Structurally unsound? Questioning the sustainability-linked loan boom

Structured products are the berserkers of the financial world: complex instruments that behave wildly in choppy markets and are prone to spinning out of control. Think of the collateralised debt obligations (CDOs) that detonated in 2008, leaving Wall Street in ruins.

When they blow up, structured products scorch more than the balance sheets of issuing dealers. They also burn the reputations of the structures themselves, scaring counterparties off anything built similarly and setting back financial innovation.

Today, banks are touting instruments akin to structured products to facilitate firms’ green goals: sustainability-linked loans (SLLs) and sustainability-linked derivatives (SLDs).

SLLs are credit instruments for which the repayment rate is tied to the achievement of a sustainability performance target (SPT). SLDs, the first of which was issued by ING in 2019, do the same with the swap rate charged to clients. Their purpose is to incentivise borrowers to become more sustainable by offering them a discount on repayments.

It’s a noble goal, and the structures craftily align firms’ economic and moral impulses. Small wonder that they’ve exploded in popularity. SLL volumes hit $133.4 billion in 2019, up 178% on the prior year, according to Bloomberg. Last month, French bank BNP Paribas made a splash by agreeing the first SLL with the aviation industry: a revolving credit facility (RCF) of $550 million with US carrier JetBlue. Also in February, US asset manager Neuberger Berman struck a $175 million RCF with lead arranger MUFG, a Japanese bank.

SLLs and SLDs are buzzy, innovative products. They’re clearly generating a lot of heat. It’s obvious the stable of green financial products needs to be expanded and this should be encouraged, et cetra et cetra.

Nonetheless, I have my reservations. Three, in fact.

Gaming Theory

First, SLLs and SLDs include some of the concerning features of structured products. And no, I don’t mean they’re ticking time bombs about to blow apart their issuers. But losses are possible, which could hurt the cause of sustainable finance.

From the issuer’s perspective, SLLs are assets linked to an interest rate plus an external indicator: the SPT. Structured products are typically zero-coupon bonds with payoffs linked to the performance of an external derivative or index. Catch my drift?

What’s the problem, then? The risk is that this external component – the SPT – could be gamed.

Monitoring of a firm’s SPTs is often conducted by a respected third-party, or at least audited by one. In the case of ING’s inaugural SLD, it’s Sustainalytics, a leading provider of ESG data. The BNP Paribas-JetBlue deal is arbitrated by Vigeo Eiris, an ESG ratings agency majority-owned by Moody’s.

This arrangement sidesteps the conflicts of interest that would arise should one of the SLL/SLDs counterparties have ownership of this process. But the extraction of an ESG “score” from non-economic information is a subjective process, hostage to the house effects of each ratings firm and potentially vulnerable to manipulation.  

An ESG ratings agency may weight one aspect of a firm’s sustainability performance over another, meaning a SLL borrower’s overall SPT progress could be determined by a small clutch of factors rather than its sustainability efforts in the round. If a corporate identified these keystone factors, it could try to alter them in its favour.

For example, an ESG rating agency may emphasise efforts to cut greenhouse gas (GHG) emissions in its score calculation, or GHG reduction may be an explicit SPT of an agreed SLL. Knowing this, a firm may report GHG data in such a way that it appears big savings have been made year-on-year, when in reality part of the deduction was because it changed what was included in the scope of emissions, or thanks to unverified carbon offsets.

It’s a hypothetical, but not an outlandish one. Last decade, proprietary index products were all the rage: structured products where the payoff was linked to a rules-based strategy cooked up by the issuing bank or third-party provider.

They attracted tough scrutiny after Swiss bank UBS was accused by the US Securities and Exchange Commission of making false and misleading disclosures about the performance of its V10 currency index, which was tied to a slew of structured notes. UBS traders allegedly manipulated the index, depressing its performance by 5%, and did not disclose to investors that its own employees had the ability to nudge the index up or down.

True, this was a case concerning an issuer of retail structured products, and the SEC complaint was centred on misstatements and omissions in disclosures, rather than the act of manipulation itself. But it’s not hard to imagine a similar scenario playing out in the institutional SLL/SLD market. A corporate may be able to hoodwink an ESG rating agency to overstate its SPT progress, especially if the latter relies solely on public reports and has no power to compel additional disclosure. Even if it were privy to non-public data, this could still be skewed in the firm’s favour.

This would ultimately redound to the issuing bank’s detriment, as it would unjustly lose money on the loan repayment. The earnings hit may be slight – the discounts offered on SLLs I’ve seen reported on are typically between five and 10 basis points – but the reputational damage to the product class itself could be far greater. It’s tough to imagine many SLLs being on offer following a story in which a bank is bilked out of thousands, if not millions, of dollars in repayment fees.  

Furthermore, if an ESG rating agency’s scoring methodology is a black box, there’s scope for all kinds of disagreements, complaints, and skulduggery by both bank and counterparty to prod the score in their favour. The use of SPTs to determine client rates also makes SLLs and SLDs unhedgeable. A bank can’t protect itself from losses as there’s no derivatives market for tailored, non-economic ESG scores.

Where there’s green, there’s greenwashing

The second reservation is linked to the first. SLL/SLDs may allow for “greenwashing” — the practice of relaying misleading information on a firm’s sustainability. An SLL counterparty could tout the agreement of a loan as evidence of its wholesomeness, though it may not be taking effective action to improve its sustainability profile.

Take the example of an SLL where the firm’s discounted repayment rate is contingent on it maintaining its current ranking in the UN-backed Principles for Responsible Investment (PRI) assessment report of ESG integration efforts — a benchmark measure of sustainability. If the SLL repayment is tied to keeping its score rather than improving its score, then the firm is being rewarded for standing still on sustainability.

Similarly, in the case of an external ESG score determined by a third-party, if the required score to win a discount is the same as that recorded at the deal’s inception, then an SLL cannot be said to incentivise firms to become more sustainable.

There are ways to combat this. In March 2019, the Loan Syndications and Trading Association, Loan Market Association and Asia Pacific Loan Market Association published sustainability-linked principles to set standards and best practice for these instruments. The principles state that the SPTs used to set the repayment rate should be “ambitious and meaningful to the borrower’s business and should be tied to a sustainability improvement in relation to a predetermined performance target benchmark”.

But there are other ways SLLs can allow greenwashing. Typically, these loans are used for general corporate purposes — meaning they can fund any and all activities of the borrower. This is in contrast to green bonds, the proceeds of which are usually earmarked for specific green projects.

Put simply, this means a corporate can agree an SLL, trumpet it to the world as evidence of its greenness, but use the funds to do whatever it wants — sustainable or otherwise. It’s even possible that a firm could use the proceeds to fund unsustainable activities, like to buying fossil fuel, but by making efforts to improve its SPTs in other areas still bag a discount on its repayment rate.

Dude, where’s my impact?

My third reservation concerns the impact of sustainability-linked products. How much can they really move the needle? Take the example of the sustainability-linked RCFs struck year-to-date. Like a credit card, they allow firms to borrow money as needed to fund everyday operations and are used to cover shortfalls at times when revenues fluctuate. They’re important, sure, but not central to firms’ funding plans. For example, last year JetBlue disclosed RCFs with Citibank and Morgan Stanley for up to a combined $625 million. Its 2018 annual report said neither had been tapped that year or in 2017.

If the proceeds of an SLL, or the exposure hedged by an SLD, are not material to a firm, then the product may be incapable of driving sustainability improvements. Instead, they may simply allow the firm to secure cheaper funding by adding an additional layer of bureaucracy to the repayment process. Savvy, but no way to save the planet.

I’m all for financial innovations that champion sustainability. But I’m not for products that pay lip-service to the notion and, worse, create opportunities for foul play and reputational fallout. SLLs may be the darling of sustainable finance today. It’s possible they’ll become its bugbear tomorrow.

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This column reflects the views of the author alone and are not those of the financial publications with which they are associated.

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