ESG financing: cheaper source of debt or too expensive to ignore?

Neil Caddy of Fried Frank examines the challenges and opportunities arising from the growing focus on environmental, social and governance criteria.

Neil CaddyAccording to BNEF and Bloomberg, global green and sustainable debt volumes hit close to $500 billion at the close of 2019, more than double the figure of two years previously. It would therefore appear that demand for assets with strong environmental, social and governance ratings is set to continue to grow as this year and throughout the next decade. Yet while the sustainability agenda, driven by public clamor as well as non-governmental lobbies and government authorities, continues to grow globally, it remains to be seen whether the proliferation of this type of financing will make debt more affordable, or less.

Investors are increasingly aligned with the ESG agenda on ideological grounds, but more of them are also coming round to the fact that poor ESG is indicative of a poorly run business. Such considerations are therefore becoming more ingrained in investment management and decision processes. Investment funds are employing dedicated ESG professionals and providing training to their investment teams. A number of vehicles have formal ESG policies and have either signed up to, or are followers of, the Principles of Responsible Investment, the American Investment Council and Invest Europe Professional Handbook and the Taskforce on Climate-related Financial Disclosures. For many firms, ESG is already about much more than just virtue signaling to win new investors.First we need to look at what is fueling such growth. On a global scale, supranational organizations are working hard to promote green and sustainability agendas. There is the UN 2030 Agenda for Sustainable Development; the Paris Agreement, which 187 countries have now ratified, commits signatories to tackle climate change through nationally determined contributions; and the European Commission is promoting its European Green Deal with a stated goal of net-zero emissions by 2050. The list goes on.

Investors are increasingly aligned with the ESG agenda on ideological grounds, but more of them are also coming round to the fact that poor ESG is indicative of a poorly run business

International working groups are also being formed to develop and promulgate principles for general application. The EU and the relevant authorities from Argentina, Canada, Chile, China, India, Kenya and Morocco have launched the International Platform on Sustainable Finance with the goal of exchanging and disseminating information to promote best practice in environmentally sustainable finance. The Loan Market Association, the Asia-Pacific Loan Market Association and the Loan Syndications and Trading Association have also launched the Green Loan Principles and the Sustainability Linked Loan Principles. These two sets of initiatives aim to provide classification criteria for loans and give credibility to such products, and thus avoid the ignominy of ‘green washing’.

Green for go

As appetite for ESG intensifies, a growing suite of green financing products are coming on to the market. Green loans or bonds are those where the proceeds are applied specifically for environmentally sustainable purposes, such as the building of a wind farm or investing in new clean energy technologies. The Green Loan Principles also enshrine an expectation that green loans will include ongoing reporting requirements in relation to the purposes for which the facilities are used and mechanisms for tracking what they are used for. These loans will not be suitable for all borrowers and there is no inherent feature of the Green Loan Principles that would imply reduced pricing. However, loans can be structured so that they do have this feature – for example, a loan could provide for a lower margin where drawings under a revolving credit facility are applied for green purposes. Lenders providing such a facility will have an even greater incentive to ensure there are rigorous monitoring provisions so that any reduced pricing is properly warranted.

The Sustainability Linked Loan Principles do not require loan proceeds to be used for a particular purpose. However, they do expect and recommend that borrowers be given pricing incentives based on certain ESG-related criteria that are subject to third-party oversight. It was in 2019 that the leveraged loan market took its first foray into this space with Masmovil, Spain’s fourth-largest telecoms company, including a margin ratchet based on an ESG rating as part of its €1.7bn debt package, which won the IFR 2019 green/sustainable loan award. Pricing incentives tend to work both ways – pricing can go up or down depending on performance, thus providing an incentive to maintain current status as well as a carrot to improve ESG performance. At this stage of the market, however, there are no hard and fast requirements as to which ESG criteria might be used and how they might operate. This provides flexibility for borrowers to come up with bespoke solutions depending on what might be most appropriate for their particular business.

Over the next 12 months and beyond we can expect to see a growing cohort of financial instruments and pockets of liquidity for companies seeking ESG credentials to tap into. However, there is likely to be a difference in the pace of development between the loan and bond markets. Liquidity and depth of investor base are key for bond investors, whereas banks making – and holding – loans are likely to be more circumspect and take a longer-term view in order to promote the ESG agenda. In any event, the more competition there is to deploy capital in ESG-friendly products, the lower the cost will potentially be for borrowers and issuers. At the very least, companies looking to raise capital in the debt markets could find themselves at a competitive disadvantage if they do not keep up with their peers when it comes to ESG, and they could pay a higher price for their debt as a result. They must therefore make sure they are on top of this impossible-to-ignore trend.

Neil Caddy is partner in the corporate department and finance practice at Fried Frank