How sustainability loans become unsustainable

Behind sustainability pledges, some loans offer banks easy applause while letting borrowers quietly slumber

Featured faculty: Cao Ying and Zhu Chunmei
Written by Sally Ho

The Net Zero Banking Alliance (NZBA) was short-lived. Founded in 2021, the alliance pledged to align its lending with net-zero emissions by 2050. Unfortunately, after major founders such as Bank of America, Citigroup, Morgan Stanley, HSBC, Barclays, and UBS pulled out, the alliance of more than 140 banks met its demise late last year.

As the union disbanded, former members reiterated their commitments to net-zero independently. Many see the breakup as a setback as the major banks stepped away from climate change initiatives, while a few saw it coming. The voluntary nature of the alliance may have created incentives for appearances rather than action and transparency.

“The net-zero commitments within the NZBA are largely self-implemented. The pressure to meet these targets can encourage the use of loan contracts that are less effective in working with borrowers to drive actual sustainability outcomes,” says Cao Ying, Associate Professor of Accounting at the Chinese University of Hong Kong (CUHK) Business School.

Professor Cao finds that the race to decarbonisation has made the alliance members more aggressive in issuing sustainability-linked loans (SLLs), where banks and borrowers agree on key performance indicators and targets for environmental, social, and governance (ESG). Borrowers will get a lower interest rate once the tailored achievements are met.

“Sustainability-linked loans can drive sustainability practices only if both lenders and borrowers see the targets as important as the loans.”

Professor Cao Ying

Unlike green loans that restrict proceeds to eco-friendly projects, SLLs provide funding with interest linked to broader environmental, social, or governance metrics. For example, a borrower can set social targets to reduce workplace accidents and improve employee health and safety, or aim for a governance target by increasing the percentage of female board members or top managers.

However, borrowers may also set indicators and targets later, known as “sleeping” SLLs. By agreeing to this provision, lenders allow borrowers to set up more workable metrics after the loan has started. Oddly, banks were more likely to issue sleeping rather than standard SLLs after joining the NZBA.

In a new study, Lender effect on SLLs — Evidence from sleeping SLLs, Professor Cao finds that sleeping SLLs have surged since the NZBA was established, peaked in 2022, and declined the following year, after the global trade associations ruled to treat sleeping SLLs as conventional loans until the sustainability metrics are verified.

Addressing the sleeping elephant in the room

Along with Zhu Chunmei, Assistant Professor of Accounting at the School, Lin Yating, PhD student at the School, and Christopher Williams of the University of Michigan, Professor Cao discovers that sleeping SLLs accounted for more than half of 403 SLLs issued to US public companies in 2017-2023. These sleeping loans were issued by 29 US lenders, dominated by Bank of America, followed by JPMorgan and Wells Fargo.

Regardless, only less than eight per cent of these sleeping SLLs were “awakened”. Borrowers with sleeping SLLs also had smaller emission reductions from their own operations and the energy they purchase, and showed less improvement in ESG ratings than those with non-sleeping SLLs.

Practicality could be the reason. Companies may need better data, internal approval, or an external reviewer before they can agree on credible yet achievable goals, but further analyses refute these excuses. Borrowers continued to use sleeping SLLs after more state governments announced Greenhouse Gas Emissions Reduction Targets and issued Climate Action Plans.

These borrowers also kept signing sleeping SLLs even after disclosing their environmental data to the global non-profit Carbon Disclosure Project, or setting net-zero targets through the Science Based Targets initiative, signalling that such tardiness may be strategic instead of a lack of capacity. Concerns then arise over whether such loans can truly improve ESG performance when targets have not yet been set.

“Sleeping SLLs are essentially conventional loans with extra sustainability labels, but that does not necessarily mean they are being deceptive,” says Professor Cao. “As outsiders, we are not fully aware of the reasons that lead to the signing of sleeping SLLs. The bank and the borrower might be willing to engage in ESG activities, but the borrower was not at a mature stage yet to write a true SLL contract.”

When the lender effect takes place

Lenders are central to the story. The lender effect was particularly strong among US banks that started or substantially expanded their sustainable-financing commitments. Banks headquartered in areas with lower climate-change awareness were also more likely to issue sleeping SLLs, while banks facing greater climate-related litigation risk were less likely to do so.

SLLs can significantly help banks engage companies in achieving sustainability targets, and sleeping SLLs can help companies that need funding but are struggling to finalise well-designed metrics. However, pressure to meet headline commitments may encourage banks to write loans with sustainability labels without meaningful provisions.

“The good news is US regulators are getting aware of this and have released some clarification memos to require companies to be more careful and rigorous when writing loan contracts,” says Professor Cao.

Calling for strict, measurable metrics

While the study focuses on US companies, Professor Cao sees its implications extend beyond borders. A strategic research arm of Bloomberg reported last year that nearly half of all financing for low-carbon energy companies in the Middle East and North Africa and emerging Asia Pacific came from SLLs.

Being aware of the debate on sleeping SLLs, the Asia Pacific Loan Market Association, a regional trade association for the syndicated loan markets, also maintains that sustainability targets should be set at or before the loan contract is signed.

“SLLs can drive sustainability practices only if both lenders and borrowers see the targets as important as the loans,” Professor Cao says. “The metrics selected should reflect the borrowers’ core business model and fundamental economic factors.”

For example, manufacturing companies will benefit the most from linking their SLLs to carbon footprint metrics if they sell products to markets with stringent ESG rules like the EU, as it directly affects costs and profits.

Finally, this study recommends a cautious approach toward voluntary sustainability initiatives in the capital markets. Financial institutions and corporate enterprises must meaningfully align ESG frameworks with their core corporate strategies. Only through this strategic integration can SLLs drive true sustainable development.