April 2021 | Issue 233
Opinion ESG
The heterogeneous set of KPIs make comparisons difficult and self-policing hurts credibility
Fatima Hadj
Chairwoman, structured finance advisory board Principles for Responsible Investment
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Loans with ESG ratchets are popular and a good way to align incentives – but we need accountable external reviewers
Increasing numbers of loans are incorporating environmental, social, and corporate governance (ESG) factors, especially in Europe, which is the leading region for issuance of ESG loans. In the EU, growth is likely to further increase in the next 18 months as around 50 European laws are under review to incorporate ESG factors.
The ESG ratchet is the latest innovation for bank loans, but the mechanism is not new. Ratchet pricing comes from private equity, although it has been adapted for the debt market.
Ratchet pricing in private equity
The aim of an equity ratchet is to align the interests of the management team with those of the private equity investors. The principle is simple — it is like offering a piece of the cake. If the management team increases the value of the company, it will increase the gains for the equity investors, who will share some of the value with the management team.
Usually this is set up so that, if the team performs according to pre-defined parameters, its share of the equity will increase, as will its share of the exit proceeds.
For the debt market, the margin ratchet creates an incentive for the borrower to improve its ESG impact. If the borrower achieves pre-determined sustainability targets, referred to as key performance indicators (KPIs), the interest rate on the loan decreases. On the other hand, failing to comply with certain KPIs can lead to a margin premium, increasing the borrower’s cost of capital.
Usually, there are one to three KPIs and the most common cite an issuer’s carbon footprint, water consumption and governance. For instance, the borrower will benefit from a lower cost of debt when the emission of carbon is reduced to a pre-defined level.
With pressure growing on investors to assess and report on their ESG impact by monitoring their carbon footprint, gender diversity and governance, this incentive-based approach aims to guarantee the commitment of all parties of a loan financing to sustainable development goals.
It’s a good start. But there are discrepancies in this incentive mechanism.
Self-policing creates issues
The two main concerns are, on one hand, the very heterogeneous set of KPIs that will make comparisons between companies difficult and, on the other hand, the fact that targets are set, measured and policed by companies themselves.
Sustainability Linked Loan Principles, published in March 2019 by the Asian, European and North American loan associations, are aiming to address those concerns and improve disclosure. They recommend that the borrower’s KPIs are assessed by an external reviewer. But even this is just pushing the concern to the last party involved in the game. How can the external reviewers be trusted and how do we prevent cherry-picking of external reviewers, where those having the less conservative methodologies win the mandates?
Does this situation ring a bell? The credit rating agencies were in a similar situation during the global financial crisis in 2008. Which solutions did we put in place to mitigate the risks identified? Effectively, we increased the accountability of the credit rating agencies by making them liable for faulty ratings. We did this by increasing oversight of internal controls and by increasing transparency about their rating methodologies and performance.
In finance, we should stick to a simple postulate: no accountability and no transparency leads to no credibility.
Co-authored by Murray Birt, senior ESG strategist, DWS
Principles for Responsible Investments is a UN-linked campaigning organisation committed to keeping market participants posted on the key milestones, industry actions and ESG tools that can help transition portfolios to net zero carbon.
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Global credit funds & CLO's
April 2021
| Issue 233
Published in London & New York.
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