Are sustainability‐linked loans designed to effectively incentivize corporate sustainability? A framework for review

• Published date: 01 December 2023
• Author: Alix Auzepy,Christina E. Bannier,Fabio Martin
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/fima.12437

DOI: 10.1111/fima.12437

ORIGINAL ARTICLE

Are sustainability-linked loans designed to

effectively incentivize corporate sustainability? A

framework for review

Alix AuzepyChristina E. BannierFabio Martin

Institute of Financial Services, University of

Giessen, Licher Strasse74, Giessen, Germany

Correspondence

Fabio Martin, University of Giessen, Institute

of Financial Services, Licher Strasse74, 35394

Giessen, Germany.

Email: fabio.martin@wi.jlug.de

Fundinginformation

Alix Auzepy acknowledges the funding

provided as part of the research fund

Klimaschutz und Finanzwirtschaft (KlimFi) of

the German FederalMinistry of Education and

Research (GrantNo. 01LA2210C).

Abstract

This paper analyzes sustainability-linked loans (SLLs), a new

category of debt instrument that incorporates environmen-

tal, social, and governance (ESG) considerations. Using a

large sample of loans issued between 2017 and 2022, we

assess the design of SLLs by evaluating their key perfor-

mance indicators (KPIs) using a comprehensivequality score.

Our findings suggest that SLLs only partially rely on KPIs

that generate credible sustainability incentives. We docu-

ment that SLL borrowers do not significantly improve their

ESG performance post issuance and show that stock mar-

kets are rather indifferent to the issuance of SLLs by EU

borrowers, while SLL issuance announcements by US bor-

rowers are met with significantly negative abnormal returns

by investors. These findings call into question the beneficial

sustainability and signaling effects that borrowers may hope

to achieve by issuing ESG-linkeddebt.

KEYWORDS

ESG-linked loans, sustainability KPIs, sustainability-linkedloans

Thisis an open access article under the terms of the Creative Commons Attribution- NonCommercial-NoDerivs License, which permits

use and distribution in any medium, provided the original work is properly cited, the use is non-commercial and no modifications or

adaptations are made.

© 2023 The Authors. Financial Management published by Wiley Periodicals LLC on behalf of Financial Management Association

International.

Financial Management. 2023;52:643–675. wileyonlinelibrary.com/journal/fima 643

644 AUZEPY ET AL.

1INTRODUCTION

A recent development in the realm of corporate finance is the emergence of debt instruments that incorporate

environmental, social, and governance (ESG) considerations.These instruments serve two primary purposes: procur-

ing capital and fostering corporate sustainability practices. One category of such instruments, sustainability-linked

loans (SLLs),1is particularly distinct from other emerging instruments such as green bonds, social bonds, and green

loans. Unlike these instruments, whose proceeds haveto be allocated toward environmentally or socially responsible

projects, SLLs are general corporate purpose loans. The issuance of SLLs is therefore not characterizedby their use of

proceeds, but by the borrower’s performance against predefined ESG targets.

Achievement of these targets is measured by key performance indicators (KPIs), which typically impact loan

pricing in the form of an interest rate discount or premium. The Loan Market Association (LMA), which published

the Sustainability-Linked Loan Principles (SLLP) as a set of voluntary guidelines for market practitioners, defines

SLLs as “any types of loan instruments and/or contingent facilities for which the economic characteristics canvary

depending on whether the borrower achieves ambitious, material and quantifiable pre-determined sustainability per-

formance objectives” (LoanMarket Association, 2023b, p. 2). The primary objective of SLLs is therefore to support the

borrower’s efforts to improve its sustainability profile overthe life of the loan (Loan Market Association, 2023b).

While SLLs havegained increasing popularity, accounting for approximately 10% of the global corporate syndicated

loan market in 2021 (Kim et al., 2023), there is still limited understanding of the specific characteristicsof the sustain-

ability KPIs that are included in these contracts. This aspect is particularly relevant when considering that SLLs can

be tied to multiple KPIs covering a wide range of ESG issues. At a time when there is growing concern about green-

washing practices (Carrizosa & Ghosh, 2022; Kim et al., 2023), it is critical to gain more clarity on whether—and if so,

which—KPIs are credible and meaningful for achieving sustainability goals.

This is where our paper seek to contribute. By providing a detailed analysis of KPI characteristics,we aim to further

the discussion on the effectiveness of SLLs in promoting ESG activities beyond “business as usual” (LoanMarket Asso-

ciation, 2023a, p. 3). Specifically,we evaluate the design of KPIs in ESG-linked loan contracts along six key dimensions

derived from the SLLP.We then use this evaluation as a basis for investigating whether the issuance of SLLs positively

incentivizes borrowers to improve their sustainability performance expost. In addition, we examine whether SLLs are

perceived by the stock marketas credible signals of corporate commitment to ESG considerations.

Our study is based on a sample of SLLs extracted from the Refinitiv DealScan database. We focus on borrowers

headquartered in the European Union and the United States for both historical and regulatory reasons. From a histor-

ical perspective, the emergence of SLLs, which were virtually nonexistent prior to 2017, saw a rapid increase in total

issuance volume, rising from over $2 billion in 2017to more than $310 billion by the end of 2021.2This growth trend

was particularly pronounced in Western Europe in the early yearsand later spread to other regions of the world, most

notably the United States (Kim et al., 2023). While current regulations do not specifically require companies to report

comprehensive information about their credit agreements, the existingregulatory frameworks in both the EU and the

United States still create important incentives for disclosure. In the EU, for example, large companies are required

to disclose environmental and social policies in their nonfinancial statements. Large US corporations proceed simi-

larly. Such disclosures allow us to obtain detailed information about the issuance of SLLs and the KPIs set forth in

those contracts.

In the first part of this paper,we examine whether the design of KPIs creates credible incentives for companies to

improvetheir sustainability practices. We address this question by developing a qualitative scoring methodology along

six key dimensions: (1) strategicrelevance, (2) materiality, (3) measurability, (4) benchmarking, (5) pricing mechanism,

and (6) external review. These dimensions serve as a frameworkthat outlines distinct criteria that, according to the

1SLLsare also sometimes called “ESG-linked loans.” We use the terms interchangeably throughout this paper.

2Kim et al. (2023) capture a similar trend by documenting a rapid increase in ESG lending activity from 2017 to 2021, with most of the SLL borrowers

concentratedin the United States and Western European countries.

AUZEPY ET AL.645

LMA, SLLs should meet in order to be considered credible (Loan Market Association, 2023b). Our analysis delivers

a multidimensional KPI score per loan that can be used to assess and compare the quality of the incentives defined

in the SLLs. As each dimension captures unique information that contributes to a comprehensive understanding of

the KPIs’ credibility, our approach is consistent with the recommendations of Edmans (2023), who calls for granular

assessments in ESG-related studies.

The results of our KPI analysis suggest that SLLs only partially rely on KPIs that create credible sustainability incen-

tives. In particular, our results show significant variation across the dimensions assessed in our framework. On the

positiveside, we find that most SLLs include KPIs that are strategically relevant and part of the borrowers’ existing sus-

tainability strategies: Only 22% of SLLs feature KPIs that do not match the borrowers’ stated sustainability objectives

or priorities. This suggests that firms employ SLLs as a holistic approach to further integrate existing ESG consider-

ations into corporate operations. In addition, we observe that the vast majority of SLLs are tied to measurable and

objectively quantifiable KPIs that allow lenders to easily track performance against the selected KPIs.

However,on the negative side, our materiality assessment against the Sustainability Accounting Standards Board

(SASB) standards shows that 42% of the SLLs in our sample are linked to KPIs that are not financially material. This

indicates a misalignment between the sustainability goals that the SLLs seek to achieve and the sustainability con-

siderations that are most likely to impact the company’s financial performance. In addition, only 15% of the SLLs in

our sample are clearly benchmarked, suggesting a lack of reference points for setting the KPIs. As a result, key stake-

holders, including investors, may not be able to objectively assess and compare the levelof ambition of the KPIs. Our

analysis furthermore reveals mixed results with respect to the pricing mechanism and external review of the KPIs.

While 40% of the SLLs in our sample explicitly include a malus system that requires borrowers to pay higher interest

rates if they fail to meet their sustainability targets, we find that 17% include only a bonus and no financial penalty.In

addition, only half of the SLLs in our sample are linkedto KPIs that are subject to external and independent verification

at least annually.

Overall, the SLLs in our sample achieve an average KPI score of 3.47 on a scale of 0 to 6, suggesting that these

debt instruments are only partially designed to incentivize sustainability efforts by their borrowers. Surprisingly,

we observe that the number of KPIs that are included in a loan is negatively associated with this score. While

companies may fear that focusing on only a small number of ESG objectives could signal a weaker commitment to

sustainability, increasing the number of KPIs actually seems to make such instruments less effective in improving

sustainability incentives.

In the second part of our paper, we empirically test whether the issuance of SLLs is associated with a positive

ex post change in borrowers’ ESG performance. To do so, we employa difference-in-differences design based on a

matched sample. Toidentify the relationship between SLL issuance and ex post ESG performance, we use a two-way

fixed effects (TWFE) estimator that compares SLL issuers to a control group of conventional borrowers before and

after the treated firms issued their first SLL. Our analysis relies on several ESG performance metrics obtained from

Morgan Stanley Capital International (MSCI), including the overall industry-adjusted total ESG scores and environ-

mental, social, and climate change pillar scores. We primarily examine these performance metrics to account for the

fact that most KPIs in ESG-linked loan contractsrelate to environmental and social issues (58% and 25% of all KPIs in

our sample, respectively), while governance-relatedKPIs make up only 1.35% of our sample. In addition, about 17% of

the KPIs in our sample are linked to ESG ratingsor similar certifications.

Our results show that the issuance of SLLs is not associated with a significant change in the ex post ESG perfor-

mance of the borrowers. In other words, we observe neither an improvementnor a deterioration in ESG performance.

This holds also when looking at the overall ESG score and the scores of each pillar separately.We repeat our anal-

ysis by measuring the weighted group time average treatment effect on the treated (ATT),as proposed by Callaway

and Sant’Anna (2021). This procedure allows us to address concerns about the reliability of the TWFE estima-

tor in ordinary least squares (OLS) (Baker et al., 2022; de Chaisemartin & D’Haultfœuille, 2020). Once again, the

ATT coefficients are statistically insignificant, confirming our earlier findings and suggesting that SLLs are not asso-

ciated with a subsequent change in ESG performance. Overall, these results indicate that the issuance of SLLs