As investors widen the net of how ESG screening should be applied to different elements of their portfolio management criteria, Richard Jefferies and Marina Petroleka of Sustainable Fitch tell Environmental Finance why the firm has turned an ESG lens to the leveraged finance broadly syndicated loan market and what can be learned from their analysis.
Environmental Finance: What is driving demand for ESG scores in the broadly syndicated leveraged loan market (BSL)?
Richard Jefferies: Asset owners and institutional investors are increasingly seeking to conduct ESG assessments and sustainability screens on all their assets and portfolios. This includes leveraged finance.
The BSL market is roughly a $2 trillion market, with around 2,200 issuers. However, is it largely a private space and these instruments are not usually considered sustainability investments. These are everyday businesses that are issuing debt, often purchased by collateralised loan obligations (CLOs), to finance their own acquisitions. It is very difficult for investors to unearth the information they need to understand the sustainability of the activities of the underlying borrower in this scenario.
EF: How can investors seek to invest with sustainability in mind in the BSL space?
RJ: Large institutional investors buy the CLO notes, and the asset manager then uses the proceeds of those notes to fund loan purchases from the BSL market.
Every ESG-focused asset manager has their own way of making ESG assessments on these assets and so there is very little comparability across screening methodologies. One asset manager might give an asset a "green stamp of approval", another might give it an internal score of "57" and a third asset manager might give it a "C-". For the institutional investor, there is no way of comparing those methodologies.
We seek to give investors a comprehensive, third-party, independent view of the business activities or asset of a company. We create an ESG score that you can compare on a like-for-like basis across different companies and sectors for over 1,600 issuers covering over 90% of the European and North American markets.
EF: What sustainability trends have you observed in the BSL/CLO market?
RJ: ESG ratchets in loan documentation have decreased recently. Our sister company, Covenant Review, found in 2021/2022 ESG ratchets were seen on about half of the BSL deals. In 2023, that dropped to 19%. This remains unchanged in the first quarter of 2024.
This reflects a trend we are seeing more broadly in the sustainable finance market of investors becoming more discerning and demanding for more robust KPIs, targets, and more broadly commitments on sustainability credentials from issuers of labelled debt.
The other trend relates to data disclosure. If investors want to access a carbon metrics for a CLO, that information might not be available. As such, there's a lot of reliance on estimation of data. In Europe, 64% of BSL issuers disclose a Scope 1 and Scope 2 number, which drops to 32% for Scope 1, 2 and 3 emissions. Whereas in North America that figure for Scope 1, 2 and 3 is at 9%.
Given the lack of comprehensive and consistent disclosures, our scoring considers industry-wide sustainability considerations, including baseline emissions. This is then adjusted on an entity-by-entity basis using our own bespoke scoring methodology which is based on science-based taxonomies of reference and the social SDG to provide a holistic view of the sustainability impacts of the company.
EF: While commercial confidentiality between borrowers and lenders has a place, do you feel that there will be a growing trend for increasing transparency in sustainable loans and leveraged finance?
Marina Petroleka: Most ESG sustainability-related disclosure regulations tend to be aimed at public companies. However, some of the key pieces – such as the Corporate Sustainability Reporting Directive in Europe – will bring companies of certain sizes, whether public and private, into the fold. That is going to be one of the key step changes in the market. Other jurisdictions are also starting to mention private companies explicitly in their ESG or sustainability-related disclosure regulations. There are about 70 mandatory corporate disclosures in our ESG Regulation and Reporting Standards Tracker database now and we expect more to come.
It remains to be seen how strongly investors will ask for this information to be public. While investors are seeking consistency in ESG assessments, they may not require such disclosures to be public if they get the disclosures that they need. However, for regulators, some visibility is essential, especially for the very large private players that are present in the universe that we score and rate.
EF: How can commercial confidentially be navigated as you develop your offerings in this space and seek to enhance visibility?
RJ: Given that when a loan is issued most of the information is disclosed to lenders under a confidentiality agreement, we have structured our business to be able to work with confidential information disclosed by the lenders. Whilst the actual numeric score is not confidential, the reports are only available to those that have access to the underlying documentation.
MP: It's a high barrier to entry market. As far as we know, we don't really have a competitor that does what we do in the CLO market.
RJ: We've scored over 1,600 issuers held by CLOs to date. We turn those scores around within three business days of a primary deal transaction so that investors can efficiently use our scores as part of their decision-making process.
We also provide benchmarking. We have a monthly and quarterly report where we highlight minimum, maximum and average scores for a sector so an investor can benchmark where a portfolio holding sits in terms of different ESG performance metrics for a company or sector.
EF: How do you access these data points if they aren't disclosed?
RJ: As I said, we're disclosure agnostics. So, if a company hasn't disclosed a Scope 1 figure, that doesn't influence our score. Our analysts break a company down into its key business activities instead.
Every company has an analyst assigned to it, they write the review, and then that gets reviewed by two separate people to ensure consistency. Within the overall ESG score, the environmental weighting is 45%, social is 30% and then governance of 25%.
For the environmental score, we reference the major science-based taxonomies, such as the EU taxonomy and the CBI taxonomy. For the social score, we look at the social Sustainable Development Goals and assess whether a business is having a positive or a negative impact on those. And governance is judged via scorecard-based methodology, largely driven by the OECD Principles of Corporate Governance.
EF: How are different sectors performing on an ESG basis?
MP: Figure 1 shows the different environmental scores and ranges for different industries. Within that, we highlight the outperformers and underperformers. For example, environmental services – i.e. waste recycling. hazardous waste disposal companies – tend to consistently perform well. It's no surprise to see the resources and energy sectors tend to underperform. However, within that you do also have outliers.
RJ: It is interesting to note the difference between environmental and social scores as well. If you take the gaming, leisure and entertainment category, for example, you can see the social score (Figure 2 brings the overall score down quite significantly as we have a negative social view on gambling and certain gaming activities.
Another interesting example is the chemicals sector. The sector clusters in mid-20s environmentally, which is similar to the pharmaceuticals sector. But when you look at the social score for both sectors, you can see that pharmaceuticals scores much higher given its focus on human healthcare which positively impacts SDG 3 'Good Health and Wellbeing'. These are interesting portfolio considerations that CLO managers may want to take into account.
With CLOs, the noteholders are taking the portfolio risk. There are often constraints on portfolio managers in terms of the maximum concentrations they can have and industries they can invest in, etc. So, if you're constrained in a sector, you want to make sure you are holding a best-in-class company. Having an ESG score – and the ability to benchmark ESG performance – will help you identify sustainability outperformers amongst your holdings.
EF: Are there material sustainability performance differences between CLOs?
RJ: The average score for CLOs in the US is 47.9 out of 100, and the average in Europe is 50.4. So, you can see the US trends lower. I think part of that is due to the underlying assets that they have available to invest in – in the US a lot of energy companies in this space are hydrocarbon-based.
What we see globally is CLOs that have the largest holdings in healthcare, pharmaceuticals and telecommunications perform best across both environmental and social dimensions, whereas, when the CLO most exposed to retail power, utilities and broadcasting, they tend to form worse.
EF: How do leveraged finance issuers' climate targets compare with the publicly listed space?
MP: In a recent piece of analysis of the 1,600 issuers on our database, we found just under 30% have disclosed any sort of climate-related targets. Within this group, most of them reference Scope 1 and 2 targets.
In terms of net zero targets – which is a gold standard in the publicly listed space – fewer than 10% have a net zero target. When we break that down further, we find that many do not meet recommended best industry practise, such as being aligned with the Science Based Targets initiative.
Looking at it on a sector basis, the environmental services, telecoms, media technology and transport sectors have slightly better disclosures, but it's not a strong outperformance. It's ever so slightly better when compared to the other industries.
Interestingly, when we look at the consumer space, a lot of entities that do disclose climate-related targets tend to focus on 'climate neutrality'. Under best practise criteria, that can be a red flag. The point with climate neutrality is you could, in theory, keep increasing your emissions if you offset and still claim carbon neutrality.
The other point to note is that a lack of publicly disclosed targets tends to suggest exposure to transition risks and poor climate risk management.
EF: What are you hoping to achieve next with your leveraged finance ESG offerings?
MP: ESG Scores are given at a point in time, without any benefit given for initiatives that have not yet been completed. As we review the portfolio, we will start to be able to track which companies are improving their score which will be another data point for investors to consider.
Further adoption from both end investors and managers, leading to greater demand for debt from more sustainable companies.
Figure 1: Industry Comparison - Environmental Scores
Figure 2: Industry Comparison - Social Scores
Marina Petroleka is managing director, global head of research and Richard Jefferies is senior director, head of ESG Scores for leveraged finance at Sustainable Fitch.
For more information, see: sustainablefitch.com
