How banks put their transition plans into practice is attracting growing scrutiny as they seek to tap new transition financing instruments. Federico Pezzolato, Camille Roux and Masaki Kadowaki explain how ISS-Corporate is assessing their transition approaches and related issuance
Environmental Finance: The banking sector will play a central role in the net-zero transition. How are you assessing banks' approach to the transition?
Camille Roux: Despite the recent turmoil impacting the Net Zero Banking Alliance, launched in 2021, we've seen a growing number of banks committing to net zero, signalling increased efforts towards the transition and to aligning with the pathway to net zero by 2050. On the other hand, it takes significant efforts to move from a commitment to a real action plan, and we see that the sector is still in the early stages of a transition to a low-carbon economy.
For that, banks need to assess the transition plans of their borrowers. It is on this premise that we have developed our methodology to assess the transition frameworks of financial institutions. It considers both the bank's own decarbonisation strategy as well as its assessment of the transition plans of the companies that make up its loan books.
EF: What are the key considerations at the bank level?
CR: The main things we look for are a quantified climate transition plan, with short-, medium- and long-term targets to reduce their greenhouse gas (GHG) emissions, including both financed emissions (through direct lending) and facilitated emissions (through advisory and underwriting, for example). We focus first on financed emissions, as banks are only just starting to quantify facilitated emissions.
We look for a clear scope, in terms of what proportion of emissions are covered, and which sectors, businesses and geographies. We assess the bank's target-setting methodology, which climate scenarios are used, and whether the targets are aligned with 1.5°C and verified by a third party. The final consideration is the bank's action plan to reach these targets, including information on its exposure to high-emitting sectors, any sectoral phase-out targets or policies, and the extent of its locked-in emissions.
The second step is to assess the ability of the bank to screen and monitor corporate transition plans as borrowing companies progress through their transitions. This is essential for banks in their capital allocation decisions, in their corporate engagement and to deliver their own decarbonisation goals. Under our methodology, the bank must check whether its borrower's transition plan includes several key elements, such as a transition commitment, a quantified transition strategy and an associated delivery strategy, the impact on the core business and disclosure of climate-related impacts.
EF: Looking specifically at how banks are assessing their portfolios, what are the issues they are grappling with?
CR: This is the more challenging part. First, banks need to develop a whole governance structure to gather, analyse and monitor the relevant data at the borrower level throughout the life of their loans. Second, and as with all sustainable finance instruments, there are challenges around data availability and quality. The lack of data standardisation makes it difficult to compare transition plans from one borrower to another or across sectors, for example. The third challenge is that borrowers need to be actively pursuing a decarbonisation strategy, so are most likely to be companies in high-emitting sectors. This means that banks will be exposed to transition risks that stem from the increasing regulatory and market pressures these companies face.
EF: How does the approach you are taking align with existing market guidance?
CR: Currently, there is no single recognised transition finance standard for financial institutions. Our methodology leverages different frameworks and guidelines that have been developed by recognised organisations. They include the UK Transition Plan Taskforce, the International Capital Market Association (ICMA) Climate Transition Finance Handbook, the Glasgow Financial Alliance for Net Zero's Expectations for Real Economy Transition, the Climate Bond Initiative's Financing Credible Transitions paper, the European Commission Sustainability Reporting Standard, and the OECD Guidelines on Transition Finance. But new guidance is continually being developed, and we'll continue to update our methodology in response.
EF: How can banks integrate this assessment with their existing sustainable financing frameworks, and potentially use it to issue sustainable financing instruments?
EF: A number of banks have issued SLL financing bonds (SLLBs) – what are their motivations for this issuance?
Masaki Kadowaki: SLLBs are bonds issued to finance a selected portfolio of sustainability-linked loans. These SLLs themselves can be linked to any green or social key performance indicator (KPI) and sustainability performance target (SPT) but, to date, most have included decarbonisation goals. As such, they have the potential to be important transition finance tools.
We have worked with most of the financial institutions who have issued SLLBs, and we have ongoing mandates with others who are working on forthcoming issuances.
We see three motivations. The first is to contribute to the bank's sustainability effort and climate strategy; supporting their clients' climate transition plans helps banks achieve their Scope 3 emission reduction targets. ICMA's Sustainability- Linked Loans financing Bonds Guidelines require issuers to set a sustainability objective in the bond's eligibility criteria: if that objective is climate change mitigation, then the instruments help drive reductions in financed emissions.
The second motivation is that SLLBs help banks to showcase the ESG and sustainability governance of their SLL portfolios. Due to the private nature of those loans, the bank's due diligence processes and the quality of the KPIs or SPTs are not always disclosed. An SLLB sheds light on these processes, as the bank needs to disclose how it selects and evaluates the underlying SLLs.
Finally, from a financial perspective, SLLBs provide new liquidity to reinvest in other green, social or sustainability-linked assets. SLLBs are emerging as a complementary funding instrument to bridge the gap between asset origination and asset funding.
EF: What approaches are banks taking to structuring SLLBs?
MK: There are two approaches to structuring SLLBs. The first is to define the eligibility criteria of the SLL portfolio, mapped to the five core components of the Loan Market Association's Sustainability-Linked Loan Principles (SLLPs), especially with regards to how the KPIs and SPTs are assessed at the SLLB framework level. In addition, they need to define the KPIs and SPTs that they would like to incorporate into that particular framework.
The second approach is to have a selected portfolio of SLLs reviewed by an external reviewer, with each of the SLLs needing to align with the SLLPs. But then the heavy lifting of assessing the KPIs and SPTs for each SLL is done by external reviewers.
This approach trades this more in-depth assessment of each SLL for future flexibility. Every time a bank wants to add a new SLL to the SLLB portfolio, it will be expected to update the external review.
Currently, the market is dominated by the second approach. But the inquiries we are currently receiving are mostly for the first, and some banks are considering a mixed approach.
EF: What guidance should banks apply to SLLB issuance? What challenges do they face?
MK: SLLB's are guided by two sets of guidance: ICMA's guidelines, which set out how banks should formulate their frameworks before issuing an SLLB; and the SLLPs, which provide the minimum requirements for any underlying SLLs to be included in the portfolio. These two sets of guidance should ensure consistency, transparency and accountability in the issuance of SLLBs and assure their alignment with sustainability objectives.
From our conversations with market participants, most of the challenge lies in the underlying SLL selection. This is because guidance and market expectations have continued to evolve since the first SLLs were contracted, so banks need to have methods or processes in place to ensure that their underlying SLLs meet current market expectations, such as around what constitutes ambitious targets, or what KPI is considered 'Relevant, Core and Material', according to the SLLPs.
Banks need to be very clear on how they conduct ESG due diligence on their borrowers before structuring an SLL facility, how they identify, select and monitor eligible SLLs to be included in the SLLB, and how they communicate these processes to potential investors. For banks taking the first approach to SLLBs, they also need to consider the granularity of the KPIs and SPTs that investors are comfortable with, and borrowers are willing to commit to. Banks need to structure their SLLB framework in a manner that is sufficiently transparent to inspire confidence among their investors but also respect their borrowers' confidentiality.
EF: What are the key considerations for investors in assessing SLLBs specifically, and banks' transition financing frameworks more broadly?
MK: Investors will need to decide how comfortable they are with the level of transparency the banks offer and how much they trust the banks' ESG governance structures. In terms of tying SLLBs to transition finance, they will be looking for environmental KPIs that address carbon emissions reductions. In a broader sense, banks will need to explain how the SLLB fits in their wider transition strategy and, if possible, the extent of the financed emission reduction it contributes to.
CR: Investors will play an important role in supporting the banks in their own transition. When it comes to the transition framework itself, investors will pay specific attention to how the banks are assessing their borrowers' transition strategies and the project categories financed that are contributing to climate transition in order to deliver on their own financed emission reductions. Investors will hold the banks accountable for their long-term strategies.
EF: What developments are you anticipating in this part of the sustainable finance market in 2025?
FP: We are seeing considerable interest from banks on SLLBs and other transition financing instruments, and we're having conversations with banks in a variety of jurisdictions in Europe, Asia and the Middle East.
The market is evolving. Initially, issuers had very long and extensive lists of KPIs, for instance, or very large portfolios. Now, we are seeing a more specific approach, with a reduced number of KPIs or sectors considered, or a reduced number of loans with a recurring verification of the portfolio. As mentioned, issuers are also considering mixing the two approaches, so having a list of KPIs as well as portfolio reviews at the same time.
We see SLLBs as a useful instrument not just to finance the transition, but also to help banks' clients meet a number of their sustainability-linked objectives.
Federico Pezzolato, based in London, is global sustainable finance manager, Camille Roux, based in Paris, is sustainable finance research team lead, and Masaki Kadowaki is a Tokyo-based sustainable finance research associate at ISS-Corporate.
Learn more about ISS-Corporate's Sustainable Finance solutions here: www.iss-corporate.com/solutions/sustainable-finance
