by Martin Sharkey, Partner, Dentons
A concern for the environment, fair treatment and the rule of law are not new. However, in a post-industrial and capitalist world where technological advancement and profit have for so long been the goals of large corporations and many individuals, the perception and urgency of these considerations is beginning to change. Whether you are attending structured finance conferences or reading magazine articles in the financial press, the buzzword or phrase has very much become ESG.
Environmental, social and governance (ESG) issues are now at the forefront of corporate thinking, as a source of risk and opportunity. Several factors are driving this change – including stakeholder activism, ESG related litigation, and new legislation on ESG related issues, much of which has extra territorial reach. Stakeholders, including shareholders, bondholders, financiers, counterparties, employees, contractors, communities and supply chains, are effectively influencing corporate behaviour. ESG forms part of wider societal trends including climate change, artificial intelligence and data privacy.
The very human challenges of dealing with a pandemic has accelerated this shift, and ESG has become an imperative in 2020. Increasingly ESG is becoming a fundamental part of the investment process.
What is ESG?
ESG stands for the environmental, social and governance factors to be taken into account when making investment decisions and assessing risk. To take each in turn:
Environmental: Will there be a positive or negative impact on the environment from the transaction? For example, is the proposed financing linked to “green” energy (solar, wind, hydro etc), or on the other hand fossil fuels? This might include consideration of factors such as climate change, energy consumption, water use, biodiversity and waste management.
Social: This considers the wider social impact of the company, commercial activities, or the transaction, including factors such as diversity and inclusion, community relations, human rights, labour standards, and data and privacy. Certain industries may be particularly high risk (for example gambling, munitions, pornography, and tobacco). However, social factors may be relevant across a wide range of sectors, particularly as it also covers supply chain matters. Even in the UK today, slavery and human trafficking may be present in companies’ supply chains, especially given the cheap costs of labour and manufacturing in some countries with questionable human rights regimes.
Governance: Whether checks and balances are structured into the transaction, particularly with regard to conflicts of interests, moral hazards and transparency. This could arise in areas such as LIBOR replacement, consents needed for the making of amendments to documentation, credit default swaps etc. Additionally, is there compliance with sanctions, anti-bribery and anti-corruption laws and best practice?
The above are only examples for illustrative purposes and should not be treated as exclusive or all encompassing. Although the main focus tends to be on environmental aspects of transactions, we would expect that, in the aftermath of COVID-19, more attention will also be paid to social aspects. Whereas it could be said that governance issues within a transaction are often already items that tend to be heavily negotiated.
ESG and Securitisation
It then falls to consider what would merit a securitisation being labelled as ESG. Different positions have been advanced in this respect:
- Regard should be had to the assets backing the transaction and whether these meet ESG criteria
- Does the issuer or originator of the securitisation have strong ESG credentials which can be evidenced;
- Will the proceeds from the securitisation ultimately be used for purposes which have a positive ESG impact; or
- Will the investor profits from the securitisation be used for purposes which align with ESG considerations.
Securitisation industry bodies, including in particular AFME which has published position papers on “green securitisation”, appear to be coalescing around the view that for securitisations the evaluation should be founded upon the assets which back the securitisation. On the basis that the assets are what underpin the financing and incentivise the investors (both primary and secondary) to provide funding or make the investment. Anything else could be said to be too far removed and would be too remote a link. For example, a securitisation of corporate loans to fossil fuel companies, but which also provides funding to the originator to establish a wind farm, may not be as palatable to ESG conscious investors, whose funding would then have been used to acquire fossil fuel assets and whose return will be linked to the performance of such fossil fuel assets.
It is notable that ESG criteria can apply across the whole gamut of asset classes: auto-loans, SMEs, leveraged loans, transportation, RMBS, CMBS and whole business. Even for consumer loans there are considerations such as origination and servicing practices – has there been a robust appraisal of the applicants’ ability to repay the loan, the fairness of the terms of the loan, its purpose and whether there is a willingness to grant payment holidays in a stressed scenario, for example.
Documents and Structuring
Offering documentation should also contain disclosure on the ESG aspects of a transaction, or arguably the lack thereof. This disclosure could include origination and servicing policies, a description of the use of proceeds, a description of how the securitisation complies with any ESG framework or taxonomy, and the contents of any ongoing reporting. As a general principle, in Recital (30), the Securitisation Regulation states that where data on the environmental impact of assets underlying securitisations are available, the originator and sponsor of such securitisations should publish them. Accordingly, Article 22 of the Securitisation Regulation specifically requires the originator and sponsor to publish the available information related to the environmental performance of the underlying assets, where such assets are financed by residential loans or auto loans or leases.
In terms of structuring, a transaction’s eligibility criteria can be used to both require that the portfolio assets meet certain ESG criteria, and to prohibit assets which fall into certain areas such as fossil fuels or armaments etc. For dynamic portfolios an ongoing testing regime can be put in place which measures whether or not the portfolio is meeting ESG targets. The results of such testing may solely be for transparency purposes or could conceivably impact the way the transaction is managed or operates.
It will be important to carry out diligence and seek assurance of any claims made relating to ESG performance in offering documentation. ESG criteria and performance do not currently have a universally regulated benchmark, and traditional due diligence in areas such as environment, health and safety (EHS) and employment will not adequately assess ESG risk. A new approach is needed.
When evaluating whether a transaction is ESG or “green”, one should also be wary of “greenwashing”, whereby a transaction is characterised as “green” but in reality may not truly be so. With this in mind we believe it important that “green” securitisations should be backed by green assets and that it is not helpful if the portfolio were “polluted” or “contaminated” through the inclusion of non-green or so called “brown” assets. Although some allowance could be made for assets which are transitioning into becoming “green”. It would also assist if the industry and regulators could agree benchmarks for what leads to a transaction being eligible to obtain an ESG label. Independent third party verifiers also have a role to play here.
Third Party Verifiers
It is vital that an independent verification of a securitisation’s ESG credentials is available. Currently the credit rating agencies are building ESG factors into their analysis where this has an impact on credit worthiness. However, this is far from ideal and, in our view, the ESG evaluation should be independent of credit. Although we can see how the credit evaluation, in particular with regard to the assessment of the long-term sustainability of an asset or business, may be impacted by ESG concerns. Therefore, there is a need in the structured finance space for ESG specific third party verifiers, similar to as currently exist in the equities and corporate bond space. Albeit we also welcome the fact that ESG is recognised as having an impact on credit and business sustainability.
In our view, the measurement of whether a structured finance transaction is ESG or “green” should not only be decided simply at the closing date, but be continuously monitored throughout the ongoing life of the transaction. It is important to bear in mind that what is considered an acceptable ESG performance standard today, may not be so considered in 5 or 10 years’ time hence. Analogies can obviously be drawn with the credit worthiness of assets which may fluctuate during the life of a transaction and are not static. Certainly credit ratings are not static and may be subject to downgrades or upgrades. It therefore would be helpful to have ongoing periodic measurement and reporting of the assets’ compliance with ESG criteria, and for third party verifiers to update their ESG ratings from time to time as merited. Even if there is no sanction for poor ESG performance this transparency will enable investors to evaluate whether they should buy into a particular product or even to divest themselves of it, and ultimately to pressure originators/issuers to improve standards and even to exceed current minimum ESG criteria.
Incentives and Treatment for ESG Transactions
As a policy tool it has also been suggested that to stimulate the market ESG securitisations should receive beneficial regulatory capital treatment. This is a complicated area but, on balance, the arguments seem to be in favour. It would help encourage the market in its infancy and also be in line with the goals of governments and global organisations to achieve a more sustainable and fairer world. However, in order to receive more favourable regulatory capital treatment a securitisation should also be required to have sufficient levels of credit quality and performance as well. Other incentives could include better treatment for central bank eligibility programmes, government investment in ESG transactions, or otherwise some types of subsidies, tax relief or guarantees for the underlying assets. This could help to address one of the limiting factors for ESG securitisations in Europe, namely the lack of sufficiently large and homogenous pools of “green” assets.
Perhaps the required stimulus is not dissimilar to what we are currently seeing for sections of the economy impacted by COVID-19. Such subsidies, tax reliefs or guarantees for underlying assets which are then securitised in ESG securitisations could themselves play a part in maximising the chances of a “green” recovery from the COVID-19 pandemic.
ESG bonds are also said to have created demand from a wider range of investors, who may not have previously invested, or only had minimal participation, in debt capital markets, and the ESG label can help to differentiate bond offerings in a crowded financial marketplace.
Many banks and financial institutions now include an ESG analysis as part of their investment decision, and ESG factors are increasingly important in that decision making process.
Indeed, we have seen a dramatic rise in the profile of ESG and green financing transactions, and this is also combined with an increase in investor demand and queries relating to the same. This is an area with massive potential for growth and which is here to stay.
The legal framework is evolving quickly in this area. Many jurisdictions, either through regulation or listing standards, require a certain level of ESG reporting and disclosure from companies to provide investors with material ESG-related information. Examples include
- Human rights focused disclosure obligations such as the UK Modern Slavery Act 2015 , the California Transparency in Supply Chains legislation, and the French Corporate Duty of Vigilance Law 2017;
- The UK Companies Act 2006 S414C requires quoted stock companies to have a section in their strategic report which includes information about environmental matters (including the impact of the company’s business on the environment) and social, community and human rights issues.
- The revised UK Stewardship Code which came into effect on 1 January 2020, includes a new principle under which signatories are expected to take into consideration material environmental, social and governance issues, which may include human rights issues.
- The EU Non-Financial Reporting Directive 2014 imposed non-financial mandatory reporting on certain large companies (those with more than 500 employees and a balance sheet total of more than EUR 20M or net turnover of more than EUR 40M). The non-financial statement should include information relating to environmental, social and employee matters, respect for human rights and anti-corruption and bribery matters and the main risks from those factors.
On 22 June 2020, the EU Regulation on the Establishment of a Framework to Facilitate Sustainable Investment (widely referred to as the Taxonomy Regulation) was published. The Taxonomy Regulation sets out an EU-wide classification system, or “taxonomy”, to provide businesses and investors with a common language to identify environmentally sustainable economic activities. The detail of the taxonomy is being developed currently and should be established by the end of 2021 for application by the end of 2022.
The UK government has not yet published a decision on whether it will adopt the EU’s taxonomy as the UK approaches the end of its post-Brexit transition period.
As well as legislation, we are seeing a rise in ESG related litigation, including negligence cases concerning human rights issues or lender liability cases against development banks such as the World Bank.