023 has been attributed in part to closer scrutiny of facilities as regulators grew more wary of greenwashing risks, although also coincided with a broader decline in corporate loan volumes.
Experts believe this regulatory attention, as well as improved market guidance, now appears to be improving market integrity.
In the UK’s case, the FCA’s involvement “has undoubtedly made the market more cautious”, says Jason Marret, a partner at law firm HFW specialising in trade and commodity finance.
Model provisions published by the Loan Market Association in 2023 – which sit alongside a set of principles and guidance most recently updated in March this year – “have also driven more robust documentation”, he says.
So-called sleeping sustainability-linked loans – where specific targets are established only after a loan has been originated – are “more tightly policed” and not typically publicised until targets go live, Marett tells GTR.
The Geneva-based lawyer adds that renewed facilities have also been strengthened.
“The repapering we’ve seen over the last 24 months has introduced more robust sustainability provisions,” he says. “In commodity trade finance, sustainability-linked loans remain important, but they now come with stricter legal terms.”
An article published by HFW in July suggests that borrowers in the commodities sector “will need to be agile and aware of the risks” that come with closer scrutiny, but adds: “Successfully navigating these headwinds will be key to accessing capital on competitive terms.”
