31 December 2019
Greater demand for sustainable investment products could lead to pricing advantage, argues Neil Caddy
With global green and sustainable debt volumes set to hit close to $500 billion in 2019, more than double that of two years ago, according to BNEF and Bloomberg, the seemingly unrelenting demand for environmental, social and governance (ESG)-themed finance looks set to continue as we enter the new decade. As the sustainability agenda continues to push this rapidly expanding asset class, will this result in greater affordability for borrowers and what are the key drivers that we should be aware of?
The last twelve months have seen a number of interconnecting factors and developments fuel growth. Supranational organisations are working hard to promote green and sustainability agendas. The UN 2030 Agenda for Sustainable Development includes Sustainable Development Goals, 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. Globally the agenda is ubiquitous.
International working groups are also forming to develop and promulgate principles for general application. For example, the EU, together with 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 practices in environmentally sustainable finance.
ESG considerations are becoming more ingrained in investment management and decision processes of investors. Investment funds are employing dedicated ESG professionals and providing ESG training to their investment teams. A number of funds have a formal ESG policy and have signed up to or are followers of the Principles for Responsible Investment, the American Investment Council and Invest Europe Handbook of Professional Standards and Task Force on Climate-related Financial Disclosures (TCFD). So, for many investment firms this is already much more than just virtue-signalling to win new investors.
The Loan Market Association, Asia Pacific Loan Market Association and Loan Syndications and Trading Association have launched the Green Loan Principles and Sustainability Linked Loan Principles designed to provide classification criteria for loan products, give credibility, and avoid the ignominy of so-called 'greenwashing'.
Following on from this there is an increasing cadre of 'green' financing products emerging. Green loans or bonds are those where the proceeds are applied specifically for 'green' purposes – for example, building 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 they are used and mechanisms for tracking this. These loans will not be for all borrowers and there is no inherent feature of the Green Loan Principles that would imply reduced pricing, but loans can be structured so that they do. For example, allowing for a lower margin for drawdowns under a revolving credit facility which are applied for green purposes. Clearly lenders providing such a facility will have even more incentive to ensure there are rigorous monitoring provisions so that any reduced pricing is properly warranted.
The Sustainability Linked Loan Principles do not contemplate loan proceeds being used for a particular purpose but they do expect and recommend borrowers to be given pricing incentives based on certain ESG-related criteria which are subject to third party oversight. The leveraged loan market took its first foray into this space this year with Masmovil, Spain's fourth-largest telecoms company, including a margin ratchet based on an ESG rating, as part of its €1.7 billion ($1.9 billion) debt package. Pricing incentives tend to work both ways i.e. pricing can go up or down depending on performance, 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 what 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.
While there is concern in some quarters as to whether certain new products are truly promoting the ESG agenda – with the US Securities and Exchange Commission conducting its own investigation into this area – the groundswell of initiatives to improve scrutiny and promote best practice can only serve to grow investor and borrower confidence in these new products.
As best practice develops, and credibility and sophistication grows, investors will know more about what they are buying and about whether investments meet their ESG goals, as well as fulfilling more traditional investment criteria. The more investors that are comfortable and therefore mandated to invest in these products, the higher the demand. The more competition there is to deploy capital in ESG-friendly products, the lower the cost for borrowers and issuers. A wider array of products will also mean that there are more opportunities for borrowers to take advantage of them. With this in mind, companies could well be missing a trick if they don't consider how they could take advantage of this trend.
Neil Caddy is a partner in the corporate department and finance practice at law firm Fried Frank.