ESG and the finance market

Answer

Environmental, social and governance (ESG) finance has continued to gain traction since the first corporate green bonds were issued in November 2013, growing 15-fold in the past four years, with sustainable bond issuance for the year predicted by Moody’s to reach $1 trillion by the end of 2021. The sheer variety of financial products and transaction types means that adoption of ESG criteria has historically been inconsistent. However, 2021 has seen a significant increase in focus on ESG criteria and labelling across the finance universe. Lawyers are increasingly being asked to advise on matters relating to ESG compliance and, in the wake of COP26, it is expected that this trend will continue. A number of recent developments indicate how prevalent ESG concerns have become in the finance market.

Sustainability-linked bonds

Under sustainability-linked bonds, certain financial or structural characteristics of the bond (eg, the interest rate payable) are linked to the performance of the bond issuer against its stated sustainability targets. Sustainability-linked bonds differ from green bonds, as there are no restrictions on how the sums raised through the bond issuance must be applied. Industry body the International Capital Market Association (ICMA) published its Sustainability-Linked Bond Principles in June 2020, representing best-practice guidelines around selection of sustainability-linked targets and reporting on compliance with such targets.

In February 2021, the H&M Group issued a €500 million sustainability-linked bond, which generated substantial interest from investors being 7.6 times oversubscribed. Under the bond, the H&M Group committed to achieving the following targets by 2025:

• Increasing recycled materials usage to 30% (from 0.5%).
• Reducing emissions from own operations by 20%.
• Reducing emissions from fabric production, raw materials, garment manufacturing and upstream transport by 10%.

If it fails to meet these targets, it will be required to pay an increased interest rate on the bond.

Emergence of ‘social’ financings

In 2020, ESG securities issuances with primarily social features accelerated to reach an aggregate amount of $147.7 billion globally: a seven-fold increase on 2019. In March 2021, Yorkshire Building Society used the proceeds it received from selling a portfolio of residential mortgage loans into a £1.9 billion securitisation structure to fund an ‘eligible social project’, namely the provision of competitively priced mortgage loans and higher-rate savings products to customers who might be underserved by other lenders in the market due to their specific circumstances. Similarly, in September 2021, German digital lender Auxmoney financed a portfolio of 30,000 unsecured consumer loans (which provide credit to people who might otherwise not meet high street banking credit criteria), via the issuance of €250 million of notes in an asset backed securitisation. Elsewhere, social housing providers have employed the proceeds of securitisation of their social housing stock to fund the delivery of additional affordable housing.

CLO ESG criteria

The inclusion of ESG criteria in collateralised loan obligations (CLOs) (ie, securitisations backed by pools of corporate loans/bonds) has become increasingly common since the first use of ESG criteria in 2018, with inclusion of some form of ESG criteria in new transactions now widely considered to be market standard by investors. One of the most common methods of incorporating ESG criteria is via industry-based screening. Under industry-based screening, certain categories of corporate loans are ineligible for inclusion in the transaction, for example corporate loans with borrowers that derive a certain percentage of their revenues from:

• the manufacture of biological, nuclear or chemical weapons;
• oil and gas production;
• thermal coal;
• payday lending;
• opioids; or
• tobacco.

Borrowers whose activities violate the UN Global Compact Ten Principles can also be excluded.

In addition, there have been trends towards the inclusion of positive ESG screening and reporting in some transactions. For example, in the recent Fidelity Grand Harbour CLO 2021-1, each underlying corporate loan received an ESG score from A (highest) to E (lowest), with a requirement that at least 50% of the portfolio must have a minimum rating of C (good).

The role of the finance lawyer

As the market for ESG compliant financial products grows (with demand for ESG and sustainable debt finance expected to increase to $11 trillion by the end of 2025), so too do concerns over ‘greenwashing’. In the EU, the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation, and in the UK, the recently announced Sustainability Disclosure Requirements, represent a new generation of ESG focused regulations that aim to increase disclosure and transparency around ESG credentials. Finance lawyers will therefore need to become increasingly familiar with not only ESG-focused financial products, but also the growing body of regulation in the field to best assist financial institution, asset manager and institutional investor clients.

Emily Firmston is an associate and Joe Payne is a trainee at Weil, Gotshal & Manges (London) LLP.