In recent years, environmental groups have called for corporate investors to allocate resources towards a sustainable future for the planet. Meanwhile, banks are building out environmentally friendly portfolios in response to growing demand.

But are banks and other lenders doing enough to foster sustainability in the industries they support? And how much of an impact do their current efforts actually have?

In a recent paper, Stacey Choy, an instructor at the University of Illinois, and PhD graduate from the Rotman School of Management, along with her co-authors Scott Liao, Shushu Jiang and Emma Wang, tackled a piece of that puzzle. In their research, they uncovered a complex relationship between environmental efforts by corporate lenders that provide loans to heavy industries and similar efforts by government agencies. At the highest level, the research team found that the two sectors work best in tandem — each amplifying the effects of the other.

The research opens up a new line of inquiry at the intersection of sustainability and big business.

“To our knowledge, this is the first paper that examines the interplay between private lenders and public sectors,” Choy says.

To vet their hypotheses, the authors gathered a novel collection of publicly available data. Their approach centered on environmental covenants — stipulations in loan agreements that require borrowers to adhere to environmentally friendly practices.

The paper reviewed 2,073 loan contracts in the U.S. for heavy industry firms from 1996 to 2016, around 40 per cent of which included environmental covenants. The researchers then matched US Environmental Protection Administration (EPA) data on toxic chemical releases to the facilities. This provided a firm-level measure of environmental harm. Finally, they gauged the amount of environmental oversight in a region by finding the average number of inspection and enforcement actions per manufacturing facility per year in a given state.

These three measures enabled Choy and her colleagues to observe how a firm’s environmental impacts fluctuated according to the degree of scrutiny levied by both lenders and government agencies.

The data showed that stricter government regulations were correlated with a higher prevalence of environmental covenants in loan agreements — meaning that environmental regulation most likely catalyzes further oversight from lenders. Choy suggests an economic incentive is at play.

“When borrowers face public environmental regulatory risk, it incentivizes lenders to include environmental covenants in the loan contract as a monitoring mechanism,” she says.

Meanwhile, environmental covenants were also most effective at curbing pollution when companies experienced stricter government regulations. Facilities that were subject to both environmental covenants and stringent government oversight emitted lower levels of toxic chemicals on average. They also were more likely to modify industrial processes to create less environmental harm.

The researchers found that even the suggestion of stricter environmental oversight might boost this effect. Analysis revealed that environmental covenants were more effective at getting companies to reduce pollution in states where a Democrat had recently won a closely contested national congressional election. Essentially, the public perception of a government’s attitude toward environmental practices might have a tangible effect on environmental outcomes.

“There is an increase in public environment intensity, and also a larger reduction in toxic chemicals if borrowers have environmental covenants in their loan contract,” says Choy.

Of course, not all environmental covenants are created equal. The authors characterize three main types: disclosure covenants, which require borrowers to self-report environmental data; action covenants, which require borrowers to take steps to prevent and remediate environmental damage; and audit covenants, which bring in a third party to assess environmental practices. According to Choy, the best way for lenders to prevent environmental harm is to combine all three.

“The greater the number of environmental covenants bundled together, the greater the effect,” she says.

Even if all three types of covenants are present in a loan agreement, the effect is greatly decreased in the absence of government regulation. This finding has implications for, not only lenders and regulators, but also investors.  Firms that aim to create truly sustainable portfolios that include heavy industry will likely need to focus their efforts in areas with robust legal environmental protections. Covenants aren’t enough to ensure environmentally friendly practices on their own.

The findings also underscore the continued need for government regulation, regardless of market-based environmental solutions. 

“It has to be a combination for it to really work,” Choy says. “Even though there has been a growing presence of sustainable finance and its role, it doesn't mean that the importance of the public sector or public enforcement has diminished.”