CLOs likely to move to positive screening for ESG, says S&P Global Ratings

CLOs are likely to shift to a system of positively screening for assets with components for inclusion in their portfolios, rather than negatively screening for prohibited industries, according to speakers at an LSTA and S&P Global Ratings webinar on ESG in loans and CLOs.

As the proportion of leveraged loans including ESG-related elements increases globally, CLO managers may soon be able to adopt language that pushes for the positive inclusion of sustainable or sustainability-linked assets, which are becoming increasingly prevalent across the global markets, as reported in LCD’s ESG Leveraged Finance Tracker.

"Currently we expect the future for ESG within the CLO industry will be for more positive screenings," said Paul Kalinauskas, a director in the structured credit group at S&P Global Ratings, at the webinar. "As we’re seeing more sustainability-linked loans, or more ESG components within products within the loan and high-yield bond market, there will likely be more CLOs able to positively screen. We expect there will be more CLOs with components comprised of these ESG loans, and in the much more distant future maybe even CLOs with whole portfolios of these products."

In the main, globally CLOs currently tend to approach ESG through a negative screening process by outlining certain non-ESG-friendly industries that they are prohibited from investing in as part of the collateral obligation definition. According to the BofA CLO Factbook published in July, some 59.8% of these prohibited industries are tobacco only, although prohibitions also exist for weapons firms, thermal coal producers, pornography, payday lending, oil and gas speculation, hazardous chemicals, opioids, palm oil and marijuana.

Negative screening of non-ESG-friendly industries poses a number of challenges to CLO managers, not least the vagueness of the prohibitions that frequently require management discretion. For example, while "hazardous chemicals" are prohibited by several CLOs as part of the ESG screening, the nature of the hazard is rarely defined and it is not clear whether this includes only producers of banned chemicals (which are not rated by S&P Global Ratings), or whether portfolio managers have to judge that all chemicals are dangerous at some level and so avoid the sector entirely.

However, all the assets from every industry that has been negatively screened for by various CLOs (including the entire chemicals sector) equate to only 6.94% of all the assets available to U.S. CLOs, according to a report entitled "The Impact of ESG-Prohibited Industries in U.S. CLOs" published by S&P Global Ratings earlier this year.

Speakers at the webinar emphasized that there is still an incredible amount of demand from investors for more information and data around ESG, recognizing that the topic presents a serious, if not existential, risk to the business models they’re investing in rather than a "nice to have" element. With the need for more information to be delivered in a harmonized, ubiquitous, and standardized way, S&P Global Ratings' new Sustainable Finance team is developing new products, such as the publication of second-party opinions and ESG evaluations — a cross-sector relative analysis of a product's sustainability and its capacity to operate successfully in the future.