BOARD MEMO 2022
The Impact of ESG on the Credit Markets
ESG concerns are having an increasingly significant effect on certain segments of the credit markets. Numerous lending institutions – including banks, credit funds and alternative capital providers – have adopted non-uniform policies restricting their own ability to engage in certain lending transactions with entities that fare poorly from an ESG compliance perspective, for example coal companies and private prisons, two industries that have struggled to raise capital as a result of negative bias from the market and governmental authorities.
While those dynamics have been well publicized, boards of operating companies that are directly or indirectly impacted by ESG issues should take heed that the lending community is becoming more proactive on ESG issues in order to satisfy the concerns of investors, regulators, clients, and employees. This evolving stance will have an impact on companies beyond those in conspicuously ESG-problematic industries.
ESG issues factoring into negotiations around amendments and restructurings
Boards should be mindful that if their companies have exposure to ESG issues and they need to amend, extend, or restructure their debt obligations, ESG will factor into those negotiations. Many lenders that have adopted self-imposed ESG constraints are using the amend and extend process to revisit financial covenants or add requirements that increase or incentivize ESG reporting and compliance. Lenders who have adopted ESG policies that limit or cap exposure to a certain industry may seek to exit a facility or not extend or refinance a maturing facility.
Our own experience is that lending institutions that have ESG lending policies often require the approval of very senior officers and ESG committees within that institution on all amendments and extensions of credit facilities that have ESG implications, and such policies often drive the structure of any such amendments and extensions. Thus, it is imperative a board understands its financing partners’ positions on ESG and considers whether the opening of negotiations will give those lenders an opportunity to extract concessions as part of their own ESG initiatives.
ESG performance is having growing influence on cost of capital
The credit markets have begun to recognize and accept the correlation between companies with low ESG performance scores (albeit based on often differing sets of standards) and creditworthiness. For instance, companies in sectors that have a bigger environmental footprint may experience higher costs of capital as the credit community adopts more stringent standards for financing those industries. With respect to implementing such standards, there is a two-part calculus for the capital provider.
First, does the lender need to reduce exposure to a specific ESG-impacted industry? If so, lenders will likely raise the cost of capital for these companies to compel them to seek financing elsewhere. Second, will the capital providers be able to exit the credit profitably if the ESG concerns associated with these industries reduce the pool of capital available to refinance their existing credit facilities and fund acquisitions and working capital needs?
As a result, lenders may charge higher rates and fees to compensate for their perceived increased risk. The takeaway is that boards should anticipate that the constraints imposed by the capital markets on firms with lower-tier ESG rankings may extend to mid- and higher-tier firms sooner rather than later.
The knock-on effect
Companies that maintain high levels of ESG performance may still be affected by ESG issues. Boards should consider the impact of doing business with suppliers or customers that are ESG non-compliant, particularly where a component of a company’s supply chain implicates ESG concerns. A troubled supply chain partner can impact production or, potentially worse, taint the manufacturer itself, which could then affect the manufacturer’s ability to maintain credit facilities on favorable terms. Beyond the risk of adverse publicity arising from doing business with an ESG non-compliant partner (which could directly affect the cost of capital), companies may face higher costs of production if a supply chain partner has to pass on its own higher cost of capital.
A good example of the knock-on effect is the electric vehicle industry, where the manufacture of lithium poses serious environmental and political risks in countries of origin like the Republic of Congo and charging stations for the cars may be powered by fossil fuels.
ESG considerations are having an effect on the credit markets, and corporate boards need to be mindful of the following.
- Boards of companies that are planning to seek a maturity extension or a restructuring of an existing credit facility and which face ESG-related challenges should expect that their lenders will require higher levels of ESG compliance and reporting going forward.
- If a board of a company that has poor ESG compliance scores fails to mandate improvements, their company is likely to face a higher cost of capital on its financings in the short term and may well have difficulty obtaining financing in the future.
- Boards should consider having their management teams evaluate their business counterparts and supply chain partners to determine the extent of such parties’ ESG compliance because there is an emerging negative knock-on effect for ESG-compliant companies that do business with lower-tier ESG-compliant companies.