ESG in credit risk: Workshop with French sub-investment grade borrowers

Company structure (size and ownership: family-owned, private equity-owned or listed) significantly impacts how analysts incorporate ESG factors in their evaluation of high-yield (HY)^[3]  companies, compared to IG borrowers.

These dimensions determine the resources that a company allocates to its ESG communication and how accessible that information is to market participants. Smaller companies, which are prevalent among sub-IG borrowers, have fewer resources to collect and disclose ESG data, while private companies are not subject to the same disclosure requirements as public companies. Finally, smaller companies are often positioned in niche markets. This complicates peer comparison, as it is difficult to identify suitable benchmarks.

A company’s ownership structure can impact its transparency, the time-horizon of its business strategy, its internal culture as well as the use of leverage and remuneration policies – factors that are important when assessing governance.

“The credit market is not limited to listed companies; regulation will have to be imposed on non-listed companies as well. But this requires standardisation of data and the creation of frameworks suitable for smaller issuers.”

Credit analysts regularly use information such as a company’s board composition to assess its complexity. Family-owned companies tend to be more flexible and faster in making decisions. They can also be more open to taking medium- and long-term risks, in contrast to the short-term share price dynamics that impact listed companies. On a negative note, they can be less transparent, often restricting access to their investor websites. While investors recognise the legitimacy of this practice, it further hampers sector comparisons.

One participant observed that family-owned companies may score poorly on governance if they are assessed by analysts using key performance indicators (KPIs) that are better suited to listed companies. At the same time, some family-owned companies can lack independent directors, thus reducing the checks and balances provided by their boards.

Private equity firms often set up complex structures for their holdings, to take advantage of the leverage used and to optimise taxation. As such, they can be reluctant to share information, particularly regarding debtholder protections in covenants or related to ESG data, and may even prevent their investee companies from making such disclosures. This contributes to a certain opacity in the financial reports of private equity-owned borrowers. Credit analysts place more importance on the transparency of financial disclosures – particularly of covenants – than private equity analysts, who are more focused on shareholder protection.

Echoing previous workshops, investor and company participants called for two-way communication on ESG issues to improve.

Investors would like companies to provide better information. For non-listed HY borrowers, this is often limited due to their size. Furthermore, since buy-side analysts cover many issuers simultaneously and from different sectors, they would like to see companies communicating more proactively on ESG targets and sustainability plans, instead of needing to request these, which makes ESG investigation difficult. On a positive note, the participating companies all plan to publish ESG reports.

Companies expect more guidance from investors on ESG issues. They observe that credit analysts only ask a few questions on ESG issues, as their primary concern is the financial health of the issuers and their compliance with covenants.

Discussions with investors on social and environmental issues remain weak and companies have little visibility on what investors think of their ESG policies (what is good or what could be improved). This suggests that:

• Investors struggle to link ESG factors to financial materiality; and
• Companies’ communication on ESG topics is primarily directed at third parties for now (customers, suppliers or ESG information providers)

“It is important to converge ESG data and financial disclosures.”

Analysts are used to assessing the impact of governance on credit quality and they are beginning to focus on environmental issues, which are becoming more measurable and understood. Indeed, companies are addressing their Scope 3 emissions to retain their customers or avoid reputational risks in their supply chains.

For instance, one participating company has started making efforts to map its carbon footprint and has invested in cleaner equipment, driven by customer demand for low-carbon products and new regulations banning diesel in large cities.

Some large investors and CRAs have started to produce in-house financial materiality maps. Building a financial materiality map can be useful but it remains challenging to model the impact of ESG factors on operating and capital expenditures in the absence of harmonised data. While reporting frameworks such as the Sustainability Accounting Standards Board or the European Public Real Estate Association exist, they are mostly used by equity investors and are not widely accepted yet.

There was agreement that the credit-relevance of social factors remains the most difficult to assess of the ESG categories.

Participants observed that among social factors, reputational risk can significantly impact a company’s financial performance and the ability to repay its debt, as potential negative publicity related to poor workplace practices, product recalls or clashes with local communities have potential repercussions on costs and profits that could hit a company’s credit quality.

However, reputational risk can also be linked to factors that are not within a company’s direct control, caused by societal changes including varying consumer preferences or values. New behavioural patterns and technological change are affecting many service sector organisations. For instance, in the retail sector, customer attitudes towards animal welfare and organic food may require production changes that impact profitability.

A company’s cost of capital will vary depending on whether it is IG or HY rated. However, some participants noted that a company’s ESG performance (their disclosures or how ESG considerations feature in their business strategy and planning) had no obvious impact on its cost of capital. Whilst demand remains strong, sustainability bonds are also not better priced at present, although one observer noted that some differentiation is emerging in the IG market.

Nevertheless, participants noted that the cost of capital may rise if access to the funding pool becomes more limited because investor expectations about companies’ ESG performance are changing or due to upcoming regulations (see box The EU taxonomy below).

“European economic policies will have to facilitate the necessary digital and ecological transitions. To achieve this, Europe needs to define more clearly the standards that will support the European growth.”

HY companies can struggle to issue thematic bonds, as it is more difficult for small and medium-sized companies to find and provide verification data regarding the use of bond proceeds. Moreover, green bonds are not suitable for sectors that may have to continue relying on fossil fuels for a while. Some participants mentioned that they prefer to fund themselves through green loans, as the pricing is more attractive than on the HY bond market.

As a result, sustainability bonds (whose financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/ESG objectives) are more suitable for HY companies. However, company objectives need to be realistic. For example, in the shipping sector, scalable technology for net-zero emissions vessels doesn’t exist today, and the frameworks for issuing green or sustainability-linked instruments, which could help fund the transition, are too restrictive. Hydrogen is one option being explored to meet decarbonisation objectives.

The discussions highlighted several considerations specific, but not unique, to the industries of the companies represented – debt repurchasing (iQera), retail (Casino), shipping (CMA-CGM), rental equipment (Loxam) and facility management (Atalian). These are outlined below: