As the energy transition proceeds, capital flows are evolving alongside shifts in the business landscape – and the two are shaping each other in fascinating ways, says James Chapman, Freshfields Partner and an expert on energy transition Issues.

'Traditional debt providers have increasingly aligned their credit risk-driven lending criteria with ESG requirements for a variety of reasons,' James observes. 'The higher fees and margins available in newer, more risky energy transition assets have appealed in an increasingly low-margin, commoditised market where regulatory capital treatment of long-term finance has not incentivised further development of these business lines within banks.'

A combination of investor pressure and reputational considerations have also spurred a move towards a lending portfolio which is more balanced towards environmentally positive borrowings, James Chapman adds.

'This has started to reduce liquidity and increase costs in the market for M&A of higher carbon assets where bank debt – and in particular longer dated bank debt – is now becoming harder to obtain. Combined with current increased interest rates, these factors are starting to put a squeeze on the more marginal higher carbon M&A opportunities where the days of cheap debt being the primary driver for equity returns are over.

A preference for environmentally positive lending has also, conversely, created greater liquidity in the market for ESG-positive M&A activity, where banks will be more inclined to participate in deals where they see a bright future lending to a business (or an investor in that business) that may well have greater longevity due to its ESG profile. This has the effect of crowding debt funding towards more ESG-positive M&A activity.

While a positive ESG score will not be able to mask a poor credit prospect, it does have the effect of making a positive difference to deals which have marginal economics and/or which may be trying to transact in a busy M&A deal market with constrained liquidity in the debt market.

The business model pioneered over the last couple of decades of enabling a developer of a low-carbon project or portfolio business to sell down an equity stake to institutional money (pension funds, insurers and the like) and so recycle capital to use on new ventures is now well established. It has relied on:

• the willingness of private developers to take on, in particular, construction and technology risk; and
• the long-term, stable nature of available from many low-carbon projects (often, though decreasingly, supported by government subsidy) once they are operational.