Sustainability linked lending: in the FCA’s sights

At a glance

The Financial Conduct Authority (FCA) wrote to Heads of ESG/Sustainable Finance on 29 June 2023 to set out its findings following a stakeholder engagement exercise it undertook across March and April 2023. The key findings for banks and SLL borrowers to consider include:

• While SLLs are not regulated by the FCA, it has set out clear concerns about how these products are operating, and how firms are accountable for decisions about SLLs.
• SLLs may have weak data and/or credentials to support their sustainability, which may lead to a potential undermining of market integrity and an increased risk of greenwashing.
• The incentives to reach SLL targets may create a conflict of interest, and lead to banks accepting products that lack robust sustainability data.
• Banks should proactively seek to address some of these issues and improve practices on SLL products as part of their transition planning process and within their sustainability strategies to reach net zero.

Relevant to: Chief Sustainability Officers, Senior Manager Functions accountable for sustainability, Chief Risk Officers, Board Members and Chief Executive Officers

As the letter notes, SLLs have grown rapidly over the past five years. In the EU, bankers predicted that at least 50% of investment grade corporate loans would contain sustainability‑linked targets in 2023.

The FCA highlights some key observations where firms need to do more.

Accountability

The FCA has tasked those in the industry who provide sustainability-linked loans (SLLs) with reflecting on its findings, including weaknesses observed. The letter is of interest not only because of the points of reflection it contains for banks, but because of its addressee. Banks are used to receiving “Dear CEO” and “Dear CFO” letters but, as far as we can see, this is the first “Dear Head of ESG” letter.

Firms need to understand where Heads of ESG and Sustainable Finance sit within their management responsibility maps and ensure that the Senior Management Functions (SMFs) that they report to, if they are not one themselves, are fully appraised of the following challenges with SLLs. While SLLs do not lie within the FCA’s regulatory remit, FCA-authorised firms may still be held accountable by the FCA where there are any weaknesses in governance under conduct rules, especially if there is a negative impact on market integrity or an increased risk of greenwashing.

Credibility, market integrity and greenwashing concerns

Banks have set public targets for increasing the share of financing that can be categorised as sustainable and have incentivised their employees to meet those, often ambitious, targets. This creates a potential risk that banks accept weak key performance indictors (KPIs) that are not material to the borrower’s sustainability strategy or linked to credible transition pathways. The FCA pointed out that banks’ own targets for sustainable lending should not compromise their duty to provide borrowers with appropriate products.

Within the FCA’s research, one firm stated that not all loans were attached to robust KPIs or considered “fit for purpose”, creating potential risks to market integrity and suspicions of greenwashing.

Conflicts of interest and weak incentives to issue SLLs

Borrowers may not value the financial benefits of a SLL relative to the costs of negotiating it. The penalty for investment grade borrowers when failing to meet sustainability KPIs was found to be ‘de minimis’, whilst SLL structures require additional services and associated costs, such as legal fees and costs to negotiate with lenders. The ambitious targets to promote SLLs and incentives linked to achieving sustainable financing, as highlighted above, may lead to a conflict of interest in testing the robustness of sustainability credentials.

What firms should do now

• The FCA letter concludes with an exhortation for industry-led action to help this nascent market scale with integrity. Therefore, banks should look for innovative ways to improve the robustness of sustainable performance targets (SPTs) and KPIs, and how they interrogate and challenge sustainability credentials.
• Borrowers using SLLs need to be transparent about the data sitting behind SPTs and KPIs, and how these link to transition plans and credible transition pathways to net zero. Assurability of these KPIs should be considered by both parties from when setting them, as assurance may be required as part of the contract.
• Both banks and borrowers need to ensure that there is high quality reporting of SPTs and KPIs linked to science-based targets and that published transition plans are an essential component of ensuring that SLLs are appropriately and meaningfully constructed. Without this, both the lender and the borrower run the risk of greenwashing.
• Banks should identify which SMF(s) are accountable and responsible for sustainability credentials and ensure that any sustainability concerns or data gaps on SLLs are escalated and dealt with effectively.

Conclusion

Alongside raising awareness of weaknesses, the FCA also points to developments which will help support the integrity of this market which is sure to continue growing, including the use of the updated Loan Market Association Sustainability‑Linked Loan Principles, the Climate Transition Finance Handbook and the work of the Transition Plan Taskforce.

Stakeholders should also consider the Science-Based Target Initiative’s recent consultations on creating a robust sustainable framework and guidance on how to set credible pathways and targets to reach net zero.

SLLs could be improved given all of the issues raised by the FCA. Therefore, banks should take to ensure that standards are raised and work with borrowers to address the issues highlighted by the FCA.