Ashurst's sustainable finance column: July 2023

First published on Thomson Reuters Regulatory Intelligence on 7 July 2023

The FCA published its findings at the end of June 2023 following a review of the sustainability-linked loans (SLL) market. We thought the publication deserved a column because it demonstrates regulatory creep in action. The FCA noted that its ESG strategy includes taking action on themes of building trust and integrity in sustainability-labelled instruments. In addition, it has regard to the government's commitment to achieving a net zero economy by 2050. For more information about the FCA's ESG strategy, see Practice note, Hot topics: UK regulation of sustainable finance: FCA ESG strategy.

Although the FCA does not regulate the SLL market directly, it wants to ensure the sustainable finance market generally works well, and that market integrity is maintained. Recent negative media coverage of the SLL market has highlighted potential market integrity concerns. The FCA reported that a number of firms they spoke to indicated that the classification of SLLs varies considerably between banks. In one case, a firm considered that of 250 SLL transactions completed in 2022, only 30% were deemed "fit for purpose", and that in 50% of cases, KPIs were not robust. Certain sectors of the market were also apparently slow to develop.

The FCA noted it had two principal areas of concern:

(i) credibility, market integrity and greenwashing and

(ii) conflicts of interest and weak incentives to issue SLLs.

As a result, earlier this year the FCA engaged with a number of stakeholders to better understand the functioning of the SLL market, gather intelligence on the SLL market from key stakeholders and determine what measures might improve the market integrity of SLL products. Having concluded this work, the FCA has shared its findings with stakeholders.

The key findings of the FCA's review include:

• Not realising potential. While a number of banks are keen to promote SLLs, the market is currently not achieving its potential. Increased trust and transparency could deliver wider uptake.
• Borrower concerns. Borrowers are concerned about unwelcome scrutiny if they miss performance targets. They may also consider the time and costs of doing an SLL against a more conventional loan.
• Weak incentives to issue SLLs. Against the backdrop of trust and integrity concerns, the incentives for a borrower to seek an SLL may be low. Small savings on margins may be outweighed by costs and negotiation time with lenders or legal advisors. Some borrowers also seem to be wary of the heightened scrutiny that comes with specifying sustainable performance targets (SPTs) and KPIs.
• Market participants the FCA spoke to believe that a more prescriptive framework would improve market integrity. A more prescriptive framework offers credible transition plan disclosures that could be leveraged to inform the design of SPTs and KPIs in sustainability-linked instruments and products. This could include more meaningful, science-based targets and transition pathways. This may reduce the threat of greenwashing accusations.
• There is the potential for conflicts of interest as there is a general sentiment among banks that the "relationship" may matter more than the borrower's sustainability credentials. This may therefore disproportionately drive the bank's decision to participate in the loan. As banks seem keen to promote SLLs, they may be more inclined to accept weak targets and count the loan as part of their sustainable finance quota.
• Several banks are advocating for uniform disclosure and independent monitoring and verification of targets. This could include well disclosed targets aligned to borrowers' published transition plans.

It was not all bad news as the FCA did note that some of these issues have been addressed by the recently published Loan Market Association's (LMA) Sustainability-Linked Loan Principles (SLLP), which had been positively received and which they believe the adoption of will assist the growth and development of a trusted market. For more information, see Practice note, Sustainability-linked loans.

The FCA will continue to monitor this market, as part of its wider work on transition finance, with a view to considering the need for further measures to support the development of a robust transition finance ecosystem.

The FCA has no current plans to introduce regulatory standards or a code of conduct for this market, however, it will reconsider this if the market needs it. As a reminder, firms will be subject to an anti-greenwashing rule that comes into force on the publication of the sustainability disclosure requirements (SDR) this autumn and which is likely to apply to SLLs issued by a firm. For more information about the anti-greenwashing rule, see Practice note, Hot topics: proposed FCA sustainability disclosure requirements (SDR) and labelling regime: New anti-greenwashing rule.

This is an important publication from Sacha Sadan, Director of ESG at the FCA, and shows the breadth of scrutiny that their ESG agenda is driving.

For details of other sustainable finance columns written by Ashurst, see Practice note, Ashurst's sustainable finance column.