Sustainability-linked loans: financing a greener future for farming

Farmers often face a difficult trade-off between short-term profitability and long-term sustainability. Practices such as excessive fertiliser use, intensive livestock farming, and poor crop rotation can boost immediate earnings but degrade natural resources over the longer term, reducing farm value over time. Our recent study highlights how sustainability-linked loans (SLLs) – which adjust interest rates based on environmental performance – can help farmers and banks align financial incentives with sustainable farming practices.

Traditional farm debt creates pressure to over-exploit land, particularly during prolonged market downturns. When debt levels are high, farmers have a financial incentive to prioritise short-term cash flow over the long-term health of their land. This ultimately harms both the farmer, whose land becomes less productive, and the lender, whose collateral loses value. The study shows how refinancing with an SLL can change these incentives, encouraging farmers to adopt more sustainable practices.

A key insight from the research is that ‘natural capital’ – such as soil quality, water resources, and biodiversity – has ‘option value’ that is not fully incorporated into financial decision-making. Farmers who maintain healthy natural capital have greater flexibility to adapt to changing market conditions. For example, a dairy farmer with well-managed soil and water resources can increase production when milk prices are high without causing lasting damage. However, if natural capital has already been depleted, this flexibility is lost.

Conventional debt does not fully account for this option value. When a farmer decides whether to exploit natural resources, the financial calculations do not fully account for the lost option value of natural capital. This can lead to overuse of resources, particularly when bankruptcy risk is high, as a portion of the long-term cost is effectively passed on to the bank. SLLs can help correct this imbalance by adjusting interest rates to reflect the full cost of depleting natural capital. Farmers who run down these resources face a higher cost of borrowing, making it less attractive to sacrifice long-term sustainability for short-term profits.

The study has found that SLLs are particularly valuable for farms where natural capital is a key determinant of profitability, such as those with slow rates of environmental regeneration. Highly indebted farms stand to benefit the most, as they have the strongest financial incentives to over-exploit resources. By designing loan terms that tie interest rates to environmental performance, banks and farmers can both benefit, ensuring that agricultural businesses remain financially viable while safeguarding the natural resources that underpin their success.