Design of sustainable performance targets: Mitigating greenwashing in sustainability-linked loans

Sustainability-linked loans (SLLs) are an innovative, sustainable financial tool that ties preferential interest rates (PIRs) to a company's sustainability-performance targets (SPTs). This study addresses two common greenwashing (GW) behaviours in SLLs, project misrepresentation and weak SPTs, focusing on carbon-emission (CE) targets as a key SPT indicator. A signaling game model is used, involving a bank and two companies with differing decarbonising capabilities and production risks. We compare the SPT signaling mechanism with traditional loan request (LR) signaling based on signal cost criteria. The results show that a separating equilibrium in the SPT signaling game only exists when the green process's decarbonising capability exceeds a certain threshold. Furthermore, a smaller gap in production risk and a larger difference in decarbonising capabilities enhance the SPT-signaling effectiveness. To address weak SPTs, we propose a feasible range for CE targets that ensures company participation, covers bank risks, and accurately identifies green companies. Finally, we suggest how banks can set favourable interest rates (IRs) to support enforcing stricter CE targets, thereby enhancing the SLLs' sustainability incentives.