Reduced emissions and cheaper capital: an overview

Oh to be a regulator during a global pandemic… It is times like these, when the economy is under significant stress, that enable the most radical leaps in terms of climate-focused structural change. This holds both on the side of companies that tend to take advantage of economic downturn to reduce emissions, and on the side of institutions like the ECB that are attempting to strike the iron while it’s hot with the hope of returning to a greener post-COVID economy. Indeed, if the EU is to achieve the climate-related targets set out in the Sustainable Development Goals 2030 plan and the Paris Agreement, and underlined in its own commitment to a climate-neutral economy and a 40% reduction in greenhouse gas emissions by 2030, it must capitalize on all present opportunities to accelerate the transition.

“Climate change is the single greatest threat to a sustainable future but, at the same time, addressing the climate challenge presents a golden opportunity to promote prosperity, security and a brighter future for all.”

Ban Ki-Moon, former UN Secretary General

In a recent keynote speech, a member of the Executive Board of the ECB exhibited the kind of thinking that is driving amendments to the ECB’s operational framework. Fabio Panetta highlighted that climate risks haven’t been correctly priced in the past, looking at risks on assets used as collateral in refinancing operations as an example. The expectations set out in guide on climate-related and environmental risks that the ECB recently issued is evidence that systemic banks are now taking these risks seriously. Beyond a series of expectations regarding risk assessment and internal audits, the ECB has also made it clear that institutions need to maintain enough internal capital to cover their exposure to environmental risks. Additionally, the guide includes an example of the proper mapping of climate-related risks, with the depreciation of assets of carbon-intensive companies deemed the most important factor in terms of strategy. Why does all this matter to companies acquiring capital? Here’s the juicy bit. Whenever an EU institution wants to issue credit, it now needs to fully incorporate climate-related risks in the process, deciding how environmental damage affects the borrower’s default risk. The quality of a company’s own environmental risk management system is stated as a consideration as concerns the final risk premium (hint: that’s where we come in). Note that the environmental risk that could drive the cost of capital up for a company is not limited to its own facilities, but rather all financed operations – the ECB considers all financed emissions to be part of institutions’ scope 3.

Where private credit isn’t following suit, it’s pushing harder for more emphasis to be placed on ESG. In a recent interview, Sonia Rocher, Managing Director at BlackRock, justified the preference for ESG leaders as clients. Specifically, ESG leadership was presented as a way to attract new clients and outperform competition long-term. This mentality is backed by the development of a proprietary rating system at BlackRock, an attempt to overcome the challenge of dealing with the wide variety of relevant variables. When asked about the challenges of including ESG ratings in private credit investment, Ms Rocher mentioned issues regarding the reliability of data and the process of comparing ratings. It is no secret that private lenders are actively focusing more on environmental risk when issuing credit, and have identified many of the problems policymakers are trying to resolve.

How ESG ratings factor in different criteria, kindly provided by carbonclick.

In a recent keynote speech, a member of the Executive Board of the ECB exhibited the kind of thinking that is driving amendments to the ECB’s operational framework. Fabio Panetta highlighted that climate risks haven’t been correctly priced in the past, looking at risks on assets used as collateral in refinancing operations as an example. The expectations set out in guide on climate-related and environmental risks that the ECB recently issued is evidence that systemic banks are now taking these risks seriously. Beyond a series of expectations regarding risk assessment and internal audits, the ECB has also made it clear that institutions need to maintain enough internal capital to cover their exposure to environmental risks. Additionally, the guide includes an example of the proper mapping of climate-related risks, with the depreciation of assets of carbon-intensive companies deemed the most important factor in terms of strategy. Why does all this matter to companies acquiring capital? Here’s the juicy bit. Whenever an EU institution wants to issue credit, it now needs to fully incorporate climate-related risks in the process, deciding how environmental damage affects the borrower’s default risk. The quality of a company’s own environmental risk management system is stated as a consideration as concerns the final risk premium (hint: that’s where we come in). Note that the environmental risk that could drive the cost of capital up for a company is not limited to its own facilities, but rather all financed operations – the ECB considers all financed emissions to be part of institutions’ scope 3.

Where private credit isn’t following suit, it’s pushing harder for more emphasis to be placed on ESG. In a recent interview, Sonia Rocher, Managing Director at BlackRock, justified the preference for ESG leaders as clients. Specifically, ESG leadership was presented as a way to attract new clients and outperform competition long-term. This mentality is backed by the development of a proprietary rating system at BlackRock, an attempt to overcome the challenge of dealing with the wide variety of relevant variables. When asked about the challenges of including ESG ratings in private credit investment, Ms Rocher mentioned issues regarding the reliability of data and the process of comparing ratings. It is no secret that private lenders are actively focusing more on environmental risk when issuing credit, and have identified many of the problems policymakers are trying to resolve.

Global breakdown of ESG funds’ assets. Source: ECB.

2020 might have been a terrible year overall, but it was actually pretty good for ESG funds. In fact, it was the year that ESG funds, which try to minimize environmental risk in their investment portfolios, surpassed expectations and surprised analysts with their inflows. What’s more, last year they held more than $1.7 tn of assets, with equity representing more than 60% of that number, according to Bloomberg and the ECB. The success of these funds reflects the success of companies that transition to sustainable operations, whose issued equity could be met with increased demand.

In summary, there are three reasons why greener companies are gaining a competitive advantage in terms of capital acquisition. Firstly, this happens because environmental risk translates directly to financial risk, meaning companies that reduce their carbon footprint protect their assets from carbon-driven depreciation. Systemic institutions are now expected to offer credit at a premium to clients that are associated with exposure to environmental risk. Secondly, ESG leaders are expected to outperform in the long-term, especially considering COVID-era regulation is advancing with considerable pace. Thirdly, ESG leaders are able to attract new clients by offering lower scope 3 emissions for them and by capitalizing on the intangible assets that emission reduction programs create (the value of which our partner, PRC Group, can help them maximize).

These advantages are reflected in the market. Indexes which track ESG leaders have outperformed their corresponding parent benchmarks by 300 basis points in Europe! The trajectory of regulation and credit premiums is clear, and therefore so is the trajectory of companies that are neglectful towards their carbon footprint. As ESG ratings measure performance relative to the rest of the sector, it is companies that act first that will gain the most. In an EU where €250 bn of the pandemic recovery stimulus has been pledged to projects that work towards achieving ambitious climate targets, and in a global market with a total of $1.71 tn in green stimulus as calculated by Credit Suisse, the road to a post-COVID economy will be greener than ever before. In contrast, those that lag behind have to deal with more expensive capital, as they represent exposure to environmental and transitional risk for their creditors, and higher operational costs, as they deal with regulation that is disrupting current market structures.

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