ESG: How climate-related due diligence will change

In 2023, leading private credit GPs will include environmental, social and governance as a core part of due diligence, both from a credit risk perspective and to ensure no unforeseen regulatory or reputational risks arise during the life of a loan, writes Tamara Close.

 In today’s volatile markets, now more than ever, capital is seeking high quality, resilient companies that can maintain strong financials irrespective of the economic cycle.  

Climate change impacts have historically not been a significant part of most private credit ESG due diligence programmes, usually due to a lack of data and a view that these risks are longer term in nature. 

However, with 2023 set to be the hottest year on record, resiliency will now depend on adapting business models in the face of multiple climate-related risks. The impacts go beyond the transition and physical risks of climate change as well, to encompass resource scarcity, biodiversity and societal impacts – both directly and throughout companies’ value chains.

As we enter a more restrictive environment for capital flows, private credit managers can expect increased scrutiny from investors into how they are adapting their ESG due diligence programmes to identify the new resilient companies of 2023 and beyond.

The increased interest in ESG across private markets is leading to closer collaboration between stakeholders, driven by the common objective to enhance ESG outcomes. The traditional view that it is not the place of lenders to provide support for corporate ESG strategies is changing. 

Private lenders are increasingly incorporating ESG into debt packages, either by requiring borrowers to fix ESG weaknesses as a precondition for lending, or by introducing ESG margin ratchets into loans. 

With the growing importance of ESG to the private debt investment case, private lenders are enjoying more access to management teams, company ESG research and monitoring, and conversations around increasing corporate ESG maturity. 

Leading debt providers are also ramping up their ESG due diligence on private equity. Aligning themselves with sponsors that share the same level of ambition on ESG is a growing priority. This multi-stakeholder support not only maximises the influence of investors, but enables borrowers to focus on making sustainability a core part of strategic and capital allocation decisions.

The penny drops

As the drive to produce tangible ESG outcomes continues, communication between sponsors and lenders will be key to ensuring objectives are aligned and management hears ‘one voice’ on ESG from their financiers. As the penny drops, expect the debt and equity relationship to draw closer still in 2023.  

Over the past year, sustainability-linked loan issuance has approximately quadrupled in terms of both aggregate loan value and deal count. Linking financial savings to an improved sustainability profile of a borrower does seem like a win-win situation. 

However, as the market matures, these types of loans are increasingly being scrutinised for their sustainability outcomes. These include having little or no impact on the sustainability of the borrower (ie, targets not being linked to “material” ESG issues); having sustainability targets that are too easy to reach (ie, the borrower was going to implement the changes anyway); and/or the discounts being too low to make a financial impact (ie, not financially worthwhile for a borrower to reach the target, or in the case of two-sided SLLs, not a high enough penalty if the target is not reached). 

Guidelines exist that advise lenders to choose key performance indicators that are business-model and business-strategy relevant, and assign targets that are ambitious, yet these guidelines remain voluntary and are not monitored to assure compliance.

As scepticism grows, expect the market to align closer to practices such as those for green bonds where second-party opinions and verification by external ESG experts are the norm. While this may increase the costs of SLLs, it will go a long way to dispel greenwashing claims.

Tamara Close is founder and managing partner at Close Group Consulting, a Montreal-based independent boutique ESG advisory firm.