ESG has had yet another turbulent year. Widespread regulatory rollbacks in Europe and persistent media scepticism in the US have fuelled a narrative that the strategy is in retreat, or even in disarray.

But Fiona Hagdrup, head of leveraged finance, and James Frankland, sustainability and product specialist, at M&G, see things differently. From their perspective, ESG hasn’t unravelled, it has matured.

To some extent, the unwinding of the 2021 ESG hype was necessary. ESG dominated investor agendas at the time, but was also marked with rampant greenwashing and marketing commitments that often lacked credible implementation strategies.

What remains is arguably a more serious cohort of investors, focused on integrating ESG considerations into investment strategies in a disciplined and durable way.

In this 9Questions, our interviewees analyse the state of ESG across LevFin, with a focus on private markets and broadly syndicated loans, and their wish list to strengthen it.

1. In previous interviews you’ve said encouraging companies to improve their climate disclosures and to outline their ESG risks is now part of the ordinary course of lending in private credit. How receptive are borrowers to that level of engagement and transparency? And how has that changed in the last few years?

Hagdrup: They are really receptive, and they always were, but about 50% of the time you felt like you were telling them something new. So they were intellectually curious, but not necessarily sure where you were coming from — but I'm talking 10 or 15 years ago. Whereas these days it’s correlated to the size of the company in terms of how a company mitigates against pertinent ESG risks.

Frankland: Engagement around climate has definitely become more sophisticated as we've gone on. I remember a couple of years ago companies may have only started reporting emissions for the first time and hadn’t thought about setting targets yet.

Conversations with companies now are almost like a partnership, with us demonstrating what we think is best practice and the types of things we would expect to see in a transition plan. We're getting ever closer to 2030 and there are loans with maturity post 2030 in the market and companies that are within the range of their near term targets.

2. How are LPs thinking about ESG when allocating to private credit strategies today? Are they becoming stricter in their expectations?

Hagdrup: I think so. I mean, there might be some regional variation. Even within Europe there are some countries and institutional investor types that care so much more than merely risk mitigation. We're looking for commentary and measurement of precisely where a company is on its sustainability agenda and looking for specific metrics on that front. Which isn't to say that away from Europe no one cares, but it may then get a little more institution specific and harder to observe.

Frankland: The baseline of client ESG expectations has risen as the markets matured as well. So what clients were asking for a few years ago that felt stretching today is just the minimum expectation.

3. Given that many ESG risks are inherently long-dated, how do you reconcile that with lending an asset you may only hold for two to four years in private credit markets? Particularly for emissions intensive sectors, how do you factor in transition risk when the financial risk may sit with a future lender rather than with you?

Hagdrup: One thing we always try to be cognisant of is that we may be the guardian of a client’s exposure to a company for quite a short period in the grand scheme of things, perhaps only three years or so. However, chances are that we have private credit colleagues who may have held a different kind of exposure before us, whether equity or growth debt, and we will also have public fixed income and public equity colleagues who may come after us. You're handing the baton — if we've done our job right, we've articulated a common narrative. For the period that we are involved, we're just trying to be high energy and supportive.

Frankland: And there are financial impacts today — you have regulation, the emissions trading scheme and CBAM, for example, impacting some of the big chemical companies. So even though it’s a long term strategy, climate is having a financial impact today.

4. One of the most prominent market shifts we’ve seen this year is increasing investor interest in defence related assets, particularly in private credit markets. For years, defence was excluded from many ESG frameworks, but that seems to be changing. Do you see defence as a special case given the geopolitical environment, or is this the beginning of a broader reassessment of previously excluded sectors?

Hagdrup: It’s always been a matter of debate. At the very high end of ESG strategies, thinking about impact for example, blanket exclusion, including controversial weapons was just the easiest and most straightforward to understand. But there is nuance in, for example, companies involved in state supported defence of the nation — that has become a very live and relevant debate. Within private credit, HY and BSL, we don’t ever actually have much cause to challenge ourselves on this, because there aren’t that many sub-IG companies active in the defence sector. The debate is wrapped up in a more general desire to categorise sources of revenue and identify their ultimate source.

Frankland: M&G recognises the important role defence plays in safeguarding national security and supporting global stability. Our approach is to provide clients with a range of investment options, some of which include defence exposure, while maintaining exclusions for controversial weapons in line with international standards.

5. Article 8 and 9 requirements were designed with public markets in mind, but private credit often lacks the level of data needed to meet those standards. How do you navigate those gaps when determining whether a strategy can credibly be classified as Article 8 or 9?

Hagdrup: That's an old challenge that has long since been minimised but I say that from a background of more BSL than private credit. The bond investment community could do better at more systematically reporting certain metrics with a common methodology. There were some initiatives to try to have, for example, CLO managers cohere to a certain level of two or three aggregatable metrics — say, an intensity metric for portfolios. With that might come an ability to measure against a benchmark. There could be more context and commonality of approach from lenders.

There are also areas that are still lacking, so we do sector exclusion data on desk manually because there are not many providers that map the whole market. Similarly, physical climate risk data is very scarce.

Frankland: The data coverage is pretty good. Obviously it depends on the size of the company, but typically a lot of them have really upped their game. For example, with emissions, the coverage of that is really good now, especially scope 1 and 2 — I think we got over 90% reported by companies. They will report some quite niche metrics where they're deemed material to a company’s business strategy, and a lot of the time most companies have done double materiality assessments as well. There's also a lot more companies committing to SBTI — almost 40% of our portfolio is committed or got a ratified SBTI target.

6. Investor interest in sustainability linked structures has cooled in recent years. What kinds of incentives or structural changes would make sustainability linked loans and bonds genuinely compelling? What’s driving investor hesitation?

Hagdrup: I’m not sure whether or not things have slipped on the public side, or at least you might say green bonds have been resilient. But even M&G felt the need to own that not all green bonds are created equally and have some kind of RAG (red, amber green) assessment. So even if it was purported to be green, we might not necessarily conclude it was sufficiently robust. On the loans side, the first sustainability linked loans set the pattern for the rest and they became arbitrary — not necessarily material metrics to which to adhere. I wouldn't want to rule them out — what we lacked for so long was quantification.

Frankland: The Loan Market Association has released the guiding principles on sustainability linked loans (SLL) and they're very similar to the sustainability linked bond principles. It's quite tough for companies to achieve proper SLL status now. It's a very rigorous process, you've got all the different thresholds you need to hit. That has also driven a bit of hesitancy in the market just because companies maybe don't have the resources to do it. Clients haven't really been asking about these structures that much. I remember a spell a few years ago where we were getting lots of queries about margin ratchets first, but then sustainability linked after that. But it has died down a little bit.

7. ESG has faced a lot of criticism in the past couple of years — some of it political, some structural, some due to inconsistent standards. From where you sit, is the ESG ‘backlash’ materially affecting how investors or borrowers behave, or is it mostly media noise?

Hagdrup: I’d say the latter in our world. But it was never that controversial to say, even to an uninterested client, that there might be a correlation between assessing the mitigation of an environmental or social risk and having a reason to say no — which is ultimately what you are doing in lending. Even the least interested client could accept that logic, that there'd be a correlation between ESG risk and financial risk. The ‘G’ in ESG over the last 12 to 24 months has exposed some value loss from poor governance and cyber security issues.

Frankland: What will probably happen is that sustainability will have to demonstrate it pays a bit more overtly. The Principles for Responsible Investment have done some really good work on the value creation of some sustainability metrics, linking disclosure and company practices to financial outcomes. There is definitely causal link between a lot of this stuff and companies performing better. But there will be more pressure to evidence that link — and then it will start to take off a bit more, as investors will ultimately want to invest in companies that perform better.

8. CSRD was expected to be a major step forward in improving ESG data quality, especially by bringing more private companies into the disclosure net. But at the same time, we’re seeing a widespread scaling back or delaying of ESG rules in Europe. Do you worry that regulatory dilution could undermine the progress and momentum that was backing ESG for the last few years?

Hagdrup: If we're just thinking about our own reporting and measurement needs, then yes. But that's such a very narrow way of thinking about things and all the regulation was really piling extra friction before the companies have the resources to handle it, at a time of low growth. It's an awful lot of change, really fast. Somebody compared ESG reporting to when GAAP accounting first came in. They'd been refining accounting standards for something like a century, and then all within the space of 10 years it was left, right and centre.

Frankland: Generally the simplification of the disclosure is good because it was like 1,000 metrics that companies had to report before, which was pretty labour intensive and therefore companies were not going to be compliant anyway. Because it's been simplified, compliance is more likely. Even companies that have been taken out of scope tend to form part of the supply chain of bigger companies. These big companies will have a lot of attention on reducing their scope 3 emissions, so there will still be pressure on the supply chain companies to report and put a transition plan in place.

9. Looking ahead, what would you like to see change to ensure ESG remains a meaningful, long term fixture in investment practices?

Hagdrup: A bit more upscaling in the ambition of those that are running Article 8 funds in the CLO tranche investing world. More of them upping their game on sustainability might engender that nudging forward of loan managers and underlying companies.

Frankland: It would be great to have some benchmark data in the market. That's one thing that is severely lacking that you see in public worlds. There are no ESG benchmarks in in our world really, so it's difficult to know how you're tracking really against other companies.

Bonus: Before we go, whats your favourite holiday movie?

Hagdrup: A Wonderful Life (black and white version), was mine but I’ve traded now because my adult kids don’t enjoy black and white films. Their favourite is The Muppets Christmas Carol, so I’ve adopted that now.

Frankland: It’s a bit of a rogue one — Bad Santa.