Second party opinions could help address reputational risks around sustainability-linked loans, says Miguel Cunha of Fitch Ratings with Richard Jefferies of Sustainable Fitch, who introduces their ESG Score product for private market borrowers.
Environmental Finance: Regulators have been raising concerns about the sustainability-linked loans (SLLs) market. Are these concerns justified?
Miguel Cunha: Yes, there are reasons for concern and there's definitely room for improvement. The main concerns are around the lack of transparency and credibility in this market, and these can lead to claims of greenwashing. While SLLs are not regulated at the moment, they are still attracting attention from some regulators.
The first thing that comes to mind is that most of the SLL structures we see tend not to be robust enough. The KPIs and targets agreed between borrowers and their lenders tend to be too easy for borrowers to meet. These are key elements for the integrity of an SLL structure. For example, the KPI that the company has selected may not be material or relevant for the industry or for the company itself, or the sustainability performance target (SPT) that it commits to may not be ambitious enough. In those cases, the SLL does not contribute to effective change.
In addition, some structures are known as 'sleeping SLLs', where the KPI and targets are only agreed and added to the deal terms after the loan agreement is closed. That is obviously a reason for concern. In other instances, we see companies committing to targets that, in reality, they are already pretty much halfway to achieving. We don't see much additionality there. Finally, there tends to be a lack of reporting by borrowers throughout the life of the loan, and what reporting there is, is usually not harmonised.
EF: Are these concerns being echoed by investors?
MC: I think investors are paying attention and, for the most part, they are also expressing concerns. At the end of the day, investors care what the companies they invest in or lend to are doing, and signalling to the market, in terms of their ESG credentials and their ESG story. With increased scrutiny from various different stakeholders, ultimately there is reputational risk here. So, if a company enters into an SLL with a very soft structure in terms of its KPIs and targets, there is the danger of accusations of greenwashing. Investors care about long-term value creation, which means that companies need to look beyond near-term easy wins and embed sustainability into their long-term strategic approach.
"Investors care about long-term value creation, which means that companies need to look beyond near-term easy wins, and embed sustainability into their long-term strategic approach" - Miguel Cunha
We need to consider the role of the banks here. Unlike the bond space, the loan market is much more private in nature. These loans are typically syndicated with the relationship banks that the company has. So these lending banks play a key role in the integrity and credibility of the SLL market.
But I think it is also important to take a step back and provide some perspective here on the stage this market is at. SLLs are an important financing tool to help companies transition to a low-carbon economy. They are also a new asset class, representing a new sustainable financing instrument that has only really taken off in the last three years or so. So, similarly to sustainability-linked bonds, the SLL market has grown very quickly and now faces increased market scrutiny. The market needs to improve, and there needs to be tighter controls and more precise guidelines for this instrument to be more effective.
Environmental and Social scores distribution for selected industries
EF: Does the recent guidance from market bodies address these concerns?
MC: I think it does. Both the Loan Market Association and the Loan Syndications and Trading Association have published guidance. These have been welcomed by the market: they are definitely steps in the right direction and address a lot of these issues. They touch on these specific challenges I mentioned: there's increased focus on and controls of KPI selection and on the level of ambition in the SPT. Some of the guidance is very similar to what we have on the bond side, such as the Sustainability-Linked Bond Principles from the International Capital Markets Association, which also has guidance in terms of the level of ambition required in the targets. They are also closing the door on sleeping SLLs.
In addition – and which is obviously close to my heart from the point of view of Sustainable Fitch – is more emphasis on the role of external reviews. Traditionally, second party opinions (SPOs) have very much been 'nice to have' on the loan side of the market, rather than 'must have', as you see these days on the bond side. For SLLs, the guidance now recommends the use of external review. They add another layer of transparency and credibility to the transaction.
EF: What sort of demand are you seeing for SPOs for SLLs? How are they different to SPOs for green bonds?
MC: We've been doing a considerable number of SPOs for loans here at Sustainable Fitch. We don't see them for every loan and it's still on a case-by-case basis, but we think that will change over time. Interest is coming from both the banks' ESG or sustainable finance teams, and the borrowers themselves, who are starting to realise how an SPO can be used as part of the due diligence on the deal and play an important role in terms of the credibility of the market.
There are a few nuances in the different approaches we take with loans compared with bonds. To start with, there is a slightly different set of principles and guidelines that oversee each asset class. Furthermore, the private nature of loans means there tends to be less disclosure and less data available from borrowers compared with bond issuers. As an SPO provider, we challenge lenders' and borrowers' assumptions to bring best practices and the most robust structures to market, but we also acknowledge those nuances. The time scale is also different. Loans tend to be structured much more quickly compared with bonds. The turnaround time for the SPO on a loan has to be much quicker, and our team here at Sustainable Fitch can accommodate that.
EF: What does an SPO for an SLL not address? What should investors bear in mind when reading SPOs for loans?
MC: Fundamentally, SPOs are transaction-driven. They will primarily look at the structure, including the KPI selection, the level of ambition of targets, instrument characteristics, the reporting, and all the features that are part of the SLL Principles. Of course, a small part of the SPO also considers the overall borrower and highlights the company's ESG profile. But it is not the role of an SPO to provide a holistic or deep-dive ESG overview of the borrower.
So, when investors look at some of these SLL deals, they need to consider what the company is doing beyond the transaction and look at the business and overall strategy through an ESG impact lens. That is not included in the SPO: an SPO is not a green assessment of the company. We offer other services, such as ESG-entity ratings, which provide a much more comprehensive view of the company's overall ESG performance and strategy. These ratings also include the impact of its business activities, and where it sits in its transition pathway.
EF: Sustainable Fitch has recently launched an ESG Scores product aimed at the collateralised loan obligation (CLO) market. What specific challenges do CLO investors have in assessing ESG performance?
Richard Jefferies: CLO vehicles predominantly hold leveraged finance loans, normally issued by private equity-owned companies across Europe and the Americas, with an overall market size of approximately $1.6 trillion. The challenge with these loans is that they tend to be made to a wide variety of sizes of companies and many of the companies only have limited disclosure.
For ESG Scores, we wanted to create a product that allowed a direct comparison between companies with high levels of disclosure and companies that have limited disclosure, to enable us and our customers to compare them on a like-for-like basis. We work with CLO managers to ensure that we have the best set of information available on the underlying companies: under confidentiality agreements, we can receive the documents that are made available to lenders to assist with our analysis. Our ESG Score analysis focuses on the impact of each companies' underlying business activities, split usually by revenue.
"Our ESG Scores product allows a direct ESG comparison between a portfolio of companies, each with varying levels of disclosure, on a consistent basis" - Richard Jefferies
On the environmental side, our analysts are guided by recognised science-based taxonomies, such as the EU Taxonomy where, if an activity is Taxonomy-aligned, the company gets the highest score for that activity. On the social side, our methodology looks at the contribution of the business activity to the socially orientated SDGs. To ensure comparability across all the entities assessed by Sustainable Fitch, we maintain a database of different business activities for both environmental and social scoring. Once each of the business activities has been assessed, they are aggregated back together, weighted by the different revenue percentages of the company. On the governance side, we use a scorecard-based approach inspired by the OECD guidelines for corporate governance.
EF: How are investors using the product?
RJ: Many CLO managers are doing their own ESG assessments and providing their own scores for the products they are offering investors. However, it's difficult for CLO investors to compare different CLOs from different managers, given that different managers have different methodologies; our score gives them an independent third-party view of the ESG credentials of a CLO's underlying assets.
For those managers with very well-established ESG processes, our product provides another data point, and a way for them to check their internal thought processes and generate debate. For CLO managers that are less established in their ESG journey, the product provides a valuable starting point from which to overlay their developing policies and procedures.
EF: What's next from Sustainable Fitch in terms of the SLL market?
MC: The CLO market was an interesting test for this approach because the correlation between the underlying portfolios is quite high. Once we've scored one name, the chances are that most CLO managers will hold it.
But we see the overall ESG lending market as a strategic growth market for us at Sustainable Fitch. We are in a very privileged position from an ESG data provider perspective in our ability to penetrate every segment of the private market. As far as we know, no other providers have the ability at the moment to provide ESG scores or opinions on this part of the market, where companies are small, and there isn't much information available. We can go into all sorts of private debt markets, looking at small and mid-market companies, and develop similar products. We are in a good position to be the ESG ratings provider of preference in the loan space.
Miguel Cunha is a senior director, ESG & sustainable finance at Fitch Ratings in New York, and Richard Jefferies is head of ESG Scores for leveraged finance at Sustainable Fitch in London.