Systemic shortcomings in current practices suggest a need for stronger regulatory guidance, says Emily Farrimond, Partner, ESG & Sustainability Lead at Baringa Partners.
Inconsistency and a lack of transparency in sustainable finance raise concerns that the practice is open to widespread abuse. As the market for sustainable finance grows rapidly, sustainable loans reached a record US$448 billion at the end of the third quarter. Baringa’s analysis suggests that up to half of these loans could be open to ‘greenwashing’.
To what extent, therefore, is sustainable finance really driving the change that its name implies? To answer this question, we reviewed a sample of sustainability-linked loans (SLLs) from a diversified pool of large, multi-region corporate borrowers totalling circa US$35 billion.
Defining sustainable finance
The European Commission describes sustainable finance as the process of taking due account of environmental and social considerations when making investment decisions, leading to increased investment in longer-term sustainable activities. The purpose is to encourage capital allocation to sustainable companies and projects that hit the sweet spot of being environmentally, socially and financially sustainable.
According to the Loan Market Association (LMA), SLLs are a subset of sustainable finance designed to assist “borrowers’ achievement of ambitious, pre-determined, sustainability performance objectives” – funds need not be for a specific project, so long as they contribute towards a sustainability target. Performance criteria outline how these targets can be measured, either by way of ESG ratings or specifically agreed targets (SBTs and KPIs).
There are no commonly accepted standards around SLLs and their target measurement, although the LMA has created a set of principles, which some fear leaves the system open to greenwashing. The EU has attempted to remedy this through its recently adopted Taxonomy Regulation that classifies environmentally sustainable activities, as well as through its Sustainable Finance Disclosure Regulation.
Sustainability plans are still lacking
Using public information, not a single loan in our sample could be shown to adhere to LMA principles, nor have a credible climate transition plan. When reducing the requirement to information that is most likely to be publicly stated (calibration of targets and verification of performance), combined with climate-plan data, only about half met the criteria. While our analysis of SLL borrowers was constrained by a lack of publicly disclosed information, what banks and borrowers choose to disclose is revealing:
- A fifth of SLLs assessed were to firms with no publicly stated sustainability targets associated with the loan. Only a further fifth had both environmental and social targets aligned to the lending, being deemed truly sustainability, and not just environmental.
- Only half of the SLLs revealed how the targets set would be measured or externally validated.
- 80% of companies had NOT set Scope 3 targets to reduce indirect emissions (often within the supply chain). This implies sustainability-linked borrowers aren’t even trying to support net zero goals.
- A significant minority did not have a publicly stated climate transition plan, yet were still benefiting from preferential pricing on the basis of lending designed to support climate transition.
- Additionally, 40% of companies did not disclose how often their boards discussed climate risk, and a further 30% were not incentivising their management towards climate objectives.
Cause for concern
While there is clearly some positive action, our analysis reveals systemic shortcomings in current practices around sustainable finance. Notably, a general lack of tracking metrics (less than half have KPIs, about 80% have published targets) prompts the question as to how finance providers are able to determine whether a loan qualifies as an SLL. Also concerning is that around half of sustainability-linked borrowers report no external verification of their transition plans.
There are also significant gaps with publicly available information around targets, reporting and verification processes. These failures open the door to criticisms that the practice is open to widespread abuse and greenwashing. Put another way, up to half of sustainability-linked loans could be greenwashed. Even among those who met our criteria, due to a lack of consistent information, it is impossible to provide any hard evidence for the impact of such financing initiatives.
This area of the market would benefit from more regulatory guidance. In order to improve the quality of SLLs across the market, regulator need to support the setting of robust standards and guidance surrounding:
- the purpose of the funds and their alignment to achieving sustainability goals
- transparency surrounding the SBTs/KPIs aligned to the lending
- short- and medium-term measurement of the progress against the targets which have been audited
- transparency about associated financial penalties.
In the interim, the onus is on companies and lenders to be more transparent about what loans seek to achieve, how they measure those achievements and the plan to get there.