September 29, 2021 - by Tess Virmani. Last week the LSTA hosted the first in a series of ESG webcasts – ESG in S&P Ratings for Loans and CLOs presented by Michael Ferguson and Paul Kalinauskas of S&P Global Ratings. 2021 is set to see more than $1 trillion of total sustainable debt. The majority of this volume comes from sustainability linked bonds and sustainability linked loans. These products are not use of proceeds instruments (unlike most types of sustainable fixed income instruments) rather the margin on the instrument is tied to the borrower/issuer’s performance on predetermined material key performance indicators (KPIs). The value of these instruments is not only to encourage companies to improve their sustainability profiles, particularly for companies in hard to abate sectors, but also to encourage disclosure on material KPIs through associated reporting. In response to the growth in this area and investors’ growing demand for ESG data and greater transparency, S&P has developed two key resources: Second Party Opinions (SPOs) and ESG Evaluations. In connection with sustainable bonds and loans, companies adopt frameworks for the relevant structure. For instance, a company will adopt a green framework under which the company can issue green bonds or green loans. Similarly, a company will adopt a sustainability linked framework under which the company can issue sustainability linked bonds or sustainability linked loans. These frameworks are designed to align with the relevant Bond Principles maintained by ICMA and Loan Principles maintained by the LSTA, APLMA and LMA. An SPO serves as an external verification of the framework and gives investors the confidence that the framework is aligned with the relevant Principles. Separately, ESG Evaluations are a form of ESG rating (0-100) based on a cross sector analysis of a company’s sustainability and ability to navigate its business environment as it evolves with respect to ESG issues. The ESG Evaluation is not focused on a company’s ability to repay debt as a credit rating is, rather it is a forward-looking assessment of a company’s ability to operate in a sustainable fashion based on presently visible ESG risks and the company’s preparedness. Public ESG Evaluations can be found here.
While loans are evolving at a rapid pace, the CLO market is also embracing ESG. To date, this has been seen through the proliferation ESG-related negative screens included in CLO indentures. The indentures provide those managers are prohibited from investing in certain non-ESG-friendly industries. According to the BofA CLO Factbook published in July, some 59.8% of these prohibited industries are tobacco only, although prohibitions also exist for weapons firms, thermal coal producers, pornography, payday lending, oil and gas speculation, hazardous chemicals, opioids, palm oil, and marijuana. (Many of these enumerated industries are also covered by the LSTA’s ESG DDQs.) While the trend of negative screens continues apace, S&P points out that all of the assets from every industry subject to a negative screen for by various CLOs (including the entire chemicals sector) equate to only 6.94% of all the assets available to U.S. CLOs. For this reason, S&P predicts that it is likely that CLOs shift to a system of positively screening for assets with ESG-related components for inclusion in their portfolios, rather than negatively screening for prohibited industries – a prediction that is enabled by the very growth of sustainable loans described above. As the proportion of leveraged loans including ESG-related elements increases globally, CLO managers may soon be able to adopt language that pushes for the positive inclusion of sustainable loans. Market participants can monitor this trend by LCD’s ESG Leveraged Finance Tracker.