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The consensus view on COP26 appears to be that the conference simultaneously achieved much more than expected and less than needed to save an environmental disaster. The same goes for the evolution of ESG provisions in loan agreements, with surprising progress but still a lot to do.
Recent Covenant Review surveys have suggested that over 50% of new syndicated loans in the European market now contain ESG-related provisions. This level was reached in early 2021 when it could have been attributed to a low supply, but as the level was maintained until 2021, it is difficult to deny that progress is being made by donors on the European market to meet ESG principles.
This level of adoption is surprising, but it is reflected in the percentage of loans passing through our European Loan Review Center, where we saw over 40% of loans taking into account ESG factors and over 30% including explicit margin ratchets linked to ESGs. Progress appears to be significantly slower in other markets.
ESG provisions did not really emerge in their current form in Europe until mid-2020, driven by investor appetite for socially responsible lending. Since then, the clauses have developed from narrow, exclusively environmental criteria to encompass a wider basket of ESG factors, such as:
- commissioning and obtaining a “first-rate” ESG rating by a third-party rating provider
- maintain policies requiring the monitoring of key environmental, social and governance indicators
- achieve zero net carbon emissions or percentage reduction in carbon emissions
- assessment of supply chains for human rights violations, modern slavery and poor labor standards
- participate in an initiative to improve local communities
- maintain a code of business ethics
Those exposed to financing from development banks will notice a correlation with some of the factors already monitored by development banks.
Companies may be able to meet the test of a margin reduction by meeting only some of these requirements, but not all, in a given year, perhaps increasing from year to year. . It is encouraging that, when agreed upon, the tests appear to convey a sense of ambition. However, it is striking to note that a certain number of facilities leave the final ESG criteria to be determined after the realization of the corresponding financing (Ed: another striking analogy with COP26). This may allow for the necessary calibration by management, but hopefully this does not preclude setting ambitious goals for the life of the loan rather than setting goals that can be achieved in the first year.
That said, it is clear that in business, what is measured is (often) achieved. The success of these clauses in conducting monitoring and publishing data on relevant ESG factors, and in identifying appropriate measures, should not be underestimated. These clauses also induce this behavior in mid-sized companies, which stock market initiatives and government requirements are less likely to achieve in the short term.
Another key feature of these arrangements is the level of margin reduction the company receives by meeting ESG targets. Typically, the margin will be reduced by 0.05% (and at most 0.075%) once the criteria are met. Compare that with a typical 0.25% reduction to reduce leverage by one turn. This difference is not sufficient to be essential driver behavior in a company.
Strikingly, banks seem to be leading the way, with banks involved (but not exclusively) in all of the transactions we’ve seen with ESG ratchets so far. This dovetails with the UK’s stated intention to make London a “net zero aligned financial center” that “will quickly and broadly mobilize private finance” to finance a carbon conscious transition. But these measures are designed to make capital available and to lead to the decarbonisation of financial institutions themselves.
It may not be up to lenders to promote improvement in ESG principles by accepting reductions beyond a certain point, when interest rates are already close to their historic lows. When the criteria are met, the margin reductions must be proportional to the reduction in risk, otherwise good behavior will be penalized and lead to an influx of capital elsewhere. If governments want to push behavior beyond that, a more rational position would be that polluters and abusers face penalties rather than lenders have to accept a material reduction in return.
Important questions remain. For example, if ESG principles are widely adopted, how do you ensure that companies that are less ESG compliant and yet essential to society at a given point in time continue to be funded? It would be ironic for governments to step in to protect industries (like coal) which are vital in the short term but already have difficulty obtaining insurance products.
However, the European loan market should be applauded for making progress in adopting ESG lending principles and demonstrating that these can be properly integrated into market lending documents.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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