CATALYST // GOVERNANCE:
ESG: Building a Resilient Future
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The Covid-19 global pandemic is a humanitarian crisis first and foremost. Corporate purpose and environmental, social and governance (ESG) issues dominated headlines in the months leading up to the Covid-19 outbreak. The intense public scrutiny of corporate conduct, governance and investment behaviours during the pandemic has served to accelerate the conversation around ESG issues. To help make sense of this new paradigm, we have set out some of the ways in which Covid-19 is impacting the key ESG considerations confronting businesses, asset managers, asset owners and lenders.
Governments and businesses, as well as grappling with the immediate challenges at hand, are looking ahead to the recovery and committing to “build back better”, with implications for the energy transition, stakeholder capitalism and ESG. This is manifesting in calls for, and commitments made by, governments to link bailout support and stimulus packages to ESG standards. Emerging ESG frameworks have expanded rapidly since their earliest explicit iterations in the form of the Equator Principles – a set of risk management guidelines launched in 2003 to help financiers assess the environmental and social risks involved in the projects that they lend to in emerging markets – and the UN Guiding Principles on Business and Human Rights, established in 2011.
Summary
We explore each of these means of managing liquidity in greater detail and suggest steps that companies should consider in the short term and in the months ahead. We would expect various combinations of these options to be adopted by companies facing a cash crunch. In every instance, directors must take particular care to discharge their legal duties to the company and its shareholders and creditors. Click a above box to read more.
POLLING DATA AREA
Spotlight on business
Investors’ shifting sentiment
Sustainable lending: an ESG reset
The pandemic has emphasised the symbiotic relationship between business and society, leading some businesses to revisit their corporate purpose. Such issues may have historically been viewed as dilutive to financial value. However, there is a growing acknowledgement that sustainable business practices are not only essential from a risk management perspective, they are also often accretive. The renewed focus on sustainability and corporate purpose will likely shape the attitudes and approaches of businesses, investors, consumers and governments throughout the recovery.
Covid-19 has accelerated the growing relevance of ESG considerations to investors. The effect of the pandemic on markets is a reminder of the potential financial impact of risks which may not historically have been viewed “financial” risks. For instance, there will likely be a greater focus on “black swan” risks going forward. Political support for a recovery that contributes to a more resilient future has, in many regions, emphasised the need for strong ESG-related regulatory frameworks. As the standards set out in “soft” law instruments continue to be transposed into “hard” law, the ESG agenda will likely continue to influence investment decisions, the categorisation of financial products and the ways in which, and to whom, they can be distributed. The pandemic has also underscored the performance-related “carrot” which accompanies the regulatory “stick”, with some recent analyses indicating that investments in companies with better ESG ratings have been more financially resilient during the Covid-19 market turbulence.
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As the banking sector prepares for the likely wave of corporate defaults and the need for emergency fundraising in the aftermath of the Covid-19 pandemic, there is a growing focus on borrowers’ risk management practices, including with respect to ESG. Certain lenders and governments are taking the opportunity to meaningfully integrate ESG targets into their post-pandemic recovery strategies and attach ESG strings to lending. Lenders have generally taken a supportive approach towards waivers and other temporary relief requested by borrowers, even where it has impacted short-term returns.
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April 2020
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Companies should review all discretionary spending and cut it out where possible. Some costs, such as travel and hospitality, will reduce by virtue of the restrictions put in place by governments around the world but companies should review all expenditure to identify where cost savings can be achieved both in the short term, while work patterns are disrupted, and looking ahead as normality resumes.
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business, asset manager, asset owner and lender compliance with “soft” law and “hard” law relating to ESG; the consequences of non-compliance, including risks relating to activism and litigation; and the impact of these issues on transactions in the current context.
The ESG field has since grown to encompass a range of “soft” and “hard” laws, regulations and guidance that have created myriad frameworks for businesses, investors and lenders to better meet expectations in relation to the incorporation of ESG considerations in their risk assessments and decision-making. In the last few years, these factors have advanced to prominence in business and investor oversight. For instance, a number of businesses have voluntarily made commitments to change or reinforce their behaviours by signing the UN Global Compact, the world’s largest corporate sustainability initiative. The UN Principles for Responsible Investment (UNPRI), which were launched in 2006 as a complement to the UN Global Compact to drive the ESG agenda for institutional investors, have also seen increased uptake. As current figures stand, the pillars have been adopted by more than 3,000 signatories. This shift is due, in part, to a growing recognition of changing long-term investor appetites and to the increasing regulatory and litigation risks associated with this area, as “soft” law measures are progressively transposed into “hard” law rules with “teeth”. Since 2018, there have been over 170 ESG-related regulatory measures proposed globally – more than in the previous six years combined. Far from being eclipsed by Covid-19, ESG issues appear to have risen in significance, as the impact of the pandemic has become clearer. It has made businesses and investors more aware of the risks posed by “black swan” events and the need for strong governance and resilience. The effects of climate change were a key focus in the months leading up to the outbreak and it has, to some extent, revealed the potential for business to reduce the scale of its environmental impact. The pandemic has also focused attention on health and safety, and human rights. In doing so, the ESG dialogue has, in turn, drawn “S” factors out from the shadow of the “E” and the “G”. In these pages, we explore issues regarding:
ENVIRONMENTAL
Climate change and greenhouse gas (GHG) emissions Energy efficiency Resource depletion, including water Hazardous waste Air and water pollution Deforestation
SOCIAL
Human rights Working conditions, including slavery and child labour Local and indigenious communities Conflict Health and safety Employee relations and diversity
GOVERNANCE
Executive pay Bribery and corruption Political lobbying and donations Board independence, diversity and structure Tax strategy Transparency Shareholder rights
SPOTLIGHT ON BUSINESS
The most immediate action a business facing a collapse in revenues can take is to reduce its costs and expenditure.
Immediate Steps
Looking further ahead
Ensure adherence to any ESG and human rights related commitments made prior to Covid-19. Divergence from these commitments could lead to significant reputational damage. Many companies are looking at sustainability-linked finance and social and sustainability bonds to help ease the financial implications of the pandemic (see Sustainable lending).
In the context of M&A sales, consider the increased ESG risk exposure. Sellers may be prepared to compromise on price in order to secure post-closing undertakings that achieve better ESG outcomes. Give thought to how you will undertake ESG due diligence within the current constraints. With ESG-related shareholder and employee activism on the rise and a growing set of regulatory obligations to comply with, expect to ramp-up focus on ESG issues as part of the recovery process.
Decisions made by businesses during the pandemic will likely come to be judged by the ESG standards and principles that they committed to upholding prior to Covid-19. For instance, a number of businesses have voluntarily made commitments to change or reinforce their behaviours by signing the UN Global Compact, the world’s largest corporate sustainability initiative. In 2019, the UN Global Compact network comprised over 9,500 business and 3,000 non-business signatories across more than 160 countries. Since January this year, the UN Global Compact has seen more than 1,000 further members sign up. A growing number of regional and national legislators have committed to or are considering linking bailout support and stimulus packages to ESG standards. This includes the European Commission, which has publicly stated that it will be putting its Green Deal at the heart of its recovery strategy and has established a sustainable corporate governance initiative as part of its proposed economic recovery plan. National examples include:
Cutting costs
Government support packages
Debt finance
CAPITAL CALLS
Insurance
ASSET DISPOSALS
Businesses operating in, or with links to, developed economies have been regulated in areas such as anti-bribery and corruption, anti-money laundering, health and safety, environmental concerns and employment matters for many years. These obligations are increasingly accompanied by disclosure and reporting requirements, aimed at driving greater transparency. This, in turn, is leading to increased levels of activism and litigation risk, as it becomes easier to scrutinise corporate behaviour.
Immediate steps
Ensure adherence to any ESG and human rights related commitments made prior to Covid-19. Divergence from these commitments could lead to significant reputational damage. Many companies are looking at sustainability-linked finance and social and sustainability bonds to help ease the financial implications of the pandemic.
LOOKING FURTHER AHEAD
Emerging from the crisis, many businesses are redoubling efforts to balance financial viability with a renewed focus on corporate purpose.
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aviation industry bailouts that are conditional on compliance with sustainability targets, such as the French government’s €7 billion financial support package for Air France-KLM, which was dependent on eliminating domestic routes that can be served by trains; auto industry bailouts which have included increased electric and hybrid car subsidies and support for hydrogen power research; and the Danish government’s exclusion of companies that are registered in tax havens from financial aid during the pandemic.
Companies are subject to a growing set of non-financial reporting requirements relating to ESG issues. Some of these are dictated by industry bodies and voluntary codes; others are prescribed by law. Coupled with increasing investor demands for enhanced disclosure of ESG and non-financial risk management practices, these requirements will likely play a more significant role in the ability of a business to compete for capital during the recovery phase and beyond. As circumstances continue to change rapidly, businesses should regularly assess the materiality of ESG risks in their operations and assets, in order to prepare for these changing demands and for the growing expectations relating to corporate financial and non-financial reporting. These assessments can not only inform disclosures to shareholders, stakeholders and regulators, they can also aid board-level decision making in relation to the company’s response to the particular challenges currently at hand. Although the growing ESG disclosure requirements are particularly pertinent to public companies, the private markets will not be exempt. Given the ESG requirements faced by investors in (and lenders to) private companies, such companies will also need to ensure that they integrate ESG into their reporting procedures to ensure that they can provide appropriate disclosures. In certain jurisdictions, relief may be available for companies that are unable to comply with requirements relating to corporate filings, periodic reporting and general meetings (see more in 'Governance: Assuring and Sustaining'). However, wherever such leniency is not available, the default position will remain and companies must still ensure that they comply with these requirements. In Europe, the Taxonomy Regulation is also likely to form a new baseline for certain types of ESG disclosures, in particular by seeking to define whether specific activities are aligned with environmental sustainability. Evolving out of a need to overcome the lack of consistent benchmarking and common standards in the green investment market, the EU Taxonomy is perhaps the most ambitious and detailed attempt to date at establishing a “common language” which allows investors to make “like-for-like” comparisons between portfolio companies and funds/asset managers. It is likely that there will be many regional and domestic iterations of the framework to come. For example, similar projects to develop “principles-based” green taxonomies are already at various stages in Canada, Japan and Malaysia. Going forward, the challenge will be to harmonise these regional-specific frameworks. To this end, the IFC is developing a green finance protocol to aid the comparison of regional taxonomies and a “taskforce” between Europe and China has also been proposed by China’s green finance leader Dr Ma Jun aimed at harmonisation of these regions’ sustainability frameworks. The implementation of the EU Taxonomy Regulation and future iterations may impact businesses across the globe, as asset managers and asset owners increasingly seek Taxonomy-aligned investment opportunities. In this context, it will be particularly important for businesses to consider the messaging around their ESG footprint over the course of this year and next. Improvements in next year’s emissions reporting will likely be artificial, reflecting the pandemic’s impact on business operations rather than any longer-term shift towards “greener” business practices. There is a real possibility therefore that reporting in future years will present a comparatively dire picture. Businesses should monitor and raise this issue with investors and other stakeholders. The EU Commission has also announced that mandatory environmental and human rights due diligence rules will apply to all European companies by 2021 (see more here). It is expected that this approach will be adopted by other regional and domestic legislators in the future. This requires corporate preparedness, at both the board and operational level, to meet the growing requirements in relation to ESG due diligence and reporting on these risks through transparent and meaningful disclosure.
Disclosure and reporting
In the UK, in an open letter to the Prime Minister, more than 200 businesses called for a "clean, just recovery, that creates quality employment and builds a more sustainable, inclusive and resilient UK economy for the future". Similar calls have been made in other countries.
The “E” in ESG attracted the most attention in the months leading up to the outbreak of Covid-19. With the social upheaval caused by the pandemic, the “S” in ESG is now very much front-and-centre, including issues relating to healthcare, employee welfare, labour rights, data privacy and supply chains. The UNPRI has, for instance, encouraged its 3,000+ signatories to use media reports and existing reputation-focused ESG data providers to raise concerns with relevant companies – through “engagement, AGM statements or more assertive tactics such as voting against board members, voting against the accounts or calling for an Extraordinary General Meeting in extreme cases”. There has been a number of calls along similar lines from various international organisations and stakeholders regarding human rights. As a result, prior to the pandemic, many companies would have expected to consider environmental or social proposals in their upcoming AGM agendas. Many businesses have made commitments to ambitious sustainability and human rights reporting in the last few years. The public statements set out in these reports often serve as a hook on which class actions are brought. If businesses are then seen to be making decisions in the midst of a crisis – at the parent company, subsidiary and/or supply chain level – which fly in the face of those public commitments and end up having adverse human rights impacts further down the supply chain, this could give rise to a class action suit. Businesses should be cognisant of the potential risk of litigation and strategic activism in the aftermath of the pandemic if their short-term actions now do not align with their ESG commitments taken as a whole. This is already being borne out by growing numbers of climate change cases filed as private actions in negligence by individuals and communities against fossil fuel companies. Directors should also be mindful that they may, in some jurisdictions, be personally accountable for decisions they make which do not align with ever growing ESG regulation. Notwithstanding the considerable pressure Covid-19 has placed on businesses, the prevailing message from investors is that, in spite of the pandemic, companies cannot ignore issues such as climate change and human rights violations, including modern slavery. These issues must be included in the tapestry of considerations for good corporate governance. Businesses need to embed human rights considerations into their policies, processes and operations, not only as a response to the pandemic (see more here), but also so that they can comply with the growing number of human rights-related regulatory initiatives and laws (including the French Vigilance Law, the Australian and UK Modern Slavery Acts and the proposed German Supply Chain Law) and mitigate litigation risk (see more in Supply Chain Difficulties). As ESG regimes continue to gain momentum and “teeth”, certain types of assets and activities may become partially or entirely stranded due to their incompatibility with the new ESG global agenda. Another key factor that has come under the spotlight during the pandemic is data protection and privacy. Due to the pandemic, there has been a significant acceleration in the digitisation of various parts of supply chains and business activity, in order to increase the resilience and productivity of a company’s business operations. With these changes will come enormous growth in the personal data collected and handled by businesses and a resultant need for organisations to focus on data privacy compliance or face consequences from regulators, activists, employees and consumers. Although Covid-19 has resulted in governments around the world looking to harness the power of technology and data to fight the spread of the virus, this has led to a brewing tension between public health and privacy.
Activism and litigation risk
In the current climate, many businesses will be looking at asset disposals, as boards make invidious decisions under unprecedented financial and operational constraints. On the sell side, ESG policies, and the potential for post-transaction issues to impact the seller’s reputation, increasingly require “clean and responsible” exits from assets. Sellers who have embraced ESG are no longer focused solely on price and a “clean” break, they also wish to assure themselves that the asset will continue to be managed responsibly post-completion. This is manifesting itself in increased due diligence by sellers, even on cash buyers, and sometimes in enhanced post-completion undertakings being sought from buyers. For example, a seller may seek comfort that a business will continue to be run for an agreed period following completion to aid in job preservation in the short- to medium-term. Alternatively, a seller may negotiate undertakings for the business to adhere to ESG standards that do not form part of the relevant laws of jurisdiction in order to avoid reputational risk and any adverse impacts of the sale to the broader stakeholders of the relevant business. As a result of the pandemic, sellers may also be more willing to compromise on price where a buyer has strong ESG credentials. For buyers, ESG risks arising out of the Covid-19 crisis – and more broadly – must be brought within the scope of both due diligence and post-closing compliance. In the context of distressed asset sales, it may be difficult to undertake fulsome due diligence in relation to climate-related risk exposures, adverse human rights impacts in relation to employees and local communities or other ESG factors such as workplace culture and governance. However, failure to consider these risks at all could result in the buyer inheriting reputational costs, a downgrade of the company in ESG rankings and, potentially, exclusion from some ESG investment portfolios or costly litigation. Businesses will therefore need to rethink how they undertake due diligence within the current constraints. In this challenging environment, buyers are likely to assume a greater level of risk in respect of potential ESG exposures. Accordingly, it may require more work to integrate an asset once acquired and there should be a greater focus on the management of ESG risks through post-completion undertakings.
Transactions
Competition law issues
Evaluate the effectiveness of any steps taken before the pandemic to factor ESG considerations into the investment process. Assess whether processes need to be adapted to take into account lessons learnt from the pandemic’s impact on the global economy.
Non-financial risks can be financially material and the integration of financially material ESG criteria into investment decisions should no longer be seen as a distinguishing feature. There will be increasing commercial incentives to offer ESG products to investors. The pandemic is likely to lead to the realisation among asset owners and retail investors that the activities of investee companies could have adverse impacts on sustainability factors, and some of these impacts, such as harming ecosystems and biodiversity could potentially add to the risk of future pandemics. This realisation may further accelerate the investor-led demand for ESG-focused products. Disclosures as to the adverse impacts of financial products on ESG factors will likely result in pressure to justify the continuation of these products or to mitigate their impacts. Greenwashing risks would need to be monitored and distribution and marketing arrangements should be assessed to ensure that different types of financial products end up in the hands of investors for whom they are suitable.
There is an increasing body of evidence which suggests that ESG criteria can be financially material and, therefore, ESG-integrated portfolios may be able to provide better risk-adjusted returns to investors. Analysis by BlackRock suggests that companies with higher ESG ratings performed better than other companies during the upheaval in the first quarter of 2020, and that investments with strong sustainability profiles are “better positioned to weather adverse conditions” in the recovery phase and beyond. If, as some expect, the investment strategies with the most sophisticated integration of ESG risks and the companies with the strongest ESG characteristics do show themselves to have been most resilient through this period, we would expect a continuing and accelerating focus on ESG considerations in the Covid-19 recovery phase and beyond by asset managers and asset owners, with particular demand for greater corporate transparency and accountability. In addition, the increasing demand from asset owners and retail investors for ESG-aligned investments have led asset managers to become increasingly sensitive to the ESG preferences and requirements of their clients. Evidence suggests that millennials are becoming an increasingly influential constituency, with a much greater preference for investments that align with personal values (according to a Morgan Stanley study, 95% of millennials express interest in sustainable investing). Finally, there is a wave of ESG-related regulation, emerging largely out of Europe, requiring asset owners and asset managers to integrate ESG risks into their investment decisions, and provide detailed disclosures on the ESG credentials of their financial products and portfolios and on their impact on ESG factors. The expectation is that these disclosures would result in increased capital flows to asset managers with better ESG credentials, thereby creating a commercial driver to provide more and better ESG-focused products to attract these capital flows. We would expect these ESG headwinds to influence the investor response to the pandemic, which, to date, has been not to dilute their emphasis on ESG factors. Rather, it has refocused the existing dialogue around ESG from a heavy recent focus on the “E”, to a more balanced approach which also considers the ”S” and which brings the “G” back to prominence. For example, as at the end of June 2020, 335 long-term institutional investors representing US$9.5 trillion in assets under management have signed the Investor Statement on Coronavirus Response, which states that “when it comes to employees, we expect company responses… to be a proxy for their broader approach to human capital management. Companies with good human capital management have invested in their employees and will be well-served by having retained a well-trained and committed workforce when business operations are able to resume”. All of these developments, taken together, present an opportunity for asset owners and asset managers to adopt a clearly defined position on ESG and the role it plays in their investment decision-making processes. It is conceivable that as the global economy recovers from the pandemic, the positions adopted by asset owners and asset managers may play an important role in capital flows. However, when doing so, asset owners and asset managers should be mindful of their other legal and regulatory obligations (e.g. the duties owed by asset managers to their clients or the duties of pension trustees to their beneficiaries).
Relaxation of competition rules
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Non-financial risks can be financially material and the integration of financially material ESG criteria into investment decisions should no longer be seen as a distinguishing feature. There will be increasing commercial incentives to offer ESG products to investors. SEE MORE
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There has been a material shift in investor appetite for ESG-aligned investing in recent years, with asset owners and asset managers increasingly committing to global initiatives such as the UNPRI and the UN SDG, alongside a visible shift in retail demand for sustainable investment. We would expect that the importance of moves in this direction would be underscored by Covid-19.
Asset owners and asset managers have always played an influential role in driving improvement in corporate governance and responsible business practices by their investee companies. Asset owners and asset managers typically exercise this influence through various forms of engagement with their investee companies, meetings with senior management, the exercise of voting rights or the making of investment or divestment decisions. Notwithstanding lock-down related cancellations of shareholder meetings, we expect such engagement of asset owners and asset managers with their investee companies to continue to be an important way in which they influence corporate behaviours.
The pandemic is likely to alter the way in which financial risk is assessed. Asset managers and asset owners will be delving more deeply into the resilience of their investments to externalities and contingency planning (i.e. how sustainable are businesses in which they invest and their practices in a changing world). There is likely to be a greater focus on “black swan” risks (e.g. preparedness for climate change) and existential threats. Changes to risk-management models or valuation metrics may be required to ensure that such risks are adequately considered and priced into asset valuations. ESG risks which may have an impact on investments (e.g. stranded assets due to regulatory changes or material changes in market sentiment or losses resulting from reputational damage) will require careful consideration going forward. Investors will, therefore, need to ensure that the reporting they receive from their investee companies enables them to adequately consider such ESG risks as part of their due diligence and risk management processes. The pandemic has brought into sharper relief the realisation that investing with an eye on sustainability risks can reduce investment risk; the idea that climate change represents a significant financial risk had become more apparent in the past few years, and considerations around the risks of future pandemics and public health crises has renewed the focus on this debate. Asset managers and asset owners (such as pension trustees, in particular) are subject to a legal obligation to make investment decisions which are in the best interests of their clients or beneficiaries (as appropriate). Historically, this meant taking into account all financially material considerations, and only financially material considerations, into their investment decisions. However, the ESG-related developments over the last few years have led to a rethinking of the universe of factors that are thought of as financially material, of appropriate time horizons across which to make such assessments and of whether purely financial outcomes are always what is being asked for by clients or beneficiaries.
Impact of ESG criteria on risk management processes
The growing appetite for ESG investing underscores the importance of ensuring businesses, asset managers and asset owners produce clear and comparable ESG disclosures. One of the pillars of the wave of ESG-related regulation emerging largely out of Europe is increased disclosure by asset owners and asset managers, many of which are headquartered in the United States, on their ESG credentials and those of their financial products and portfolios, together with their impact on ESG factors. This wave is in part due to the concern of regulators on the potential of ESG mis-selling or greenwashing (i.e. managers and funds overstating their claims to have embedded ESG factors into their investment strategies and portfolios). In the United States, for instance, the SEC has sought to address such concerns by requesting public comment on the rules surrounding fund names and indicated that investment companies do not consistently explain to investors what they mean when they use terms such as “ESG” and “sustainable”. The growing regulatory pressure on asset owners and asset managers to explain their ESG credentials to investors is expected to have a significant impact on corporate reporting going forward:
there will be greater pressure on corporates to provide the ESG disclosures that will enable their investors to fulfil their own ESG disclosure obligations; and there is an increasing need for a uniform taxonomy and a common reporting framework for ESG disclosures in order to drive corporate reports in a common direction.
The EU Taxonomy Regulation will increase the focus on both corporates, asset owners and asset managers providing certain forms of ESG disclosures relating to the nature of their activities and classifying their activities and returns in accordance with the taxonomy. Evolving out of a need to overcome the lack of consistent benchmarking and common standards in the green investment market in particular, the EU’s Taxonomy Regulation (and its accompanying technical standards) is perhaps the most ambitious and detailed attempt to date at establishing a “common language” to allow asset owners and retail investors to make “like-for-like” comparisons between portfolio companies and funds/asset managers. It is likely that there will be many similar regional and domestic frameworks to come. For example, projects to develop “principles-based” green taxonomies are already at various stages in Canada, Japan and Malaysia. Going forward, the challenge will be to harmonise these regional-specific frameworks. To this end, the IFC is developing a green finance protocol to aid the comparison of regional taxonomies and a “taskforce” between Europe and China has also been proposed by China’s green finance leader Dr Ma Jun aimed at harmonisation of these regions’ sustainability frameworks. The introduction and implementation of these taxonomy frameworks may impact businesses across the globe, if asset managers and asset owners increasingly seek taxonomy-aligned investment opportunities. To date, the focus of the EU Taxonomy Regulation and the Task Force on Climate-related Financial Disclosures has been on environmental issues. However, it will be interesting to observe if the pandemic and the resulting focus on social issues accelerates the development of reporting and disclosure frameworks designed for social issues. The development of such frameworks may also lead to new systems and technologies to collect and collate data on social factors. In the United States, the Securities Exchange Commission (SEC) Investor Advisory Committee recently endorsed the adoption of a principles-based ESG disclosure framework, on the basis that such a framework would ensure the flow of capital to US markets, promote the goal of investor protection and level the playing field between issuers. The SEC's overall approach, however, has been consistently "wait and see": rather than considering any prescriptive requirements for ESG disclosures, the agency has instead relied on its longstanding principles-based approach, i.e., that "material" matters, including ESG matters, warrant disclosure. Nevertheless, shifts in the legislative landscape following the 2020 US presidential election could result in movement towards a more prescriptive approach to ESG regulation in the United States.
It is important to note that the primacy of financial materiality in the investment decision-making process has not been overridden, where that is the primary objective of the client of the asset manager (or beneficiaries of a pension scheme). For example, the US Department of Labor is currently considering a proposal to limit when and how pension plan fiduciaries may consider non-pecuniary factors, such as ESG metrics, when making investment decisions. To the extent that asset managers and asset owners are now required to take into account financially material ESG risks into their investment decisions, this does not pose a significant divergence from the traditional orthodoxy – in fact, given the evidence emerging from the pandemic that ESG risks can be (and often are) financially material, it is arguable that asset owners and asset managers must take such factors into account, even under the existing legal and regulatory regimes. However, the issue is more complicated when it comes to investment mandates with a stated ESG focus/which seek ESG-related outcomes (i.e. where asset owners or asset managers are required to take into account the impact of their investments on ESG factors, rather than the impact of ESG factors on the financial returns of their investments). There are four key categories of risks which asset owners and asset managers need to navigate:
ESG-related risks for asset managers and asset owners
Greenwashing risk – this is probably the most widely recognised risk in this context. Given that ESG credentials and ESG disclosures are playing and will continue to play an increasingly important role in directing capital flows, asset owners and asset managers need to carefully balance this commercial driver against the risk of overstating the ESG credentials of their financial products. As Covid-19 heightens the sense of urgency in being seen to be investing in green or socially accretive activities, there is an increased risk of greenwashing if proper tools are not developed and implemented to label and verify these credentials. Suitability and distribution risk – this is an important category of risk, particularly for asset managers. While there is an increased regulatory and client-led push for asset managers to take ESG criteria into account in their investment decision-making processes, and this trend has been reinforced by Covid-19, it is important to note that the primacy of financial materiality in the investment decision-making process has not been superseded. Asset managers need to understand the ESG preferences of their clients and ensure that the investment decisions taken for each client accurately reflect such client’s ESG preferences. This also has significant consequences for the way in which asset managers label and market their financial products – asset managers need to assess their distribution arrangements carefully to ensure that financial products only end up in the hands of investors for which they are suitable. A failure to assess and mitigate these risks could give rise to a wide range of mis-selling and related claims against asset managers. Regulatory risk – this is another significant category of risk for asset owners and asset managers, that could well be heightened if, as expected, Covid-19 accelerates the development of emerging ESG-related regulation. Given that such regulation is largely at a nascent stage, and since there is currently inadequate and inconsistent corporate reporting, there is a risk that practices adopted by asset owners and asset managers at present will be deemed insufficient by regulators in the future – this may involve a retrospective application of standards formulated in the future to conduct which pre-dated the emergence of these standards. In order to mitigate this risk, asset owners and asset managers should form considered and measured views as to how to implement the new legal and regulatory requirements and apply these views consistently across their businesses – these risks may be mitigated where there is industry consensus on any controversial issues or to request clarificatory guidance from regulators on such topics. Litigation risk – there is a growing risk in relation to legal challenges brought against asset managers and institutional investors (such as pension funds) regarding ESG risks. Activist and campaign groups as well as individual savers (often supported by such groups) are increasingly challenging asset managers and institutional investors in relation to perceived failures to comply with the growing body of ESG-related legal and regulatory requirements. Emissions data collected during the pandemic could also inform future climate-related environmental challenges, particularly in relation to appropriate and due consideration of climate change risk.
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See Spotlight on business section for more information.
Against the backdrop of the discussion above on the regulatory and commercial drivers which have led to an increased emphasis on the role of ESG factors in investment decision-making, it is also worth considering the impact of these developments on a few specific sectors: private equity, debt and impact investment. Private equity By applying pressure on asset managers to declare or better articulate how they are integrating ESG factors into their investment process, the increasing demands of asset owners are driving change among asset managers and capital raising enterprises. Many asset owners have now formalised ESG considerations in their internal guidelines, which form part of their duties to their beneficiaries. Even pre-pandemic, an increasing number of asset owners were looking for private equity and other asset manager firms to demonstrate and report on the integration of ESG principles into the full investment cycle (from investment evaluation, through ownership and exit). There must be substance behind claims made in offering documents and pitch materials as to how ESG factors are incorporated/relevant, as asset owners increase their investment diligence in relation to ESG criteria when allocating capital to asset managers or their funds. While we expect asset owners to maintain or even increase allocations to asset managers and private equity as part of their overall investment strategies (not least because it is anticipated that the unprecedented level of volatility and dislocation in the markets post-pandemic will present opportunities to buy high-quality businesses at attractive prices, thereby maximising financial returns), we also expect the general trend (at least among the larger asset owners) toward consolidation of the number of asset managers and private equity firms with whom they are dealing to continue. We could therefore foresee that asset managers and private equity firms that do not demonstrate and report meaningful commitments to ESG principles throughout the investment cycle, could well find asset owners voting with their feet, be it at fundraising time or in allocating portfolios. Debt We are also seeing a significant increase in social bond issuance levels during the pandemic as issuers look to address the immediate impact of Covid-19. We discuss the increase in sustainability-linked, social and green finance products in more detail here. Impact investment Impact investment and development finance institutions are also increasing their investments in initiatives aimed at social recovery from the pandemic, with many viewing Covid-19 as a “seminal test for the impact investment field”.
Companies should review the headroom under their existing debt facilities and any weaknesses in the capital structure. Whether or not facing an immediate liquidity crisis, they should consider whether to draw down on existing facilities and whether they may need increased committed borrowing facilities.
Companies looking at sustainability-linked finance and social and sustainability bonds to help ease the financial implications of the pandemic in the short-term, and as potential forms of finance in their recovery strategies should:
Lenders will see many new ESG products and instruments coming to the market. Lenders should ensure they keep abreast of these developments as they put together their post-pandemic recovery strategy. Stress-testing: banks and insurance companies will be increasingly required to include climate-related risks in stress-testing exercises Consider the longer- term inclusion of green or sustainability-linked/social finance in your strategy.
The market upheaval caused by the Covid-19 pandemic threatened to slow this momentum in the face of more pressing and immediate issues, such as satisfying immediate needs for liquidity and then repairing balance sheets. However, in contrast to predictions at the outset of the pandemic, the financial markets’ response has overwhelmingly been to maintain a focus on ESG. This reflects growing recognition that the decisions made in the short-term to counter the immediate effects of the pandemic may have a significant impact on the medium- and long-term state of the economy. The pandemic has also brought into sharper relief the realisation that sustainable investing may reduce investment risk; the idea that climate change represents a significant financial risk had become more apparent in the past few years, and considerations around the risks of future pandemics and public health crises has brought a new focus to the debate. Activities that harm ecosystems and biodiversity could add to the risk of future pandemics; in contrast, projects that help the transition to an economic system which is compliant with the Paris Agreement targets and assist in conserving biodiversity could well have a role to play in helping to mitigate pandemic risk as well as the more obvious climate and biodiversity benefits. Projects that support effective sanitation and healthcare in crowded lower-income cities can also help promote pandemic resilience. A report published in May 2020 by Oxford University collating input from major global economic players including central bankers and G20 finance ministers and analysing over 700 stimulus proposals concluded that Covid-19 fiscal recovery packages that incorporate green policies will deliver better results than traditional economy stimulus. Many lenders have endorsed this approach. For example, over 50 chief executives from the banking and insurance sector have joined the European Alliance for a Green Recovery, calling for biodiversity and climate change to be placed at the centre of any European stimulus package. In Australia, a coalition of the four largest banks has called for stimulus measures to align with the Paris Agreement targets. The Network for Greening the Financial System (NGFS) – an international platform of over 60 central banks and supervisors aimed at strengthening the global response necessary to meet the Paris Agreement targets – has also called for a “green recovery” that builds a new climate-resilient financial system. To date, however, there has been limited evidence that central banks have incorporated climate change risk and sustainability in their Covid-19 measures. Prior to Covid-19, central banks and supervisory bodies were already preparing for climate risk “stress-testing”: for instance, the Bank of England proposed in December 2019 that UK-based banks and insurers should be tested together to assess the financial impact from climate change on their businesses. Their proposals came as a result of the NGFS’s “call for action” issued in April 2019 which outlines the steps for assessing climate-related risks relating to financial stability. In the United States, by contrast, legislative proposals to introduce climate risk stress tests have stalled. The Climate Change Financial Risk Act of 2019, which would direct the US Federal Reserve to use stress tests to measure the resilience of large financial institutions to climate-related financial risks, is unlikely to be passed into law in the near term. Nevertheless, shifts in the legislative landscape following the 2020 US presidential election could reinvigorate this proposal and the wider movement towards a more prescriptive approach to ESG regulation in the United States. Going forward, financial authorities will likely expand these stress-testing requirements to also test for “black swan” risks, i.e. high-impact, unforeseeable events such as future pandemics.
Accessing resources / supplies / components
Prior to Covid-19, the sustainable lending and debt market had reached record volumes. In 2019, the total cumulative issuance of sustainable debt was measured at US$1.17 trillion. In particular, sustainability-linked loans for 2019 (loan facilities with ESG performance linked pricing) totalled US$122 billion, an increase of 168% since the previous year, and green bond issuances totalled US$271 billion.
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Many lenders are taking the opportunity to reset and fully and meaningfully integrate ESG into their post-pandemic recovery strategies, and lower credit risks by linking sustainability objectives to new loans.
Prior to the pandemic, financial markets regulators and central banks had been increasingly turning their attention to ESG factors. A number of new reporting and disclosure obligations have been enacted in recent years, requiring banks to have policies around ESG factors, to disclose information about such policies to clients and to make a risk assessment in relation to their exposure to ESG-related financial risks. As a large number of banks have signed up to the UN Principles for Responsible Investment (UNPRI), the reporting and disclosure obligations set out therein also require them to show how ESG considerations are incorporated into investment decisions. In addition to the UNPRI, many of the “soft” law principles relating to ESG investing are being transposed into “hard” law, such as the legislative proposals set out in the European Commission’s Green Deal. As these disclosure, reporting and risk management requirements increase and cover multiple jurisdictions, firms will increasingly need a centralised process that brings together different business lines and geographies in order to identify, quantify, monitor and manage ESG risks across their global business, as well as a process for drafting and updating disclosures to make sure that their message is consistent and that they record and verify the sources of any published information.
Businesses face the pressure of complying with new ESG laws and honouring previous ESG commitments, while ensuring their short-term viability in the face of market turmoil. The environment is therefore ripe for activism on the part of investors. A number of banks have felt the pressure of shareholder activism at this year’s AGMs, facing questions on climate change policies, alignment of their investment strategies to the goals of the Paris Agreement and even shareholder resolutions obliging them to phase out the financing of fossil fuels. These developments demonstrate the growing impact of shareholder activism, particularly in relation to conduct on ESG issues. Given the growing recognition of the symbiotic relationship between business and society (see Spotlight on business section for more information), this trend may well increase. Lenders should therefore monitor such activity in the market particularly when undertaking KYC on new borrowers and work with their institutional clients to manage any ESG risks.
Activism and litigious risk
Debt Capital Markets (DCM) Despite the initial market upheaval, appetite for ESG bonds has persisted. Early analysis of bond performance during the pandemic suggests that these bonds are outperforming other debt instruments, strengthening the case for a “green” recovery. As the Covid-19 pandemic has led to an increased focus on mitigating social risks, one of the key trends emerging this year is the rise of social bonds (bonds whose proceeds fund new and existing projects with positive social outcomes, such as improving food security and access to education, health care, and financing). Whilst social bonds have been in the market for some time now (the International Capital Markets Association (ICMA) published the Social Bond Principles, setting out guidelines on issuing social bonds, in 2017, for instance), the social bond market has historically taken a back seat to green bond issuances. Following the onset of the pandemic however, social bond issuance levels have risen rapidly, with recent ICMA data estimating US$11.58 billion in social bond issuances as at May 2020, an increase of nearly twofold compared to the US$6.24 billion in issuances for the same period in 2019. This increase in social bonds has largely been driven by the need to finance Covid-19 relief measures. Often termed “Covid-19 response bonds”, these bonds have been utilised by issuers to alleviate the economic and social consequences of the pandemic and have been met with a surge in demand from investors. In response to this, ICMA confirmed in March 2020 that existing guidance for social and sustainability bonds could apply to social bonds issued to address Covid-19. Illustrative examples provided in ICMA’s guidance on eligible social projects include: Covid-19 related-healthcare, medical research and vaccine development, investment into additional medical equipment or manufacturing facilities to produce more health and safety equipment and hygiene supplies and specific projects designed to alleviate unemployment. In June 2020, ICMA updated its Social Bond Principles to include an expanded list of social project categories and target populations. External reviewers such as Sustainalytics, have since published revised methodologies for assessing the activities related to Covid-19 that can be financed through social bond issuances. While supranationals, sovereigns and subsequently government agencies initially dominated the social bond market, corporates and financial institutions have also started issuing more social and sustainability bonds (where the proceeds will be exclusively applied to finance or re-finance a combination of both green and social projects). This trend is expected to grow as the pandemic accelerates private issuers’ interest in social considerations. Given the speed with which issuers have come to market during the pandemic, the risks of “social washing” remain, particularly as the impact metrics and targets for social bonds are not as easily quantifiable as for green bonds. It is hoped that the updated ICMA principles, coupled with an increased focus on impact reporting and disclosure as the market matures, will lead to a permanent improvement in transparency and standardisation. This, together with an increased focus on social risk factors more generally, could mean that social bonds remain an important, permanent feature of the sustainable debt market beyond the pandemic and its recovery phase. Turning to green bonds, one rather significant step in the road to market standardisation will be the development of the proposed EU Green Bond Standard (EU GBS). The EU GBS is a voluntary, non-legislative standard that issuers can choose to follow when issuing green bonds. Crucially, the EU GBS will be aligned with the EU Taxonomy referred to above and will enhance the effectiveness, transparency and comparability of the green bond market. In June 2020, the EU Commission has published a consultation together with an impact assessment on how to best translate the EU GBS into legislation. Another area of focus in DCM has been Sustainability-Linked Bonds, following the release by ICMA in June 2020 of the new Sustainability-Linked Bond Principles (SLBPs), which are intended to outline best practice to market participants on the structuring, disclosure and reporting of sustainability-linked bonds. The SLBPs represent the first framework for a new type of sustainability-linked instrument. The SLBPs are aimed at forward-looking performance-based bonds where the issuer is committing to future improvements in sustainability outcomes within a predefined timeline. In other words – and unlike green, social and sustainability bonds – these bonds are not linked to a specific project, but to an issuer’s overall sustainability strategy and efforts and crucially will not be based on use of proceeds. This provides issuers with more flexibility in setting their own ESG performance goals and structuring more bespoke ESG deals. Whilst sustainability-linked financing has become popular in the loan market, there has not been the same level of uptake in DCM. It will be interesting to see if the publication of the SLBPs will help cement this market and lead to an increase in issues of sustainability-linked bonds. As issuers look to change or reinforce their internal sustainability performance goals to align with the heightened focus on ESG issues, such products may represent new and appropriate forms of finance in the post-pandemic recovery phase and beyond. Syndicated Loans The syndicated loans market has also recently seen the development of two very different products:
green loans: lending based on green loan principles to a dedicated ESG project, with a mandated ESG-related use of proceeds; and sustainability-linked loans: lending with a relatively small incremental pricing benefit for reaching certain targets.
Such products represent new forms of finance that may be available to businesses revisiting their corporate and social purpose in light of the pandemic (see Spotlight on business section for more information). To assist the market, the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA) have jointly produced the Green Loan Principles and the Sustainability-Linked Loan Principles, which are a high-level set of what are intended to be market standards to promote the development and integrity of the new loan products by encouraging consistency and also flexibility across the new markets. The Green Loan Principles are built on ICMA’s Green Bond Principles. The proceeds of the loan must be used for green projects which provide clear environmental benefits which must be assessed, quantified and reported on, for example to directly address climate change, natural resources depletion, loss of biodiversity or air, water and soil pollution. The focus is very much on transparency and integrity, and the proceeds must be tracked, with appropriate levels of internal governance required by the relevant corporate. Reporting is also absolutely key and emphasises the focus on transparency. The degree of verification will vary. In some cases, self-certification by listed companies may be appropriate in the context of the loan market, which is largely relationship-based, and where concerns around greenwashing are minimal. The Sustainability-Linked Loan Principles are much more flexible, and are generally structured as revolving credit facilities for general corporate purposes. They are intended to incentivise corporates to achieve ambitious and meaningful, predetermined sustainability performance objectives based on the relevant company’s own sustainability strategy. The meeting of these objectives is assessed using sustainability performance targets which measure improvements in a borrower’s sustainability profile. The result of meeting the relevant objectives is an incremental pricing benefit. Verification and reporting are key to transparency and the robustness of the product, once more with the spectre of greenwashing. Self-certification may be acceptable, particularly where the relevant company reports the relevant information publicly in any case. Separately, the Equator Principles have been a feature of project finance for a number of years. These are a set of voluntary social and environmental principles which are intended to provide a framework for financial institutions to identify, assess and manage environmental and social risks when financing projects. Adherence is voluntary but common, and they have been amended this year to include new commitments on human rights, climate change, indigenous people and biodiversity.
consider if a form of impact finance is the right option in any new finance and new products offered; and consider any additional reporting requirements, whether internal or external, the impact of those and whether internal processes need to be adapted to ensure that these requirements can be met.
Government SUPPORT: UK
Covid Corporate Financing Facility (CCFF) The CCFF is operated by the Bank of England (BoE) to provide funding to businesses by purchasing commercial paper that meets certain minimum ratings criteria of up to one-year maturity from issuers who “make a material contribution to economic activity in the UK”. The aim of the CCFF is to assist corporates during a time when they are likely to experience severe disruption to cashflows. The CCFF was initially intended to operate for 12 months and the BoE will provide 6 months' notice of withdrawal. Companies who do not currently issue commercial paper but who are capable of doing so are able to access the CCFF (provided they meet the eligibility criteria); to do so they will need to set up a commercial paper programme, which can be done relatively quickly. The CCFF purchases new commercial paper (at a minimum spread over reference rates) in the primary market via dealers and, after issuance, from eligible counterparties in the secondary market. All businesses that wish to draw from the CCFF for a term extending beyond 19 May 2021 will be expected to provide a letter addressed to HM Treasury that commits to suspending the payment of dividends and other capital distributions, including share buybacks, and showing restraint on senior pay during the period in which their commercial paper is outstanding. More details on the UK CCFF are available here. Coronavirus Large Business Interruption Loan Scheme (CLBILS) Under this temporary scheme, the UK Government provides a guarantee of up to 80% of loans, overdrafts or invoice or asset financing facilities of up to £25 million, £50 million or £200 million (depending on turnover) made available by accredited commercial lenders. The facilities will be offered at a commercial rate of interest and with tenors of up to three years. The intention is that this will give banks the confidence to support businesses that were viable before the CoVid-19 outbreak but are facing significant cash flow difficulties that would otherwise make their business unviable in the short term. Companies borrowing more than £50 million through CLBILS will be subject to restrictions on dividend payments, senior pay and share buy-backs during the period of the loan, including a ban on dividend payments and cash bonuses, except where they were previously declared or agreed. More details on the UK CLBILS are available here. Coronavirus Business Interruption Loan Scheme (CBILS) This scheme provides financial support to smaller businesses. It is currently available to businesses with turnover of up to £45 million. Lending is through accredited commercial banks for amounts up to £5 million with the Government providing a guarantee of 80% of the facility amount and meeting fee and interest costs for the first 12 months. Finance terms are from three months up to six years for term loans and asset finance, and up to three years for revolving credit facilities and invoice finance. It has been confirmed that private equity backed companies are also eligible for CBILS. When assessing the £45 million turnover eligibility threshold, the business will be considered separately from its private equity investors, and its other investments. If the business’s turnover is below that threshold, they can be eligible for the CBILS, provided they meet the other eligibility criteria. However it has been reported that many private equity-backed companies have been unable to access Government support facilities because of EU State Aid rules. Under those rules, companies are only eligible for State Aid under the temporary relaxations that have been introduced for CoVid-19 where they were not already a “firm in difficulty” before January 2020. As many private equity investments are highly leveraged, and so have high interest payments and lower levels of share capital, many of them could fall into the definition of a firm “in difficulty” and so could be blocked from accessing the financial support schemes. More details on the UK CBILS are available here. Bounce Back Loan for Small and Medium-Sized Businesses (BBLS) The scheme will help SMEs borrow between £2,000 to £50,000 through accredited lenders, with the Government guaranteeing 100% of the loan. There will be no fees, interest or repayments needed for the first 12 months and the term will be up to 6 years. The Government has announced that the interest rate will be a flat rate of 2.5%. Businesses claiming under CBILS, state funded schools, public sector bodies, banks, insurers and reinsurers (except insurance brokers) cannot apply for the scheme. The scheme is focused on providing quick cash to SMEs. Proposed changes to insolvency law The UK Government on 20 May 2020 published the Corporate Insolvency and Governance Bill, which contains the most far-reaching reforms to UK insolvency law in over 30 years. New company moratorium: A novel, free-standing moratorium (unconnected to any other insolvency process) giving up to 40 business days of protection even without court or creditor approval during which a payment holiday will apply to all pre-moratorium debts except certain limited categories (principally for liabilities to employees and financiers). The moratorium prevents legal processes against the company, including commencing a claim, commencing insolvency proceedings, crystallising a floating charge and forfeiture. Directors retain management control. An insolvency practitioner will be appointed as moratorium monitor, responsible for ensuring that the moratorium is at all times likely to result in rescue of the company as a going concern. The monitor’s consent will be required for many company payments. Certain liabilities incurred during the moratorium will remain payable, and therefore will be effectively prioritised. Fixed and floating charge assets will be capable of disposal subject to certain limitations. Winding up petitions: Winding up petitions cannot be presented if based on statutory demands dated 1 March 2020 to 30 June 2020. Creditors will also be prevented from winding up a company unless the creditor has reasonable grounds to believe that coronavirus has not had a financial effect on the company or that the company would have become insolvent even absent coronavirus’ effect, which will be a significant hurdle for most creditors. Winding up will now commence from the date of the order, meaning that transactions entered into between the petition and the order will no longer be void unless validated by the court. Ipso facto (termination) clauses: Contractual clauses permitting a supplier of most goods or services to terminate supply as a result of the customer’s entry into an insolvency procedure will cease to have effect. The supplier will not be able to exercise any pre-existing right to terminate either. Suppliers will also not be able to withhold supply to the company in insolvency until pre-insolvency debts are paid, preventing ransom payments being sought. Suspension of wrongful trading: When determining what contribution, if any, a director should make to a company's assets following a finding of wrongful trading, the Court must assume that a director is not responsible for any worsening of the financial position between 1 March and 30 June 2020. While otherwise directors may feel compelled to cease trading so as to take every step to minimise loss to creditors once they believe that there is no reasonable prospect of avoiding insolvency, directors can now take some comfort that they will not be liable for any deterioration since 1 March 2020. This reform may allow directors to continue trading though other duties of directors will continue to apply, including the common law duty to have regard to creditors’ interests when a company is likely to become insolvent. Given the purpose behind the reforms is to ensure that companies continue to trade even when they are insolvent or in financial distress, the need for directors to consider these common law duties become ever more important to avoid personal liability. Further information available in our briefing here.
Counterfeits and misleading advertising
Last updated 16 June 2020
Government and regulatory action
Existing and new credit facilities
Preserving cash and improving working capital
Capital calls
Restructuring businesses
