Sustainability-linked loan (SLL) volumes have weakened since a surge in 2022. Moody's Ratings analysts Adriana Cruz Felix, Matthew Kuchtyak, and Jeffrey Sukjoon Lee explain why, sharing insights from Moody's Second Party Opinion portfolio and highlighting the path for resumed growth.
Environmental Finance: Why did SLL volumes fall last year following record volumes in 2022?
Matthew Kuchtyak: SLL volumes have been constrained by perceived reputational risks and administrative costs that can minimise the structure's financial benefits. In 2023, global SLL volumes tumbled 19% to $548 billion from a record-high of $677 billion in 2022.
Concerns around missed targets and potential greenwashing have discouraged some borrowers from entering the market. Moreover, reporting and verification costs may outweigh the potential price-adjustment benefit of some SLLs, which are linked to a borrower's achievement of sustainability performance targets (SPTs).
Lenders' tightening standards on the ambition of SPTs and concerns around the materiality of financial adjustments could also be deterring some companies from incorporating SLLs into their financing strategies. Although lender scrutiny has been intensifying, given banks' concerns around financing credible sustainability strategies, this scrutiny is less likely to influence SLL volumes than investor scrutiny of sustainability-linked bonds (SLBs), given the private nature of many SLL structures.
EF: Concerns around quality seem to be weighing on SLL volumes to some degree. What do Moody's Second Party Opinions (SPOs) tell you about SLL quality?
Adriana Cruz Felix: We conducted an analysis of our SPO portfolio as of 31 May 2024, which included 199 SPOs for financing frameworks and instruments from issuers across 47 countries.
Our SPOs provide a sustainability quality score (SQS) to indicate our opinion of the overall sustainability quality of a financial instrument or financing framework. An SQS combines an alignment with principles score, reflecting how well financial instruments or financing frameworks align with relevant sustainability principles and Moody's-identified best practices, and a contribution to sustainability score, reflecting the extent to which they are expected to contribute to the issuer's advancement of long-term sustainable development. An SQS is expressed on a five-point scale ranging from SQS1 (excellent) to SQS5 (weak).
SLL-only structures account for a modest 11% share of our portfolio of SPOs. Use-of-proceeds structures account for 74%, while sustainability-linked structures that include both bonds and loans (SLB-SLL) account for 13% (see Figure 1). There are striking differences in sustainability quality across the various structures we evaluate under our SPO assessment framework. Only 42% of SLL structures receive our highest sustainability quality scores of SQS1 (excellent) and SQS2 (very good), compared to 88% of use-of-proceeds structures and 78% of SLB-SLL structures. Despite the relatively small sample size, these differences in quality likely represent the more nascent status of sustainability-linked instruments generally and the private nature of many SLLs.
Figure 1: SLLs demonstrate lower quality than other structures in Moody's SPO portfolio
EF: What are some of the key drivers of SLL quality?
ACF: Frameworks with SLL structures include key performance indicators (KPIs) that reflect a wide spectrum of sustainability quality. This is illustrated by the distribution of their expected impact scores based on the relevance of KPIs and the ambition of SPTs (see Figure 2).
Figure 2: SLLs' KPIs demonstrate varied quality, with environmental KPIs more robust than social KPIs
Green KPIs tend to be more robust than social KPIs, with higher expected impact scores on average. The weaker quality of social KPI categories can generally be explained by their less ambitious SPTs, most likely because of the limited availability of comprehensive data and a lack of established reporting standards that would support the development of more ambitious targets.
SLL structures tend to score higher if they have KPIs that address an important sustainability issue for the company, sector and the local population, and cover a large share of the borrower's sustainability footprint. Additionally, high-quality SLL structures have ambitious SPTs that are likely to create a long-term and sustainable impact, with commitments to surpass business-as-usual trajectories, keep pace or outperform sector peers and adhere to internationally recognised standards.
An example of an SQS1 (excellent) quality framework that includes an SLL structure is the SPO for Helen Oy, a power and utilities company based in Finland. The strong KPIs, which aim to reduce greenhouse gas emissions, are very relevant based on the critical importance of lowering emissions for the company, coupled with the KPIs' broad coverage of more than two-thirds of the company's carbon footprint. Moreover, the framework's SPTs demonstrate a high level of ambition for achieving long-term sustainability goals. The strength of the SPTs are underpinned by their alignment with science-based targets, and the company has credible implementation plans for achieving its climate goals.
EF: How does alignment with market standards influence your view of sustainability quality among SLLs?
Jeffrey Sukjoon Lee: The quality of SLL structures is influenced by their commitment to observe recommended voluntary market guidelines that promote transparency, disclosure and integrity, such as the Sustainability Linked Loan Principles (SLLP). All frameworks with SLL structures evaluated under our SPO assessment framework are in line with the SLLP, and about one-third reach the best practices score by committing to best-in-class market practices on accountability and transparency.
About 91% of SLL structures demonstrate best practices in the verification process by committing to verify the performance of KPIs throughout the life of the loan. However, about half of these frameworks fall short in meeting best practices around a KPI's measurability and verifiability, often because of the absence of an external reference that allows for benchmarking and verifying historical data. In addition, about one-third of frameworks with SLL structures do not attain best practices for SPT consistency and ambition, largely related to the credibility and disclosure of the borrower's implementation plans to achieve the targets.
EF: How are corporate decarbonisation plans being advanced through the SLL structure? Are companies prioritising KPIs for greenhouse gas emissions?
JSL: SLL structures can be an important financing tool for carbon transition plans. The increasing efforts of companies to formalise their decarbonisation plans and incorporate KPIs to advance climate mitigation goals are visible across our portfolio. Among frameworks that include SLL structures, the most frequently included KPI category is for greenhouse gas emissions reductions, which features at least once in about 72% of these structures.
Emissions KPIs demonstrate higher quality than other environmental and social KPIs on average. This reflects the almost universal relevance of climate change mitigation efforts across sectors, as well as the availability of more established guidelines and standardised market reporting on emissions levels, which can help borrowers develop credible SLL structures with ambitious targets. However, emissions KPIs score lower in relevance, largely because of KPIs that cover a narrow portion of the company's overall emissions footprint, for example, by excluding material Scope 3 emissions.
Another high-profile SLL-focused SPO is that of PB Vessels Holding Ltd. (SQS2), a maritime transport company headquartered in Hong Kong SAR, China. The KPIs, which focus on reducing greenhouse gas emissions and improving employee health and safety, address material sustainability hurdles facing the shipping industry. However, the greenhouse gas emissions reduction KPI only covers Scope 1 emissions from the company's owned fleet and excludes its chartered fleet and Scope 3 emissions, covering only about 36% of the business' total carbon footprint. The expected impact of the KPI is boosted by the framework's ambitious SPTs, which reflect a significant improvement from the company's business-as-usual emissions trajectory and surpass its sector peers' carbon-intensity reduction targets. Moreover, the company's SPTs and transition pathway are in line with a 1.5°C trajectory and consistent with internationally recognised benchmarks for its sector.
The quality of SLL structures is likely to improve as companies establish stronger sustainability strategies and ratchet up decarbonisation commitments amid growing exposure to carbon transition and physical climate risks. This sharpened focus is evident from the sector composition of SLL structures in our SPO portfolio. While the SPOs cover a broad range of sectors, companies in sectors that have very high or high inherent exposure to carbon transition risk account for 38% of the SLL structures in our portfolio, compared to 14% of use-of-proceeds structures.
EF: How does Moody's expect the quality of SLLs will develop?
MK: The quality of SLLs is likely to build over time with the support of initiatives to enhance their transparency and strengthen credibility. Updates to the SLLP in 2023, which seek to improve comparability with other sustainable debt instruments, address some of the market's concerns around the quality and ambition of SLLs.
The changes to the SLLP bring it closer to the standards of the equivalent set of principles for sustainability-linked bonds, aligning guidance for improving the quality and standardisation of sustainability-linked structures. Some key updates to the SLLP included recommendations that could enhance the ambition of SPTs, such as setting an SPT per KPI for each year of a loan term and encouraging SLL targets to exceed both regulatory required targets and business-as-usual targets. The latest guidelines also intend to improve transparency by broadening annual reporting requirements to include a sustainability confirmation statement with a verification report that covers SPT performance, and encouraging SLL verification by an external reviewer until the last SPT trigger event of the loan has been reached.
Increased regulatory scrutiny of SLLs and reporting disclosure requirements could also help boost quality. In June 2023, the UK's Financial Conduct Authority (FCA) identified what it views as key weaknesses that could weigh on the SLL market's growth potential, such as greenwashing concerns, conflicts of interest and weak incentives to use SLLs. The FCA said that a more prescriptive framework, including meaningful science-based targets, uniform disclosure and independent monitoring and verification of targets would help build trust.
Mandatory disclosure standards across jurisdictions could also help bolster SLL quality. Regulators are increasingly requiring companies to disclose information related to climate and sustainability considerations. Standardised disclosures and data will likely enhance investor understanding of sustainability information and reinforce best practices in the SLL market, with potentially greater use of third-party audits. In addition, companies may increasingly apply the disclosed data toward developing stronger KPIs and SPTs in their SLL structures.
Matthew Kuchtyak is a vice president and regional manager for Americas second party opinions for Moody's Ratings, based in New York, Jeffrey Sukjoon Lee, is vice president and regional manager for APAC second party opinions, based in Singapore, and Adriana Cruz Felix is vice president and regional manager for EMEA second party opinions, based in Paris.
For more information, see: https://ratings.moodys.io/products/spo
