Friday 21 April 2023
Top tier equity investors, particularly those deploying capital in emerging economies, have been tasked with considering Environmental, Social, and Governance (ESG) factors in their diligence and investment management practices for years. This is for a myriad of important reasons, including the direct relationship between strong ESG performance and increased carried interest (“carry”).
For debt providers, the use of ESG has been slower to gain adoption.
We know ESG adds value to the debt market in several ways. Firstly, it helps investors to identify and manage risks associated with environmental and social issues. By assessing the ESG risks of a potential investment, investors can better understand the potential for negative impacts on financial performance and reputation. This allows them to make more informed investment decisions, which in turn helps to reduce risk and improve the long-term sustainability of their portfolios.
Secondly, ESG can be a driver of innovation and positive change. Companies that are committed to ESG principles are often more innovative in their approach to sustainability, which can lead to cost savings, increased efficiency, and improved profitability over the long term. This can be particularly relevant in the debt market, where investors are seeking de-risked investments that deliver long-term value.
Thirdly, ESG can be a catalyst for engagement between investors and companies. By engaging with companies on ESG issues, lenders can encourage them to adopt more sustainable practices, which can lead to improved financial performance and a better alignment with societal expectations. This can be particularly valuable in the debt market, where investors are seeking to drive positive change through their investments.
Some of the most important ESG considerations for debt providers are broken down below:
- Environmental Considerations:
- Evaluate the borrower's environmental impact and their efforts to mitigate negative effects.
- Assess the borrower's carbon footprint and their commitment to reducing greenhouse gas emissions.
- Determine the borrower's compliance with environmental regulations and standards.
- Consider the potential impact of climate change on the borrower's business and ability to repay the debt.
- Social Considerations:
- Evaluate the borrower's labor practices, including their treatment of employees, labor standards, and worker safety.
- Assess the borrower's social impact, such as their contribution to the community,
- Evaluate the borrower’s diversity and inclusion policies, and the voracity of their stakeholder engagement practices.
- Determine the borrower's compliance with human rights regulations and standards.
- Consider the potential impact of social issues, such as income inequality or political instability, on the borrower's ability to repay the debt.
- Governance Considerations:
- Evaluate the borrower's corporate governance structure, including their board composition, transparency, and accountability.
- Assess the borrower's risk management practices, including their ability to identify and mitigate ESG risks.
- Determine the borrower's compliance with legal and regulatory requirements.
- Consider the borrower's reputation and ethical practices.
- ESG Integration:
- Develop an ESG due diligence process and an ESG management framework to guide decision-making and ensure consistency.
- Integrate ESG considerations into the credit assessment process.
- Monitor and report on the ESG performance of borrowers.
- Engage with borrowers to promote ESG best practices and improve performance.
By considering these ESG factors, debt providers can help promote sustainable and responsible borrowing practices and reduce risk for both themselves and their borrowers.
Companies that demonstrate strong ESG performance can often access lower costs of capital, making it a win-win situation for both the borrower and the lender. Using ESG to structure more favorable loan terms for borrowers is a strong way to incentivize responsible business practices and mitigate risk to lenders. The steps toward doing so involve:
- Develop a clear ESG policy
The first step to incorporating ESG into lending practices is to develop a clear ESG policy. This policy should outline the criteria that borrowers must meet in order to access lower costs of capital. The policy should be based on the lender's sustainability goals and should be communicated clearly to borrowers.
- Evaluate ESG performance
The next step is to evaluate the ESG performance of potential borrowers. This can be done through a variety of methods, including ESG ratings, diligence, and third-party assessments. The goal is to identify companies that demonstrate strong ESG performance and are committed to sustainability; and to structure a causal relationship between ESG performance and loan terms.
- Offer incentives
Once a borrower has been identified as having strong ESG performance, the lender can offer incentives to access lower costs of capital. For example, a lender could offer a lower interest rate or longer repayment terms to a borrower that meets certain sustainability criteria. This incentivizes borrowers to prioritize ESG factors in their operations and can lead to improved sustainability outcomes.
- Provide support
Debt providers can also provide support to borrowers that are working to improve their ESG performance. This can include providing resources and guidance on how to improve sustainability practices, such as reducing carbon emissions or improving social impact. Support can also take the form of technical assistance by the lender, which is often separately allocated capital in grant form, earmarked for initiatives that will improve the ESG performance of the borrower and adds value to the underlying asset. By providing support, lenders can help borrowers meet ESG criteria and access a lower cost of capital.
- Monitor ESG performance
Finally, it is important for lenders to monitor the ESG performance of borrowers over time. This helps to ensure that borrowers are meeting the sustainability criteria outlined in the ESG policy and are continuing to prioritize sustainability in their operations. If a borrower's ESG performance falls below a certain threshold, the lender may need to reevaluate their cost of capital.
Incorporating ESG into lending practices can benefit both debt providers and borrowers. By developing a clear ESG policy, evaluating ESG performance, offering incentives, providing support, and monitoring performance, debt providers can structure more favorable cost of capital for borrowers that prioritize strong ESG risk mitigation and value addition.