The appetite for environmental, social and corporate governance (ESG) investing continues to grow. In May 2023, the Loan Market Association, who govern the syndicated loan market, published model clauses for sustainability-linked loan agreements which aim to reflect current practices of rewarding positive sustainability performance.

What is a sustainability-linked loan (SLL)?

A sustainability-linked loan (SLL) is a loan that contributes to sustainability from an ESG perspective, but unlike traditional green loans, where the use of proceeds is limited to green projects, SLLs do not have specific restrictions on the use of funds and can be used for general corporate purposes.

The specific terms of these loans are negotiated between the borrower and the lender and are typically based on the borrower’s achievement of pre-agreed sustainability performance targets (SPTs).

What are sustainability performance targets (SPTs)?

The SPTs can vary, depending on the borrower and the industry, but generally focus on performance metrics – Key Performance Indicators (KPIs) – based on the borrower’s sustainability priorities, the industry standards, and the market conditions.

KPIs previously disclosed by various borrowers in the lending market include carbon emissions/greenhouse gas reduction, achieving energy efficiency, gender diversity, employee wellbeing and inclusion, supporting local communities (e.g., employability schemes and community training), and reducing accidents at work.

What happens if the target is met – or – missed?

The key characteristic of an SLL is that the borrower is financially incentivised to meet the target. For example, successfully meeting the SPTs can result in a reduced interest rate on the loan. Conversely, if the SPTs are missed, interest rates may go up.

Reporting requirements need to be complied with by the borrower, and, an independent external verification report in relation to the borrower’s progress against SPTs, is required to be provided to the lender.

Challenges and risks

The number of SLLs continue to grow significantly. The Financial Conduct Authority (FCA) recently undertook a review of the SLLs market earlier this year and identified several issues with the product:

• Borrowers may not be incentivised to seek an SLL because small savings on margins may be outweighed by negotiation costs and time, as well as heightened scrutiny.
• There is the potential for conflicts of interest in that banks may value the relationship with the borrower more than the borrower’s sustainability credentials.
• Banks typically count SLLs towards their sustainable financing targets, but the classification of SLLs vary considerably between banks and KPIs were not robust enough in more than half of the transactions completed in 2022.
• There are potential risks to market integrity and suspicion of greenwashing in the absence of disclosure of SPTs and KPIs by borrowers.

Although the FCA does not directly regulate this part of the market, it stated it is keen to ensure the sustainable finance market works effectively and market integrity is maintained, and will continue to monitor the market and consider further measures to support the development of SLLs.

SLLs can be employed in real estate finance and real estate development finance transactions with many banks promoting them. You may wish to speak with your bank to explore the terms on which they provide SLLs.

If you would like a conversation to find out how we could help you or if you have any questions in relation to sustainability linked loans, please email or call our Real Estate Finance team.