Screening for ESG Criteria in Lending and Investment Transactions

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September 13, 2021

Client Alert
Last month the United Nations’ Intergovernmental Panel on Climate Change (IPCC) issued a dire report in which the IPCC concluded that sustained and large-scale reductions of greenhouse gas emissions are imminently needed to reach the Paris Agreement’s goal of limiting global warming to 1.5 degrees Celsius as compared to pre-industrial levels. The report warns that, without such reductions, the planet will face increasingly devastating changes to the global climate system, including more frequent and severe weather events.

Such reports, coupled with recent severe weather events and the effects of COVID-19, continue to increase awareness of Environmental, Social and Governance (ESG) criteria amongst investors and lenders. Lenders and investors are taking different approaches to building ESG portfolios based on the entity’s own preferences and values. However, one widely used tool involves screening of select assets or transactions that align with those values. Screening describes the process of using a set of filters to determine which companies, sectors, or activities are eligible to be included in an ESG portfolio.

According to the Principles for Responsible Investment’s (PRI’s) guidelines, screens can be negative, normative, or positive (or a combination of the three). A negative screen is used to avoid the worst performers by excluding certain sectors or activities either absolutely or for poor performance relative to their industry peers. A normative approach screens loans or investments against minimum established standards of business practice. Positive screening, on the other hand, involves affirmatively selecting sectors, issues, or projects based on their positive ESG benefits or for their performance relative to industry peers.

Several useful tools are available to assist investors and lenders in screening for ESG transactions. For example, the Loan Syndications and Trading Association (LSTA) has developed a ESG Diligence Questionnaire for Borrowers and a similar one for managers. The LSTA’s borrower questionnaire addresses all three ESG criteria and incorporates negative, positive, and (to some degree) normative screening tools into its framework. The questionnaire focuses on ESG governance, framework, factors, and revenue, as summarized below:

Screening tools such as the questionnaire published by the LSTA are useful for investors and lenders alike in determining whether potential loans or investments may meet internal ESG criteria. Any such questionnaire, however, should be flexible and tailored both to meet the goals of the user and to address the most important issues confronting the enterprise being screened. Each industry faces unique ESG challenges and concerns. For example, from an environmental perspective, certain industries may not be large emitters of greenhouse gas emissions but water usage or sustainable packaging may be a crucial consideration facing the industry. Screening such a company regarding only climate change considerations would miss the mark. ESG diligence in general is still in its early stages and there is no one established protocol or approach for conducting it. The ESG issues that companies face will continue to evolve as must the tools used to measure and evaluate ESG performance.

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