Opinion ESG

The imperfect incorporation of ESG is no excuse not to act

Fatima Hadj

HSBC and Barclays have been in the spotlight over fossil fuel financing in the past few months, but they are not alone in being grilled by shareholders. Nearly 550 investors are putting pressure on the largest carbon-polluting companies to publish net zero targets with detailed and fully costed transition plans on climate change.

Understanding long-term trends

Some of the following trends are already monitored by the Forecast Policy Scenario of PRI:

Transformation of energy: 74% or more of power is expected to come from renewables by 2040.

Electrification of transport: the banning of internal combustion engines sales is expected to drive rapid deployment of ultra-low emissions vehicles, which will make up almost 70% of passenger vehicles by 2040.

Deforestation virtually eliminated by 2030: land use shifts include growth in bioenergy crops, which will meet around 10% of global energy demand by 2050.

Resilient infrastructure: according to a recent study (Springer Nature’s Scientific Reports, July 2020), the frequency of coastal flooding is set to rise by around 50% over the next 80 years, and could threaten human lives and habitat.

All these sectors need financing solutions. For debt funds, ESG criteria have thus become a focus. In the CLO market, there are some CLOs structured with an ESG component to address these risks and collect investment opportunities. But we can already hear objections from people explaining to us that ESG CLOs do not benefit from a premium. We agree: ESG screening does not yet impact the cost of capital because there is no harmonisation of ESG factors. But ESG CLOs do have similar approaches.

The most common feature is the use of negative screening in the CLO’s investment eligibility criteria. The next step will be to precisely define the terms so comparable criteria can be created. The Platform on Sustainable Finance, which advises the European Commission on ESG regulation, will have to look at that closely.

On the other hand, the scope of industries and activities excluded differs. Loans to obligors which are engaged in certain activities are excluded if the obligors derive more than a certain percentage of their revenues from such business. But that percentage can be 10%, 30% or 50%.

A manager’s ESG evaluation process does not really make them accountable for the ESG compliance of the portfolio. The assessment of compliance with the ESG eligibility criteria is “reasonably determined by” or “at the sole discretion of” the manager on “the information available to” the manager. This legal language is weak.

Nevertheless, even with this imperfect incorporation of ESG, those CLOs are screening companies with sustainable and robust business models. The next step is for CLO issuers to help obligors shift to net zero emissions and climate resilient business models.

However, imperfection is no excuse not to act. Managers should start with a snapshot of the carbon footprint of portfolios and then direct investments to long-term trends, while strengthening issuers’ engagement with obligors to help them evolve their business models.