How Is ESG Regulation Influencing Investor Behaviour? | Alston & Bird – JDSupra – JD Supra

How Is ESG Regulation Influencing Investor Behaviour? | Alston & Bird – JDSupra JD SupraHow Is ESG Regulation Influencing Investor Behaviour? | Alston & Bird – JDSupra JD SupraHow Is ESG Regulation Influencing Investor Behaviour? | Alston & Bird – JDSupra JD Supra

It took 13 years for the first $1 trillion worth of sustainable bonds to be printed. It took only one year to double that amount. Our Finance and Financial Services & Products Groups focus on the emerging trend in collateralized loan obligations (CLOs). They also examine current ESG trends and considerations that are relevant to those who want to introduce ESG CLOs to market.
Lenders have been slow to adopt ESG due to a lack of data about borrowers.
In 2021, negative screening was so common that it became almost a universal phenomenon
Regulating is a driving force behind systematic ESG incorporation.
Since the pandemic, environmental, social, and governance (ESG), have been a hot topic in global debt capital markets. Despite the slow adaptation of the securitization markets to this trend, due in part to the complex nature the market, investor interest is growing in ESG. The securitization industry is rapidly evolving across product types, including asset-backed securities and residential or commercial mortgage-backed security, with increasing green, sustainable, and sustainability issuance. Many deals refer to the International Capital Market Association’s green, sustainable, and sustainable principles or United Nations Sustainable Development Goals.
ESG considerations have been prioritised, largely driven in part by investor demand, over recent years. Investors are looking for more information and data on ESG. They recognize that the topic poses a serious, if perhaps existential, risk to their investment models, rather than being a ‘nice-to-have’ element. Citigroup Inc. reported in April 2021 that 20-40% U.S. collateralized loans obligation (CLO), managers will incorporate ESG factors in new issue CLOs in 2022 or 2023, driven by increasing investor demand. This is an increase of 11% in 2020 and just 3% in 2019. Many fund managers are adapting their investment strategies to meet these pressures. This movement isn’t just in Europe; it is important worldwide. While most of the changes are happening in Europe, investors are also watching other regions like APAC and America.
This trend can be summarized in two words: “risk management”. ESG has become a major concern for credit quality. Investors and financial market stakeholders have identified increasing numbers of ESG-related risk. The question is now how can these ESG risks be measured? How can investors and financial market stakeholders try to reduce their exposure to ESG risk in the products that they invest in?
However, these demands are not only about risk management but also reflect a desire for a positive environmental and social impact. A word of caution is required here. Many investors believe that ESG issues don’t impact whether an investment is made. This is especially true in relation to CLOs. ESG factors are considered tail-risk events and not part of daily investment decisions. This area needs to be further examined, especially given the rise in ESG after the pandemic.
These trends have led to the convergence of ESG and securitized capital markets products (while still in its infancy) evolving quickly. There has been a marked increase in ESG provisions within the CLO market as a result, in large part due to the pressure investors are exerting.
The CLO Market
CLOs are the largest buyers of leveraged loans, which they repackage into floating-rate securities. The U.S. saw record issuance, including new issue and refis, of approximately $107.5 billion in Q121. This is 169% more than Q120. New CLO issuance in Europe reached EUR7.8billion in Q121, a 35% increase year-over-year and the highest quarter for new issuance since Q219. CLO resets, which reprice existing portfolios and extend deal investment periods, saw a significant year-on-year increase. Refinancings, which maintain maturities and lower the spreads payable by investors, also saw a significant improvement. European CLO refinancings reached EUR8.3billion in Q121, compared to zero in Q120. Resets increased to EUR9.8billion from EUR790m over the same period in 2020. Analysts now anticipate that repricings and resets for 2021 will be significantly higher than initial forecasts. This is due to the continued strong supply and demand from investors. Both are due to the 2020 backlog. This is further bolstered by the short, one-year non-call agreements that will be available for refinancing in 2020. Morgan Stanley now projects that there will be EUR50 billion in CLO resets and refinancings on the European market by 2021. This is an increase from the EUR15-20billion estimate in its 2021 outlook. Investors are adjusting to reflation by buying more debt that will yield higher yields.
ESG criteria are now included in 44% of European CLOs. While the U.S. is still behind Europe in incorporating ESG criteria into its CLOs, they are now following the ESG trend. BofA CLO research has revealed that more than 70 U.S. CLO Managers are now signatories of the UN Principles for Responsible Investment. Indentures for more 200 CLOs recently priced have also included negative screening criteria.
However, unlike corporate bonds, loans have not been able to embrace ESG. This is due to a lack data on borrowers. Globally, the number of loans that are labelled “green” is very small. Leveraging to leveraged companies does not often include terms that are based on clearly defined ESG benefits. Additionally, the companies are often backed with private equity sponsors who may have an image problem when referring to ESG impact. This is changing. In Europe, particularly in the sustainability-linked loan market, companies have started to include incentives or key performance indicators (KPI) – known as ratchets – in loan documentation to, for example, reduce borrowing costs if defined sustainability goals or KPIs are met.
Negative Screening or Positive Screening?
Since the 2019 introduction of ESG negative screening, ESG and CLOs are increasingly interacting. CLOs have been convergent since the introduction of ESG negative screening in 2019. CLO managers oversee a process that involves a negative screening process. This involves identifying non-ESG-friendly sectors (typically based upon a certain percentage) that they are prohibited to invest in as part the ‘collateral obligation’ definition. These industries or sectors include tobacco products, which have been long excluded from CLO portfolios. However, they also include arms, gambling and thermal coal production. CLO managers face many challenges when screening non-ESG-friendly businesses. This is due to the vagueness of the prohibitions, which often require discretionary management. CLOs may prohibit ‘hazardous chemicals’ as part of ESG screening. However, the nature of the danger is often not defined. Portfolio managers are required to decide whether all chemicals are hazardous at some level and avoid the sector. The lack of harmonization in legal documentation accompanying CLO issuance poses further challenges. There is no standard approach to incorporating ESG considerations in CLOs. CLO managers have more flexibility than others when it comes to dealings that prohibit the same activity or industry. This documentation background makes it difficult for CLO managers to evaluate ESG risks. There is also little price difference between ESG CLOs, mainstream products, and ESG CLOs.
ESG negative screening became so common in 2021 that it was almost universal. The ESG provisions in CLOs have seen more changes this year. Forward-thinking managers introduced subjective ESG scoring across CLO portfolios. They also created objective ESG reporting on CLO assets. This information includes information about what happens if an obligor is non-ESG compliant. This is especially the case in the sustainability-linked loan (SLL) market, which has developed more ESG components within products within the SLL and high-yield bond market.
As the proportion of leveraged loans that include ESG-related elements increases globally, CLO managers may soon be able to adopt language that pushes for the positive inclusion of sustainable or sustainability-linked assets, which are becoming increasingly prevalent across the global markets. This would be a shift in which CLOs start to positively screen assets with ESG components and include them in their portfolios. In just two years, between 2019 and 2021, we will have gone from a few leveraged borrowers making ESG promises to a large number of leveraged primary issuances in 2021 that contain ESG covenants. The combination of the SFDR, bond market demand, and the acceleration in ESG in non-investment grade markets opens the door for CLOs that positively commit to minimal ESG portfolio concentrations. This could lead to CLOs with entire portfolios of these ESG products.
Regulative Pressures
Regulation is an important factor in the drive for more systematic ESG incorporation. It is not only important for risk management but also for a positive social and environmental impact. The first provisions of the EU sustainability-related disclosures in the SFDR came into force in March 2021 as part of the EU Commission’s policy focus on sustainable finance and of the EU’s ambition to be climate-neutral by 2050. The SFDR covers a wide range of financial market participants. It aims to increase transparency by preventing ‘greenwashing’ and require enhanced disclosure of ESG products. These regulatory changes are being led in Europe but their repercussions have a wider reach as all financial market participants who want to operate in the EU must comply.
The EU taxonomy to sustain activities, a system that identifies environmentally sustainable economic activities, is another source of regulatory movement in Europe. The European Union is also working towards a EU green bond standard. The new Biden administration’s recommitment of the Paris Agreement; the Green New Deal proposal in Congress; the SEC request for public input from investors and registrants on climate change disclosure; and, the Commodity Futures Trading Commission’s establishment of a new climate-risk unit.
The SFDR imposes a heavy compliance load on financial market participants, including investment mangers, by requiring them to disclose certain information about (1) how sustainability risks are integrated into their investment decision-making process; (2) whether and, if so how they consider principal adverse effects of investment decisions on sustainability factors. It requires them to disclose at the product level how they assess the principal adverse effects that investee entities might have on sustainability factors. Although the SFDR doesn’t directly impact CLO issuers, EU-based CLO managers, which are credit institutions or investment companies, are likely to be affected by the SFDR as they provide portfolio management services.
If a financial product promotes ESG attributes or objectives broadly (known under Article 8 funds, a light green’ product), or has sustainable investing as its objective (known under Article 9 funds, a “dark green” product), disclosures must include information about how these characteristics or objectives will be met. These products must also comply with reporting requirements effective January 2022. The final regulatory technical standards will provide further details about the reporting forms and disclosures. This issue will likely remain in discussion until more clarity is provided.
The UK has not yet implemented the SFDR in its domestic law. Many UK-based managers of European CLOs will therefore be outside the SFDR’s jurisdictional reach. The SFDR’s main purpose is to harmonize – the EU believes that the financial sector can play a vital role in achieving its sustainable development goals. Therefore, we expect that non-EU managers will strive to comply with reporting provisions similar to those in the SFDR. This could lead to an increase in CLOs that are structured as Article 8 funds under SFDR. Article 8 funds already invest in CLOs, and we may see CLOs being marketed as Article 8 fund (with the possibility of Article 9 CLOs following).
Conclusion
ESG-screening (both positive and negative) is becoming a standard for many products. We have seen evidence that more sophisticated data analysis is being used to assess ESG performance. There are still many challenges ahead. Not least is the need to provide more information in a more consistent and uniform manner. The biggest challenge is overcoming the inadequacy of data needed to conduct ESG due diligence. Investors can then begin systematically integrating ESG elements into their securitized product analysis. It is clear that this problem can be overcome if there is industry cooperation in order to reach a holistic, multi-pronged approach at the industry level that can provide standardized and harmonized data and information.
This will ensure that ESG CLOs continue to grow in the medium and near term. Investors are calling for CLOs who embrace ESG to be a part of the future. ESG-related investments are in high demand. This is especially true as the world gathers at COP26, where there is a greater focus on climate change. These developments are well-suited for the CLO markets. We can expect more ESG CLOs to focus on sustainable sectors like infrastructure, renewables and clean energy – electric, solar, wind, and so forth.
To print the first $1 trillion worth of sustainable bonds, it took 13 years from 2000 to 2020. To double that, it took only one more year in 2021. Just think about it…
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