Despite widespread deterioration in the US credit markets in 2022, sustainability-linked and green loan issuance held up strongly in the face of building macroeconomic uncertainty.
Sustainability-linked loan (SLL) issuance, where interest rate margins ratchet up or down in line with performance against preset key performance indicators (KPIs), was down by just 12% year-on-year in 2022 at US$205.8 billion. In the smaller US green loan market, where loan proceeds are used exclusively to fund eligible environmental projects, issuance was up 46% year-on-year, reaching US$25.4 billion in 2022.
The strong performance of the SLL and green loan markets in the US stands in stark contrast to the contraction in the overall US loan issuance—leveraged loan activity was down by almost a quarter (24%) year-on-year in 2022 at US$1.1 trillion.
Resilient SLL and green loan activity in 2022 firmly established these products as mainstream lending options, consolidating the gains made during the pandemic when environmental, social and governance (ESG) moved up the corporate and investor priority list. Although US SLL issuance was slightly down year-on-year, the market is now over ten times bigger than it was pre-pandemic, while the green loan space has grown exponentially from the US$369.4 million of issuance in 2019.
SLLs and green loans are well positioned to build on these gains in 2023 and beyond as corporations, investors and the US government continue to focus on mitigating the impacts of climate change and facilitating the transition to decarbonized energy.
The Biden administration’s Inflation Reduction Act is expected to be a major spur for ongoing SLL and green loan activity, unlocking more than US$386 billion in energy and climate-related investment in the next 10 years, according to Goldman Sachs.
Private sector investment flows into ESG-labeled assets are also growing, further supplementing the capital available for SLLs and green loans. According to Morningstar, global ESG assets under management climbed 12% between Q3 and Q4 2022 to reach US$2.5 trillion, nearly double the growth of the overall global fund market, reflecting the rising demand among retail and institutional investors for funds designed to deliver positive ESG outcomes in addition to financial returns.
As SLL and green loan financing have become increasingly embedded in mainstream credit markets, and investors and lenders have become more familiar with the KPIs and performance targets that trigger margin ratchets and, for green loans, use of proceeds criteria, the expectations around ESG reporting, standards and materiality have increased.
This has been especially intense in the SLL space. Unlike green loans, where proceeds are allocated to qualifying projects as defined by the Green Loan Principles—published by the Loan Market Association (LMA) in partnership with the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications & Trading Association (LSTA)—the SLL space is more fluid.
Use of proceeds are not restricted to issuers from so-called “green industries” and KPIs and overall ESG performance can be broadly defined. This has raised concerns around greenwashing risk, with lenders and investors eager to avoid situations where regulators could take a view that one or more SLL financings does not meet the SLL principles requiring a commitment to a meaningful, genuine ESG strategy.
Parties are also grappling with the materiality of margin ratchets, questioning whether they are significant enough to effect change. As a result, there is increasing scrutiny around how parties are assessing compliance with pre-agreed sustainability KPIs and whether these KPIs are relevant and ambitious enough.
For their part, lenders are looking to move away from issuers setting and reporting on ESG KPIs without independent or third-party verification, especially in light of recent academic research showing that disclosure of SLL contractual details is often Iimited and inconsistent, and that borrower ESG scores may deteriorate after SLLs are issued.
Closing the gaps
After the rapid growth of SLL issuance in 2020 and 2021, the market and regulators are now putting measures in place to address these concerns and to ensure that SLLs are credible and subject to more rigorous oversight.
On the regulatory front, the US Securities and Exchange Commission’s (SEC) proposals to enhance and standardize climate-related disclosures made by all SEC registrants will raise the bar for public SLL and green loan issuers, although it may take time for the SEC to complete the consultation period before moving forward, as more than 15,000 comments on the measure were submitted.
Meanwhile, the Office of the Comptroller of the Currency has also upped its climate risk oversight by appointing Dr. Yue (Nina) Chen as Chief Climate Risk Officer to assess climate-related financial risk in the banking sector.
As for steps taken by the market, stakeholders report that an independent third party setting and verifying KPI compliance is becoming a standard feature in SLL documentation, and that ratchet structures are increasingly allowing for margins not only to come down when KPIs are reached, but also to go up if they are missed. A potential margin increase more closely matches the approach in the sustainability-linked bond market where only an increase to margin following a failure to meet sustainability performance targets is the norm.
Lenders and investors are also insisting that if companies take advantage of ESG amendment options when loans close (which allow for KPIs to be set at a later date), the time frames for KPI implementation should be specifically defined and not open-ended. The LMA, APLMA and LSTA, meanwhile, recently updated the SLL guidance and principles, covering the selection and calibration of KPIs, and reporting and verification guidelines.
With no single body responsible for oversight of the SLL market and given that there is still work to be done to tighten standards, stakeholders are taking steps to fill the gaps and ensure that the market has the credibility to build on the momentum of recent years.