Before even addressing the need to integrate the assessment of ESG factors in credit analysis at the company level, we want to establish a link between ESG factors and credit risk at the sector level. There is a multitude of ESG factors to consider across all industries. We must assess their impact on financial materiality as a complement to traditional credit analysis. However, these factors do not affect all industries in a uniform way. Understanding the relative importance of these factors across different industries helps us to focus the analysis at the company level of some factors versus others. For example, climate change and carbon footprint will likely have a more material impact on a company’s operating and financial strength in the energy, utilities and bank (from a loan-book perspective) sectors than in the telecom or retail sectors. As such an analysis of the materiality within ESG analysis at the sector level frames the questions to be asked at the company level.
On a more practical basis, just as our public Credit team scores credit risk and valuations, ESG risks of individual companies based are also scored on a suite of information. Credit analysts review data from various sources, including the proprietary, quantitative ESG scores (QESG) and analysis generated by our ESG Dashboard.
The team also employs the use of a proprietary ESG pricing model that it developed in-house based on a collaboration between the investment teams and the QESG scores. The pricing model, which was constructed after demonstrating a relationship between ESG factors and credit spreads helps us to make investment decisions about which securities in the capital structure to invest in; where on the credit curve to invest, or simple whether to invest at all in a particularly name.
The team also has access to engagement information from the stewardship team, EOS at Federated Hermes (“EOS”), and meets regularly with the engagers from the team. Finally, the Credit analysts often share meetings—often at the board of CEO/CFO level—with their peers in EOS (e.g., Deutsche Bank, Suzano, Country Garden, Vodafone, Tenet, Telecom Italia, Pemex, etc.).
As outlined elsewhere, we additionally adopt a firm-wide exclusion policy with respect to companies that produce cluster munitions and/or anti-personnel landmines.
The Private Debt team considers ESG items as part of the credit analysis undertaken for each potential investment. ESG considerations are tabled at the Private Debt Investment Committee as part of the research presented for all new transactions.
For our Direct Lending team, the key is to identify meaningful ESG risks, both current and potential, before investing. Due to the difficulty of divesting and the capped upside, it is important to manage the downside ex ante. The Direct Lending team operates a three-pillar approach to ESG analysis:
- Excluded Industries: The Direct Lending strategies are exclude investment into any transaction exposed to certain industries and practices, including gambling, tobacco, distilled alcohol, pornography, weapons & munitions, GMO, fur trade, ship breaking, shark finning and cosmetics tested on animal. This is because the Direct Lending team does not think that investors are remunerated for the ESG risks associated with these industries.
- Enhanced Due Diligence: Any potential investment exposed to certain industries is subjected to enhanced due diligence, including via with the Responsibility team and EOS, as appropriate. These industries include energy, chemicals, forestry and agricultural commodities, manufacturing and mining and metals.
- Transaction-specific ESG Analysis: As part of its fundamental credit analysis, the Direct Lending team conducts an ESG assessment of each investment opportunity and applies a rating from one (very low ESG risk) to five (very high risk). E, S and G factors are then weighted by materiality, resulting in an overall weighted average rating. Additionally, the team also focuses acutely on the sensitivity of the company’s cashflows to sudden damage that could arise from the identified potential ESG risks. With that in mind, the Direct Lending team will evaluate if investors are adequately remunerated for the ESG risk(s) of the transaction.
The credit application prepared by the Direct Lending team includes a specific section on the ESG considerations associated with the transaction, highlighting the facts that led to the ESG ratings of the opportunity. These considerations and the rating are discussed and minuted at Investment Committee and a decision is made on whether they are acceptable to the investment case.
As with our direct lending investments, it is important for our Asset Based Lending team to identify risks that may impact on a borrower’s ability to repay their loan.
As part of our processes and expertise, and as with the rest of our investment portfolios, we have integrated our responsible property investment principles and programme into the debt investment procedures.
It is the responsibility of the debt investment team to implement the strategy.
This is done as follows:
1. Underwriting and due diligence
The focus of our responsibility programme is on ensuring a strong due diligence process including assessments of ESG and climate risks and opportunities before agreeing new loans. This is applicable for every loan.
2. Loan origination & documentation
At loan origination the business plan agreed is included in the loan documentation, it includes all mitigation activities identified and detailed in the asset business plan, asset refurbishment plans and/or planned and preventive maintenance programmes. Also applicable for all loans.
3. Management and monitoring post closure, asset upgrade finance
We collect and manage the sustainability information we hold on the borrowers and the underlying assets.
Where we provide capital for refurbishment, in accordance with the business plan, refurbishment agreements include a review of the Federated Hermes’ responsible refurbishment guide and minimum requirements.