Sustainability-linked loans (SLLs) see increasing popularity among commercial banks as an instrument to advocate environmental sustainability. A recent paper by ACI delves into the dynamics behind this trend and assesses the economic and environmental impacts of sustainability-linked lending rates, or “emission-elastic lending rates.” 

SLLs function by providing preferential loan interest rates to corporations engaged in emission-reduction activities. Since preferential loan rates are offered for clean production, corporates are expected to use this cheaper financing option to purchase more clean capital.

Unlike green loans, which are limited to eco-friendly projects, SLLs enable borrowers from various industries to access sustainable funding. The specific interest rate on SLLs is influenced by the borrower’s ability to meet sustainability performance targets (SPTs), often related to environmental, social, or governance metrics such as reducing greenhouse gas emissions or adopting renewable energy practices.

Two factors might fuel the growth of SLLs, namely government support and participation in global initiatives. Government support, as demonstrated by Singapore’s Monetary Authority, encourages banks to engage in sustainability initiatives, fostering SLL growth. Furthermore, large banks’ participation in global alliances like the net-zero banking consortium motivates banks globally to expand their SLL portfolios, surpassing initial targets.

Sustainability reports indicate that some major banks have exceeded their initial sustainability loan targets. This prompts questions about the exact reasons motivating banks to position themselves as champions of environmental sustainability.

As financial intermediaries, banks survive on the interest earnings from lending. Although sustainability mandates on loans provide reputational benefits, a preferential interest rate on SLL seems incompatible with the banks’ primary agenda of profit maximisation.

The authors note that the answer lies in the demand-side dynamics of the loan market. National mandates on net-zero targets trickle to businesses and consumers who face a penalty of a carbon tax in case of non-adherence. Consequently, the demand for SLLs surges. Banks, foreseeing the energy transition as a burgeoning industry, anticipate substantial investments in green initiatives.

The research of ACI finds that under certain assumptions, the spur in SLL demand might make up for the lower interest rates, leading to more profit for banks during a green transition. This aligns with banks’ profit-maximization goals. However, the rapid lending expansion raises financial uncertainty, impacting households negatively. Therefore, emission-elastic lending rates don’t necessarily lead to significant social welfare improvement.

Nevertheless, the paper highlights that while emission-elastic lending rates reduce emissions and boost bank profits, they do not necessarily enhance overall societal well-being. Increased lending due to these rates raises concerns about financial stability, as people prefer stable deposits for their long-term security. Consequently, these rates provide only a small social welfare benefit mainly due to reduced emissions.

SLLs offer a pathway for businesses to adopt eco-friendly practices with reduced borrowing costs. However, as society’s focus on green initiatives intensifies, banks and regulators eventually will have to gauge the costs and benefits of preferential interest rates and expanded loan opportunities. Businesses committed to green transitions should anticipate potential shifts in borrowing costs, emphasising the need for robust financial planning and strategic decisions to navigate these changes effectively.

By XU, Ni Scarlet

Researchers: GEORGE, Ammu, HUANG, Jingong, NIE, He, XIE, Taojun