Up until recently, a lot of the focus on impact investing was on the role that equity investors can play in making positive changes in the environment, society, and government. This is especially true on the stock market, which is why it got so much attention when sustainable investors got three seats on Exxon Mobil’s board of directors last year. People who work to protect the environment saw that vote as a turning point. But since there are many people who own shares in public companies, having a seat at the table is no guarantee that the company will change its ways quickly.
The impact community should be asking what role fixed income investors can play to make changes happen faster.
Why do we have lenders and debtors?
First of all, the global fixed income market is bigger than the equity market. According to SIFMA’s Capital Markets Fact Book and IBISWorld, the combined value of the global fixed income and commercial banking markets at the beginning of 2021 was nearly $126.5 trillion. This was more than the nearly $106 trillion value of the global equity markets.
Because lending agreements are made between two parties, banks and lenders that give loans, underwrite bonds, and give credit lines that are essential to a company’s daily operations have the power to make immediate environmental and social changes. Banks understand more than most other industries how important it is to think about the long term and how to do things in a way that is good for the environment, people, and the government. All they have to do is be willing to use the power they have.
At COP26, hundreds of the biggest banks in the world joined the Glasgow Financial Alliance for Net Zero (GFANZ). They promised to report on the carbon footprints of the institutions they lend to and to provide trillions of dollars in green finance. Before this initiative, there was already more going on in this area. So-called “green bonds,” which try to raise money for projects to build renewable energy sources, green buildings, and infrastructure that is good for the environment, were on the rise. This trend led to the use of similar types of project-based debt, such as blue bonds to fund marine projects and social bonds to support projects in certain communities that promote values like financial inclusion or gender equality.
A recent Bloomberg report says that because of these efforts, the so-called “ethical debt universe” has grown from $1 trillion to $2 trillion in the past three years. The World Investment Report 2021 from the United Nations Conference on Trade and Development says that from 2019 to 2020, the number of stock exchanges with dedicated sustainability bond segments grew by more than 58%, to 38.
The problem is that the global fixed income universe is a lot bigger than the ethical debt universe. Also, green bonds and other forms of proceed-based debt don’t do much to change a company’s overall strategy, the way it decides how to use its capital, or its long-term exposure to risks related to environmental, social, and governance issues. But the point of taking ESG factors into account when making investment decisions is to reduce the long-term risks that companies face because of the environment and society.
A Different Way to Do It
There are, however, ways for lenders to have a bigger impact on getting companies to reduce their ESG-related risks. For instance, instead of focusing on individual climate or social projects, the money from public debt could be used for general operations while aiming for key indicators of sustainable performance. Covenants in the terms of the debt could say how not meeting agreed-upon sustainability KPIs could affect the cost of borrowing over time.
Say a company issued a 10-year sustainability-linked bond but didn’t meet the goals in the bond to reduce its climate risk over the next 10 years. The bond’s underlying risk would go up every year, and if the annual interest rate stays the same, the value of the underlying security would go down every year because lenders aren’t getting paid for the rising risks.
This method could be used for both publicly traded debt and bank loans with longer terms. In fact, this idea is already being used in what are called “sustainability-linked loans.” The money from these loans can be used for anything, but the coupons are tied to sustainable goals.
Again, the market for sustainable loans is only a small part of the market for green bonds as a whole. This ratio could change, though, because banks and commercial paper lenders are putting in place similar mechanisms for short-term and commercial paper lines that have to be rolled over every three to six months. Working capital is the lifeblood of a business, so the risk that credit or commercial paper won’t be rolled over because of ESG issues would be very bad and give lenders even more power.
This year, the investment giant BlackRock, which is a strong supporter of sustainable investing and good corporate stewardship, reached a deal with a group of lenders on its $4.4 billion credit facility for a five-year revolving credit line. The costs of borrowing from that credit facility depend on whether or not BlackRock can meet a number of sustainability goals, such as a certain amount of assets under management (AUM) in sustainable investments and a certain level of diversity in its senior leadership and overall workforce. The Carlyle Group set up a similar ESG-linked $4.1 billion credit facility for its private equity funds in the Americas, which is the largest ESG-linked private equity credit facility in the U.S., and €2.3 billion for its European private equity and real estate platform. In addition to reaching the 30 percent board diversity goal, the European facility is tied to two other sustainability goals: having more accurate and complete measurements of greenhouse gas emissions across all of Carlyle’s portfolio companies and giving ESG-related board training to all Carlyle board directors.
Emerging markets are also slowly getting on board, though their current strategies focus mostly on sustainability and green bond markets. When it comes to addressing ESG risks, government regulations have been the way to go. For example, the Central Bank of Brazil has proposed laws that would require banks to give more information about ESG risks. It is also proposing new rules that would make it illegal for banks to lend money to projects on indigenous or deforested land. In South Africa, a technical paper put out by the government in 2020 suggested that ESG monitoring, reporting, and mitigation guidelines be made for the portfolio and transaction levels of the financial sector.
Why Aren’t We Seeing a Bigger Push?
Part of the delay may be because banks and investors are too busy competing with each other. Still, it wouldn’t be surprising to see progress soon on this front, since banks are more environmentally friendly than many other industries.
According to a 2020 survey by Fitch Ratings, 67 percent of banks around the world are already screening their loan portfolios for ESG risks to improve their underwriting and risk management. In some cases, this is a “negative screen,” which means that banks might not lend money to certain businesses, like those that make guns or start making coal-fired energy. In some cases, it’s a review with underwriters and experts on sustainability. ESG alignment also includes committing to global actions, like the U.N. Principles for Responsible Banking, which one-third of the world’s biggest banks have signed as of May 2020.
This is especially true in Europe, where 95 percent of all corporate loans are made by banks that have agreed to follow the “well below 2 degrees Celsius” goals set by the Paris Climate Accords. Compared to that, less than 10% of companies in Europe have adopted that standard.
Climate and other environmental, social, and governance (ESG) risks must be reduced for the health of financial institutions, especially those with long-term assets or liabilities.
Regulators also have a role to play in this situation. They need to push banks and lenders to avoid systemic risks and the possibility of another financial collapse like the one that happened almost 15 years ago.
As a result, the EU has started to make it a requirement for different financial institutions to tell the public about sustainability risks as part of SFDR. Officials at the U.S. Federal Reserve continue to hint that big banks might soon have to take climate-related stress tests to see how vulnerable they are to climate risks.
As world leaders look for ways to speed up sustainability efforts to meet important goals like 1.5 or 2 degrees Celsius, they should look to lending and credit more as a way to move things along faster.
