Adaptation equals evolution – What's the future of sustainability-linked loans?

When sustainable loans first became popular in Europe around 2020, the focus was on so-called 'labelled' products.  However, a number of factors have led to a significant flattening of the sustainability-linked loan market from its peak, despite the continued centrality of sustainability to the political and corporate agenda. Sustainability-linked loans provide entity-level finance, can they be rejuvenated as part of the transition finance tool-kit? 

Around 2020, sustainability-linked loans were primarily accessible by sophisticated corporates which had developed sustainability frameworks or plans of their own.  These could be used to set the loan's parameters – the sustainability targets – by reference to which any pricing reduction (or increase) would be made.   

In our 2023 Corporate Debt Report, which was based on a survey of over 80 UK large corporates, we reported that appetite for sustainable loans appeared to have diminished among these borrowers. This theme was continued in our 2024 Corporate Debt Report. We found a bifurcation in approach between corporates which saw the inclusion in their loan documentation of specific sustainability contractual provisions as inevitable, and those which considered sustainability to be a fundamental part of lenders' wider lending decision rather than a contractual feature leading to a minor pricing adjustment.

These included market credibility and concerns around greenwashing, in particular in terms of determining the sustainability targets which must be met.  The complexity of documenting the contractual requirements and conducting the necessary external verification of the borrower's performance, as against the modest pricing benefit associated with satisfying them (which has generally not kept pace with the wider interest rate environment), has also been a disincentive. 

Transition finance has been in sharp focus in the last 12 months: the European Commission published its recommendations in 2023.  In the UK, the Transition Finance Market Review published its report on 17 October 2024, following extensive consultation with the market.  This gives detailed recommendations on how to scale and develop the transition finance market, including on how best to scale finance for transitioning entities.    

The TFMR report highlights the continuing value of labelled sustainable finance instruments.  The broader adoption of transition plans by corporates (and the associated on-going improvement to disclosures) should help the setting of sustainability targets and the ability of lenders to monitor compliance with them.  Specific principles and guidance for transition loans are being considered, too.  These should assist in catalysing and re-energising the sustainability-linked loans market in some form.

A specific use-of-proceeds transition finance product, similar in structure to a green or social loan, has been mooted.  This could assist in making funds available for projects or to finance assets which are vital in the energy transition but which could be considered more olive or khaki than pure green. 

The sustainable finance market is a dynamic and reactive one. While sustainability is absolutely central to lending decisions generally, labelled products continue to have an important role to play in the drive to net zero