ESG lending: momentum is building for the mid-market

We surveyed over 40 UK-based lenders – from the large clearing banks to smaller alternative lenders – to understand their ESG lending to mid-market firms. The results show that while ESG lending to date has been dominated by large, listed companies, there has been an important change in the direction of travel with lenders increasingly focusing on ESG for the mid-market.

ESG for the mid-market has lagged – until now

For large, listed corporates, ESG has permeated the mainstream agenda. In 2021, the global loan markets issued over USD 681 billion of green and sustainability-linked loans (SLLs). Of that volume, SLLs accounted for more than USD 600 billion, an increase of 3.5 times the level reached in 2020 according to US trade association, LSTA.

However, this is not yet the case when we examine lending to mid-market companies.

According to the results of this survey:

The greater uptake of ESG at the larger end of the market where firms have more formal ESG policies in place is understandable. This has made the move towards ESG lending a more natural step.

Mid-market firms often have more constraint upon resource, however, and corporate governance can be less formalised. They have had different priorities: surviving the pandemic has inevitably taken precedence over the past two years. They also typically don't face the same ESG pressures from shareholders or institutional investors as listed companies.

Importantly, there has not been the same pressure from their lenders either, but the results of our survey show that this is going to change.

Direction of travel is changing – mid-market firms need to be alive to ESG

ESG lending represents less than a tenth of existing mid-market lending for over two-thirds of lenders. However, our survey shows an important change in the direction of travel.

When looking at new mid-market lending, a third of lenders surveyed said that green loans or SLLs accounted for 11-25% of new loans being advanced, while 30% of lenders said the proportion of new green loans or SLLs was over 26%. 

The trend is clear - the proportion of green or SLL lending to the mid-market will only continue to grow. For this reason, all the major banks are committing significant resources to ESG, including formal training for front office corporate teams.

Lenders under pressure to increase ESG credentials

Lenders themselves are facing scrutiny on their ESG credentials from their own stakeholders, limited partners (LPs), regulators and non-governmental organisations. Virtually every large bank has made a commitment for their balance sheet to be net zero by 2050.

Some have gone further and set themselves interim targets. For example, Lloyds Banking Group has the target of reducing the carbon emissions they finance by more than 50% by 2030 and Barclays has set reduction targets across four of the highest emitting sectors in their portfolios: energy, power, cement and steel. These ambitious targets could directly affect the loans lenders make to mid-market borrowers.

Non-bank lenders are also growing their SLL offering. As an example, the majority of our non-bank respondents are now offering ESG financing on new deals.

With this challenging transition to net zero in mind, lenders are focusing on ESG issues even when not directly connected to SLLs. ESG is increasingly becoming part of due diligence and viewed as an important element of corporate performance. It can also be a driver of value in terms of access to capital, regulatory compliance and customer satisfaction.

ESG now factors into a lender’s credit risk assessment for mid-market firms

Bank lenders now undertake a ‘transition to net zero’ risk assessment as part of their annual credit review process for their mid-market and large corporate clients. Our survey shows that in the mid-market, ESG is increasingly a lens through which decisions about credit risk are made.

That a mid-market firm’s ESG credentials are now feeding into a lender’s internal credit risk assessment is an important change. It speaks to the fact that ESG credentials and performance are directly related to the sustainability and longevity of a business. 

Inevitably, this potentially translates to both the price and availability of capital. Mid-market firms need to be aware that each time they come to refinance a loan facility with their lender, the pressure to show their ESG credentials will be ramped up. It is vital that firms start to pay attention to this now.

Supply chain pressures will affect mid-market firms

As regulatory requirements and shareholder expectations around ESG intensify, larger listed entities are incentivised to show they are focused on ESG throughout the entirety of their supply chain. Mid-market firms who feed into these supply chains may find themselves losing key customers or penalised if they are unable to meet ESG expectations. 

For example, in 2017 Tesco set science-based climate targets for its supply chain and consequently, in 2020, its 70 biggest suppliers reported a 12% reduction in manufacturing emissions. In 2021, Tesco offered its supply base sustainability-linked supply chain finance, enabling suppliers to achieve preferential financing rates based on their ESG credentials. 

We are also seeing growing focus on scope 3 emissions – emissions that are indirectly created by a company’s supply chain and represent 65-90% of all emissions at many companies according to Carbon Trust. This follows the COP26 climate summit in November 2021 and the Glasgow Financial Alliance for Net Zero (GFANZ) commitment to transition to net zero emissions by 2050.

Momentum is building behind this, and as more companies publicise their scope 3 credentials the trend will inevitably trickle down. Mid-market firms are already at risk of losing business if they are not able to prove they are taking active steps to reduce their emissions, and this will only increase.

What ESG lending might look like for mid-market firms

The emphasis of ESG lending has broadened from green loans and social loans – where the permitted use of proceeds is limited to funding sustainable projects – to sustainability-linked loans which are accessible for all borrowers.

SLLs are for general corporate purposes, but the terms of the loan periodically track specified sustainability-based key performance indicators (KPIs). These are then measured against sustainability performance targets (SPTs) and borrowers are incentivised to meet targets by receiving adjustments on the interest rate they pay – typically 5-25 basis points. In a lot of transactions that we see, any savings made on improved pricing is designated as being reinvested in sustainable activities. Some SLLs will also be subject to an upwards margin adjustment if KPIs are not met.

There are usually two to three KPIs in an ESG-related loan. While our survey shows that environmental-related KPIs are the most common, the market has broadened to include social and governance goals as well. Examples could be the numbers of female or under-represented people in management positions. KPIs should be achievable yet ambitious, or even dynamic. Firms who have set low or meaningless targets can open themselves up to accusations of greenwashing.

Some lenders don't require borrowers to have an ESG strategy in place before considering them eligible for an ESG-related loan. This can be considered as part of the borrowing process with lenders willing to help, or with the help of third-party advisers.

While environmental considerations may weigh more heavily on some sectors than others, the breadth of factors covered by ESG make it an increasingly important consideration for all businesses. Therefore ESG lending is relevant across every sector of the market.

Mid-market firms need to act now on ESG

ESG is not yet embedded in the mid-market, but the direction of travel is clear.