ESG integration in private debt: Towards Data Template Convergence?
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In our July 2022 article entitled, “ESG integration in private debt, challenges and opportunities”, we discussed the rise of the private debt market in recent years and its expected continued growth, in tandem with the wider trend of ESG integration into debt capital markets, including the underlying asset classes of private debt (Corporate, Infrastructure, Real Estate…). We observed the extent to which private debt investors were committed to evaluating borrowers ESG credentials based on various metrics and including these parameters as part of their sustainable investment strategies, while recognizing that significant constraints were preventing further ESG integration, including lack of regulatory clarity around new rules and classification systems being introduced in Europe (such as CSRD for Corporates and SFDR for Financial Market Participants), and difficulties in accessing appropriate ESG data.
Subsequently, from Sep – Dec 2022 we conducted a series of meetings with private debt investors focusing on ESG integration to better understand their related objectives, strategies, tools and resources. Our inquiry revealed the following:
- ESG integration strategies are generally intended to achieve one or more of the following three objectives: achieve investors’ inhouse CSR goals (mentioned most frequently as the key driver), improve portfolio risk/return profile and create investment products in line with end investor demand.
- Widespread use of third parties to obtain ESG-related data and analysis (80% of investors).
- Private debt investors’ focus on addressing gaps in the market (smaller scale companies and projects, proven “new infra” technologies such as CCS, Hydrogen, EV batteries storage, Biomass…).
Clearly, data collection, harmonization, standardization, analysis, and reporting represent both a critical driver and a primary constraint in terms of further ESG integration by private debt investors into their investment strategies.
ESG disclosure initiatives – Frameworks & templates
In response to this situation, several initiatives have been undertaken to improve the amount and the quality of available ESG data, to allow corporates and investors to (i) fulfill their reporting obligations, (ii) measure their progress in achieving their respective CSR goals and commitments and (iii) supply information to end investors about the environmental and social footprints of their portfolios). These efforts have been undertaken by large private debt investment firms with the strong support of industry trade associations, or by the trade associations themselves. They include notably:
The European Leveraged Finance Association (ELFA) ESG Committee
The ELFA’s ESG Fact Sheets, first published in 2020, are designed to be used by borrowers as a guideline for disclosure on ESG topics and associated metrics that could be relevant to an investment decision. Additional related templates have been progressively developed along the way, to provide a full range of disclosure guidance in the area of leveraged finance, including the Guide for Company Advisers to ESG Disclosure in Leveraged Finance Transactions (Jan. 2021), the CLO Manager ESG Diligence Questionnaire (Jun. 2021, Oct. 2022), the Best Practice Guide to Sustainability Linked Leveraged Loans (Jul. 2021), the ESG Provisions in Leveraged Loans Questionnaire (Nov. 2021), and the ESG Exclusion Checklist for Business Activities (Jan. 2022).
The ESG Integrated Disclosure Project (IDP)
The ESG IDP promotes transparency, harmonization, and consistency of ESG disclosure by borrowers in private credit and syndicated loan transactions. It integrates SASB Standards to facilitate disclosure of industry-specific financially material information by private companies. The ESG IDP was formed by the Alternative Credit Council (ACC), the private credit affiliate of the Alternative Investment Management Association (AIMA), the Loan Syndications and Trading Association (LSTA), and the United Nations-supported Principles for Responsible Investment (PRI) in co-operation with a group of leading alternative asset managers and credit investors. The ESG IDP is also supported by a coalition of market stakeholders including the Carbon Disclosure Project (CDP), the ESG Data Convergence Initiative and the Loan Market Association (LMA).
To be noted that the ESG IDP’s template aims to be a universal template for ESG disclosure for all types of borrowers.
The ESG Covenant Package
The ESG Covenant Package was designed by a group of major infrastructure lenders, including Aviva Investors, LGIM Real Assets, IFM Investors, Macquarie Asset Management, Aberdeen, BlackRock and Allianz Global Investors. The package is largely based on the EU’s Sustainable Finance Disclosure Regulation (SFDR) and focuses primarily on ESG reporting obligations. The package is intended to be part of the term sheet negotiation stage between relevant parties. It has been updated to reflect the Regulatory Technical Standards (RTS) under SFDR, in April 2022.
The initiative aims to:
- unify ESG data collection by providing a consistent set of requirements as “best practice” for borrowers when reporting to lenders in respect of ESG matters; and
- facilitate lenders’ compliance with their increasing ESG disclosure obligations under applicable EU and/or UK law and regulations and, where relevant, lenders’ compliance with their own net zero targets and investor demand.
The Devil is in the Data
The structure of the private data templates mentioned above integrate at a certain level the general approach of the SFDR PAI, whilst going into more detail.
Update on Sustainable Financial Disclosure Regulation (SFDR)
Recall that SFDR mandates disclosures by Financial Market Participants (FMP) and Financial Adviser (FAs) based on “Double Materiality” principles. Financial Materiality is captured in the “Sustainability risks” disclosures and the Impact Materiality is captured in the “Principal Adverse Impacts (PAI) on sustainability factors”.
SFDR requires disclosure at both entity and product level.
FMPs are required to make entity-level disclosures on how the firm assesses PAI and establishes fund-level disclosures on a comply or explain basis.
FMPs are also required to disclose product level information for ESG-related and non-ESG related products. This means that FMPs will have to follow product-specific disclosures, that require reporting of PAI on 14 mandatory indicators, plus a choice of 2 optional indicators from a list of 46. The products and services organizations offer must be classified into three categories, as laid out by article 6) mainstream products which do not integrate of sustainability into the investment process, article 8) products promoting environmental or social characteristics, and article 9) products targeting sustainable investments.
Entered into force in March 2021 (RTS 1 – General rules: high level principles), further requirements will apply from January 2023 (RTS 2 – Product-level: pre-contractual documents and periodic reports).
On the 2nd of June 2022, following what they describe as “numerous requests for clarifications received from stakeholders and national competent authorities”, the European Supervisory Authorities (ESAs) published a document entitled “Clarifications on the ESAs’ draft RTS under SFDR” (the Clarifications).
The Clarifications confirm several interpretations which we have taken to date and, in some areas, reduce the potential regulatory burden arising from the Level 2 RTS made under the SFDR. The document includes:
- Clarifications related to disclosure of principal adverse impact (PAI) of investment decisions on sustainability factors
- Guidance related to periodic financial product disclosures
- Guidance related to taxonomy-related financial product disclosures
- Guidance related to “do not significantly harm” (DNSH) disclosures
- Guidance related to disclosures for financial products with investment options
Towards ESG Data Template Convergence?
Focusing on the ESG Covenant Package and ESG IDP template (as ELFA initiative mostly revolves around the identification of best practices, the release of guidelines, and sectors specific ESG Fact Sheets), both provide data that can be broken in two ways:
- core general questions, optional general questions, and industry-specific questions
- by category of ESG-related criteria:
“ESG Covenant Package” initiative mirror SFDR PAI template, addressing both mandatory and optional PAI that are relevant for the infrastructure sector (14 mandatory + 34 optional).
- In addition, it addresses also the TCFD (Task Force on Climate-related Financial Disclosures) requirement on climate physical and transition risks identification and assessment, it aims at evaluating the ESG policies in place at sponsor level, with a focus on Health & Safety management systems, and the E&S incidents which could be registered at project company level.
- However, note if the questionnaire provides an exhaustive assessment of the Environmental and Social pillars, pure Governance issues are not really taken under considerations.
In contrast, “ESG Integrated Disclosure Project” does not mirror SFDR, although several questions allow to address some PAI (mandatory and/or optional).
The 3 ESG pillars are considered either through qualitative or quantitative questions:
- Environmental: e.g., on Climate, GHG emissions and Energy management
- Social: e.g., Employee turnover, Workplace safety
- Governance: e.g., Board and Management diversity
It is also worth to note that the template requires transparency on exposure to controversial sectors (e.g., Coal, Nuclear, Weapons, Alcohol, Tobacco, etc.), as well as compliance with Sustainability frameworks (e.g., ILO, OECD guidelines, UN Global Compact, TCFD, etc.).
With widespread recourse to third party data by private debt investors currently required to fulfil their needs, the above mentioned ESG template initiatives serve several purposes:
- quantifying required information in a more or less exhaustive way,
- managing borrowers and investors’ expectations, and
- responding to reporting requirements for which required data is often lacking.
Indeed, the larger scope of the private initiatives compared to SFDR PAI repository suggests that the former will boost investors reporting capacity under the latter.
These templates are also intended to boost reporting directly from borrowers in response to private debt investors’ requirements, although borrowers’ ability to fully address investors data requirements on their own may be some years away, in particular with regards real assets financing.
Finally, we can also foresee an evolution of market practices on the banks' side. Indeed, we reckon that in the near future credit term sheets could include borrowers’ ESG covenant information.
 On the 5th of January 2023 the Corporate Sustainability Reporting Directive (CSRD) entered into force. This new directive modernizes and strengthens the rules about the social and environmental information that companies have to report. A broader set of large companies, as well as listed SMEs, will now be required to report on sustainability – approximately 50 000 companies in total.
 The Sustainable Finance Disclosure Regulation (SFDR) is a European regulation introduced to improve transparency in the market for sustainable investment products, to prevent greenwashing and to increase transparency around sustainability claims made by Financial Market Participants. On the 1st of January 2023, the Regulatory Technical Standards (RTS) come into force with Level 2 requirements (see below).