Lenders focus on the fine print as ESG emissions rise

The increase in sustainability-related debt issuance seen in 2021 showed little sign of slowing down, with borrowers continuing to focus on improving environmental, social and governance (ESG) performance in response to the crisis. demand from investors.

According to the Institute of International Finance, global sustainability bond issuance – where issuers pay higher or lower coupons based on meeting ESG key performance indicators (KPIs) – nearly quadrupled in the first year. semester 2021 to reach $ 160 billion.

White & Case’s September ESG leveraged loan tracker, meanwhile, shows ESG-linked loan issuance in Europe (the world’s largest ESG debt market) to reach $ 18.52 billion. ‘euros, going from 29 transactions for the year to August 10, 2021. This has seen the ESG – Tied loans represent 19% of all European B term loan issuance in 2021, compared to only 4% in 2020 .

ESG-related margin ratchets have also gained traction in private debt markets, with Ares Management forecasting £ 1billion sustainability-related funding for environmental engineering and technical services firm RSK Group .

The deal is the largest ever private debt sustainability deal and will link RSK’s financing costs to carbon reduction, health, safety and ethics targets. If these KPIs are achieved, RSK could save up to £ 500,000 per year in interest charges. He pledged to donate half of the interest saved to charity.

Strengthening surveillance

While borrowers have noted the opportunity to tap into the buoyant ESG debt market for capital and lower borrowing costs, lenders have stepped back to reassess eligibility criteria for ESG loans and loans. high yield bonds.

White & Case research shows that 84% of ESG-related debt transactions used KPIs as a benchmark for margin ratchets, with only a limited number opting for ESG scores or a mix of KPIs and ESG score metrics .

However, the rapid growth in ESG-related issuance has increased the risk of ‘greenwashing’ and measuring and communicating compliance with KPIs have become of particular concern to lenders, who believe that further scrutiny is necessary.

A survey of 170 credit investors conducted by the European Leveraged Finance Association (ELFA) found that 72% of high yield bond investors want external verification of KPI selection and targets to be a prerequisite for issuance. A quarter (26%) of respondents say they are prepared to forgo third-party verification if there is full disclosure of internal expertise and methodologies used to define KPIs. Almost all of the high yielding participants agree that issuers should report on progress towards KPIs at least once a year.

Investors in leveraged loans also want to see more rigor applied to ESG KPIs, with 71% of them requesting that a rating agency or third-party ESG agent be involved in establishing the KPIs. A third of loan investors want their contribution to be included in the definition of KPIs. More than four-fifths of lenders (87%) want KPIs to be audited annually by external parties, with 82% saying interest rate margins should be increased when issuers fail to provide a sustainability report or l third party approval.

Since completing the survey, ELFA and the Loan Market Association have updated their sustainability lending principles and published a best practice guide that focuses on establishing well-defined KPIs. before ESG-related loans are offered in the market.

It is hoped that these guidelines will help ensure that ESG loans are credible, thus reducing any involvement of “greenwashing”, but the guidelines are voluntary. It remains to be seen whether investors and lenders will continue to push for mandatory third-party verification.

The good deal at the right price

In addition to reassessing the verification, lenders are also considering ways to ensure that ESG margin ratchets are high enough to prompt borrowers to make meaningful changes.

Lenders want to ensure that margin rebates influence behavior in the right way and are sensitive to the risks that issuers play in the market to secure so-called “greenium” pricing advantages.

Investors in green bonds – where proceeds are collected for specific qualifying ESG projects rather than through margin ratchets tied to the company’s overall ESG performance – have already faced this problem and considered whether to offer debt. cheaper for specific projects is effective when the rest of a business continues to operate with little change.

After a period when debt for particular green projects was available at a significant discount to “conventional” debt, spreads narrowed as investors became more attentive to reducing the cost of capital simply because a bond falls into the “green” category.

Leverage financial investors are also investigating whether ESG-related discounts offer good value for money and are an effective tool for changing lender behavior. Rather than just looking at their own costs, these investors explore whether increasing increases (the increments at which interest rate margins decrease or increase as borrowers meet or miss KPIs) will have a greater impact.

The ELFA survey found that on average, step-ups amount to 0.25%, but three-quarters of investors polled say they don’t think it’s substantial enough. More than a third (39%) say an increase in the range of 0.25% and 0.5% is appropriate, with an additional 30% saying the level should be 0.5% or more. Almost all lenders (90%) agree that ESG KPIs should be crystallized from the start and not be subject to flexibility for high demand transactions.

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