ESG laggards could discover debt drying up

Companies that fail to align their businesses to commitments necessary to achieve the goal of the Paris Agreement on climate change may soon find themselves being denied capital they want to raise on bond markets.

A handful of investors have started implementing or are considering a new mantra: Deny the debt. Discussed in academic circles over recent years, the idea is a way for institutional investors to express their climate change views and requirements of portfolio companies in their bond holdings. By refusing to give their cash to companies looking to raise funds on the primary bond markets, they hope to force climate-related progress.

The Paris Agreement is a global pact to limit the rise in global temperatures this century to well below 2 degrees Celsius — and ideally below 1.5 degrees Celsius.

The importance of denying funding and refinancing to certain companies cannot be underestimated, and pledges to invest in green capital is not enough, sources said.

"A necessary condition for Paris alignment is actually defunding or closing the 'brown' (or fossil-fuels-related) cash tap. That's necessary and sufficient," said Andreas Hoepner, professor of operational risk, banking and finance at University College Dublin's Michael Smurfit Graduate Business School.

"Green investments are necessary for Paris alignment at our current quality of life, but they are not sufficient for Paris alignment as they don't close the brown cash tap ... I think we're often so focused on green investments that we're ignoring the fact that denying debt is the No. 1 requirement for Paris alignment," he said.

Denying the debt as a concept is "the original bond vigilantes," said Ulf G. Erlandsson, Stockholm-based CIO at Diem Green Credit and founder of non-profit organization Anthropocene Fixed Income Institute, which advocates the use of fixed-income markets for climate-change mitigation.

"That's a demand and supply function of where that price is going to be — hence, if a big investor goes out and says it's not investing, that removes part of the demand for the debt and basic economics means they need to compensate by increasing the yield of the bond to entice other investors to come in," Mr. Erlandsson said.

The £8 billion ($10.4 billion) Lothian Pension Fund, Edinburgh, in June adopted a new statement of investment principles and, with it, a new mantra: Engage your equities, deny your debt.

"If you are not Paris-aligned … you're not getting our money, basically," David Hickey, portfolio manager and responsible investment lead at the fund, said during a panel discussion at the Pensions & Investments virtual WorldPensionSummit, held in October.

Sources said Lothian — Mr. Hickey in particular — is leading the way when it comes to institutional investors being vocal and stating their positions on the subject.

But other investors are considering it or at least recognizing its importance.

Research into divestment led by academic Ellen Quigley, adviser to the chief financial officer at the University of Cambridge — which pledged last month to divest its £3.5 billion endowment fund by 2030 and be net-zero carbon emissions by 2038 — found that most new financing for fossil fuels comes from bond issuance or bank lending rather than equity. Ms. Quigley said the university will have more to report on the topic next year.

And Laura Chappell, CEO at the £33 billion Brunel Pension Partnership, Bristol, England, said in an email that executives at the pool have very much turned their attention to fixed income.

"The capacity to deny debt to companies can be a useful tool in a manager's toolkit as they seek to align their fund to net-zero — and we would expect them to make use of it as needed," she said.

Executives at the pool will be conducting a full review of their own approach as an asset owner in a 2022 review, she added.

A closer focus on fixed-income markets is not surprising. One reason is materiality, said My-Linh Ngo, London-based head of ESG at BlueBay Asset Management LLP. "The fact that the absolute size of the debt market trumps the size of the equity market means that if you want to make an impact, you need to think beyond equities."

BlueBay has more than $67 billion in assets under management.

Another reason is that denying debt is a relatively simple thing for an investor to do, Mr. Hoepner said. "If you do an equity divestment, you have to think about how to make up for it in your portfolio diversification. If you're denying debt, there's very little you need to do. You even save time skipping investment banker pitches."

Some industry participants think denying debt to companies could seriously move the needle when it comes to meeting the requirements of the Paris Agreement.

By the end of next year, €266 billion ($309.7 billion) in global corporate debt across 343 bonds issued by 147 companies is due to mature, according to data from University College Dublin's Michael Smurfit Graduate Business School, presented at a webinar Nov. 5. By 2025, €969 billion is due across 2,477 bonds. Just 34 of these bonds are green bonds, the data show. Figures relate only to companies targeted by investor initiative Climate Action 100+, whose partner organizations include Ceres and the Asia Investor Group on Climate Change.

If an investor can target primary capital and affect supply and demand dynamics, "the logic goes that it will have more of an impact in terms of driving up the cost of capital. Companies that find they are struggling to get access to capital or having to pay more for that access, may then start to take action," Ms. Ngo said.

For Mr. Erlandsson, the impact of investors denying debt "could be enormous — and I'm usually a very conservative guy." Although on one hand, Mr. Erlandsson objects to the terminology 'debt denial.'

"The real terminology should be 'stop supplying loans.' Investing in bonds is simply lending to companies. No one is forcing you to do it."

Calvert Research and Management takes a company-by-company and sector approach to investment, "but the cost of capital — the spread that company and that sector should be paying for not (aligning to the Paris standards) or taking that into account in their normal business standards is how we conceptually think about it," said Vishal Khanduja, vice president, lead fixed-income portfolio manager in Boston. Executives may choose to buy only shorter-dated debt or not at all. "It's become a way for us to vote on the company, by not participating in a certain issue," he said.

Calvert had $23.4 billion in assets under management as of June 30.

The concept of denying debt is one that, while nascent right now, could snowball.

"It could have pretty significant (impact) — the market could start pricing it in very slowly, but the moment it gets (to be a) more quantifiable impact on a company, then it can be very quick" in pushing the cost of capital higher, added Brian Ellis, portfolio manager at Calvert, also in Boston.

And coupling debt denial with increased engagement is even more powerful.

"In isolation, where we have seen divestment campaigns in equities, we have seen a modest impact on share prices and cost of debt," said Rory Sullivan, London-based chief technical adviser to the Transition Pathway Initiative, which assesses companies' readiness to transition to a low-carbon economy. "In and of itself, divestment may not be that significant. But when married to corporate engagement, public policy engagement and investors publicly refusing to invest when issuers come to market, the leverage and influence becomes much clearer. The call to 'deny the debt' may not change much, but if it becomes a philosophy beyond how you invest in debt, then it becomes more powerful."

However, some market sources are more cautious about the impact denying the debt could have and warned that it could get complicated.

One potential issue would be for those asset owners that want to deny debt but also hold the equity of a company.

"Because you're potentially harming equity returns by enforcing a higher cost of capital — assuming deny the debt can be organized and implemented," said Mitch Reznick, London-based head of research and sustainable fixed income at the international business of Federated Hermes Inc. "There is a risk there you are potentially impairing your equity returns by forcing higher cost of capital on the debt, which increases the weighted average cost of capital, the discount rate and can diminish equity returns," he said.

However, there will be times that the approach can be "deployed when all else fails when working with companies on engagement and the rest of the capital structure."

A preferred approach would be to engage with a company, encouraging them to align to the Paris Agreement in order to become positively screened into portfolios, he added.