A-Z of ESG: A-C

In our A-Z of topics to illustrate what a socially responsible approach to credit markets should embrace, here we cover Alignment, Biodiversity and Carbon reporting.

Alignment

Private debt managers that want to achieve better ESG outcomes need to align their interests with multiple stakeholders – including sponsors, LPs and the management teams of portfolio companies.

A-Z of ESG - AlignmentAn increasingly prominent way to achieve alignment with portfolio companies is through sustainability-linked loans. These contain ESG ratchet mechanisms, which allow borrowers to benefit from cheaper financing if they can achieve KPIs linked to ESG metrics.

Rita Mangalick, global head of ESG at Blackstone Credit, told a Private Debt Investor panel in May that SLLs are a “key tool that credit can use to track and measure ESG value creation”. Providing that “KPIs and the sustainability performance targets are appropriate and clearly defined” it is possible to ensure that “all stakeholders’ incentives are aligned”.

Ares Management agreed a £1 billion ($1.19 billion; €1.15 billion) loan with environmental engineering consultancy RSK Group in August 2021, one of the largest such deals in the market to date. As Blair Jacobson, partner and co-head of European credit at Ares, told us in January: “In order to work well, the target KPIs on these loans have to be real, measurable and quantifiable by a third party, and it can’t be a one-way street.”

RSK will receive a discount on its interest rate if it meets its KPIs – but the rate will increase if it fails to do so. Borrowers need to “take it seriously”, Jacobson told us. “It can’t be a free option – it needs to work for all the stakeholders. When it works, it’s beautiful, and we believe it’s going to become much more common.”

Although there is still much discussion about the relevance and measurability of KPIs, these types of financing structures are becoming relatively commonplace in European private debt. Some private fund managers believe a similar approach can also bring about greater alignment between GPs and LPs by linking carried interest to ESG performance.

While this is still nascent in private debt, Emilie Huyghues Despointes, ESG officer at MV Credit, tells us that the European credit specialist plans to link carried interest in its future funds to ESG metrics. This would see executives rewarded for the firm hitting its KPIs relating to ESG.

Meanwhile, it is, of course, also critical that private debt lenders align with sponsors in their approach to ESG. “We used to hear a lot that it’s not the place of the lender to engage the borrowers to try to provide support on ESG,” says Huyghues Despointes. Now, things have changed. She says she is regularly invited by MV Credit’s main private equity sponsors to attend quarterly calls or site visits, and notes that sponsors and lenders are working together to find ways to help streamline ESG reporting for portfolio companies.

Biodiversity

With all the focus on carbon emissions and climate change, it is easy to overlook other human impacts on the environment, including the grave crisis facing the world’s biodiversity.

A-Z of ESG - BiodiversityAccording to the World Wide Fund for Nature, monitored wildlife populations have declined by an average of 69 percent since 1970. A 2019 UN report warned that one million plant and animal species are threatened with extinction. Many scientists argue that the extent of damage to biodiversity is such that the Earth is entering its sixth period of mass extinction.

The biggest threats to plants and animals come from changes in land use, notably deforestation and urbanisation. Climate change is another key driver of biodiversity loss: extreme climate events such as floods and drought can cause mass animal mortality.

Investors are beginning to wake up to the threat. The Taskforce on Nature-related Financial Disclosures (TNFD) was established in 2020 to develop a risk management and disclosure framework to encourage organisations to report on nature-related risks. The goal, according to the TNFD, is to support “a shift in global financial flows away from nature-negative outcomes and towards nature-positive outcomes”.

While few private debt managers have made biodiversity a focus area, the asset class will inevitably face growing pressure to compel borrowers to assess and disclose nature-related impacts. Regulators in several jurisdictions, including France and the Netherlands, are taking a keen interest in biodiversity. In those countries, financial institutions are required to identify their exposure to biodiversity risks.

Ashim Paun, head of sustainable investing at Triton Partners, told affiliate title New Private Markets in April that fund managers need to see biodiversity as a priority. “Private capital is particularly well placed to help the world address biodiversity issues, both by encouraging best practice within investment portfolios and by backing innovative businesses proactively tackling the crisis,” he said.

One way to address biodiversity impacts is through a ‘natural capital’ approach. This is based on an understanding of nature as an asset that provides benefits to human society. The approach provides a system that helps account for gains and losses to biodiversity. Investors are then better placed to measure how their activities affect biodiversity, and to prioritise investments that produce net benefits for nature.

“We also seek to invest in companies offering products and services that are well placed to provide solutions to biodiversity loss,” Paun said. “We view natural capital as an investable theme in and of itself, not just an exercise in risk management.”

Carbon reporting

Private debt firms have increasingly made commitments to reduce their portfolio-level emissions – which naturally entails measuring and reporting emissions across portfolio companies.

A-Z of ESG - Carbon reportingThis is easier said than done – there is much uncertainty over what should be measured and reported. Even calculating Scope 1 and 2 emissions, which cover emissions in companies’ own operations and the emissions generated in producing energy that companies use, is far from straightforward. And Scope 3 emissions – the upstream and downstream emissions that companies are only indirectly responsible for – are considerably more difficult to estimate.

By no means all publicly traded companies report Scope 1, 2 and 3 emissions. Reporting is also still less advanced among mid-market companies that tend to receive financing from the private debt market. “Very few private middle market companies have been able to calculate their Scope 1 and 2 emissions and almost none on Scope 3 emissions – they generally don’t have the expertise or resources to do so,” says Mickey Weatherston, head of sustainability and ESG integration at Churchill Asset Management, an investment specialist affiliate of Nuveen.

On the positive side, managers can access a growing toolkit of resources to help with carbon reporting. In May, for example, the Initiative Climat International published guidance for GPs that promotes a consistent approach to reporting emissions at portfolio company and fund levels.

“As we partner with more PE sponsors on emissions reduction plans, and as investors request better emissions data, we hope that middle market companies will improve their capacity to calculate their true carbon footprint,” says Weatherston.

In the meantime, given the difficulty in collecting data, Weatherston says that modelling is the “best way to provide our investors with a reference data point on carbon emissions”. He tells us that Churchill engages specialist third-party data providers to model emissions for its portfolio companies, based partly on emissions reported by companies with similar characteristics.

Regulatory pressures, meanwhile, are driving managers to develop their approach to carbon reporting. In the EU, SFDR requirements for reporting Scope 1, 2 and 3 emissions, among other data, will be tightened from January 2023.

Kirsten Lapham, partner at law firm Proskauer, said the limited availability of data on ESG is a key issue. Some managers, she said, are insisting on contractual provisions in loan agreements to ensure access to relevant data. She told Private Debt Investor in May the supply of data will improve as regulatory requirements become embedded: “We expect to see a hotch-potch of best efforts to start with, and disclosures will all look a bit different, but after a few years the market will evolve.”