Diversified Energy Company recently converted its existing traditional $300m reserve base lending facility into a sustainability-linked reserve-based revolver – one of the first of its kind. The conversion incorporated some demanding environmental and social KPIs. John Crain, Vice President of Treasury, Diversified Energy, recounts the experience to TMI.
When it comes to matters of sustainability, some sectors naturally start from a lower base than others, with oil and gas perhaps having further to travel than most to make a positive impact. But because their journey is a longer one, many players in this space know they must work even harder to make an impact.
Diversified Energy Company is an independent energy business focused on acquiring primarily mature natural gas producing assets and related midstream infrastructure in the US. Today the London Stock Exchange-listed company owns more than 69,000 oil and gas wells, making it the largest well owner in the US.
In mid-2022, Diversified’s treasury team, led by Crain, set out to realign its activities with the company’s broader strategic ESG plan. As part of this process, treasury fully converted its existing $300m ‘standard’ reserve-based revolver into a sustainability-linked facility with a new four-year tenor. The new revolver incorporates two environmental KPIs and one social KPI.
Rusty Hutson , Jr., Diversified’s CEO, commented: “These measurable [KPIs], if achieved, will reduce our cost of capital and increase our potential to attract new bank capital”.
The company completed the entire conversion in just a matter of weeks with the aid of Redbridge Debt & Treasury Advisory, the independent consultancy appointed to guide Diversified through the conversion process. The facility became active in August 2022.
Canadian Imperial Bank of Commerce served as lead sustainability structuring agent and DNB Bank was the co-sustainability structuring agent, and both banks supported the validity of the KPIs to the bank group. Working experienced banks in the lead sustainability roles helps to ensure that the KPIs are accepted by the bank group, and provides an additional piece of ‘side business’ to the selected banks. Redbridge generally advises companies to conduct an RFP to select the right partner banks to serve in the lead roles.
One of the key drivers for seeking the facility conversion is the listing of Diversified on the London Stock Exchange (LSE) and it is also a constituent of the FTSE 250. “UK and European investors are generally more ESG-focused than other investors, and we recognised several years ago that it would become an unwritten requirement if we were to maintain and grow our LSE listing,” comments Crain. “We are happy to embrace that understanding.”
Diversified established a separate ESG group and began work to create that its first sustainability report in 2019. This was an important step. Crain soon understood that to establish a successful sustainability-linked financing tool – whether it’s a bond or a loan – it is essential to “put in the groundwork” around capturing the relevant data.
As a natural gas company, Diversified maintains a huge pool of emissions data. The gathering, collation and formation of this into coherent baseline and trend reporting was its first big test. Crain acknowledges that “the company really had to work together from an operations, ESG, and EHS [Environment, Health and Safety] perspective to determine our right pathway and targets”.
The company built a data-driven view of how it functions at an ESG level. From this it set its enterprise strategy in motion with its sustainability reporting regime. It was then decided in early 2022 that treasury would adopt a sustainability-linked designation within one of its term financing products, namely an asset-backed securitisation (ABS) note. In February 2022, that note qualified for sustainability-linked financing, with independent scoring provided by Moody’s.
The note was well received by institutional investors, says Crain. More than that though, he believes that by indexing the coupon and the cost of financing to its future ESG performance, Diversified was demonstrating to the wider market that it was serious about sustainability.
Although several members of Diversified’s 15-strong banking panel had earlier contacted Crain and his treasury team to raise the idea of sustainability-linked lending, at the time the company was still establishing its base metrics and building out its ESG strategy. Following the readiness demonstrated by the success of the ABS note, completion of much of the groundwork, and the dedicated ESG and EHS leadership, he says the company was now ready to pick up that idea “with not a lot of additional effort required to convert our standard revolver”.
For any oil and gas company, one of the main KPIs that investors will focus on is its emissions. As part of the sustainability-linked facility, Diversified naturally agreed to a greenhouse gas (GHG) reduction target. But while in the US, such targets tend to cover overall GHG emissions, in Europe the scrutiny – certainly by ratings agencies and banks – is more focused on methane as well as GHG emissions. For this reason, given its investor base, Diversified’s KPIs for institutional investors include an aggressive methane reduction target.
Furthermore, while GHG and specific methane emission KPIs are the only metrics required for Diversified’s asset-backed securities, the banks involved in the sustainability-linked facility required more. Indeed, Crain notes, “the magic number tends to be three KPIs”.
This saw the team adding a health and safety target for its US-based employees. With total reportable incident rate (TRIR) metrics – covering aspects such as workplace injuries – already being routinely filed with the US government Occupational Safety and Health Administration (OSHA), this was a quick win. However, the third KPI agreed is unique to Diversified.
Working with legacy gas wells presents the company with an ongoing set of asset retirement obligations. As a well ceases to be economically productive it must be safely and permanently shut down, usually by plugging it with cement. Currently, Diversified has agreements in place with states to plug around 90 wells per year. The company wanted to set internal minimums above that rate, incorporating its additional asset retirement effort into a new KPI for the sustainability-linked facility.
With the additional KPIs in place, assessment will be carried out annually over the four-year tenor of the new facility. Of course, the intention is to keep on track. To assist, an audited account of its KPIs is being managed for Diversified by an independent verification agent. An industry-focused engineering consultancy had already been brought in to assess the emissions status of the business for its sustainability reporting programme. The emissions data it gathers will now be provided to the funding banks, alongside the data concerning well-retirements, and the ongoing OSHA employee safety reporting metrics.
But there’s more to it than simply repurposing existing data, says Crain. Indeed, he comments that the sustainability-linked loan process is “more rigorous” than Diversified’s previously issued sustainable ABS notes. “The sustainability-linked loan principles require a very robust examination of a company’s entire ESG reporting regime and strategy,” he notes. “The KPIs we use need to be ambitious, and our ESG and EHS teams really deserve most of the credit in this project for leaning in further to what were already aggressive targets. Having Redbridge as our partner to provide project management leadership enabled us to better understand the key focus areas and seamlessly navigate the process, both internally and externally.”
Indeed, Crain feels that Redbridge was able to provide greater transparency over the entire process for Diversified. It was, for example, able to advise during the discussion with the banking panel around sustainability pricing structures and KPI levels, assisting with the setting of amendment terms, and in negotiating with the lenders around validating highly specialised activities such as well-plugging.
Although the initial effort was something of a heavy lift for all involved, Diversified had completed the bulk of the groundwork prior to treasury pushing for the sustainability-linked revolver. But while the company now has well-rehearsed ESG and EHS teams, Crain warns that for any kind of debt product, treasury often becomes the de facto project manager.
“You have to be careful what you wish for,” he cautions. “It can be a lot of work to put in place, and you may be stepping into the unknown, hoping to see some benefit down the road – these are still novel products that you have tacked onto your organisation – but not every bank or bond-holder understands, appreciates or ascribes value to it.”
And, he continues, there will almost certainly be some additional administrative work for treasury in gathering data for the compliance package for its banking group. “Although for the most part, the heavy-lifting work is at the front end, the agreement we have for asset acquisitions and divestitures, for example, could require us to do some mid-cycle work to modify those if needed.”
By establishing a strong foundation of ESG and data-gathering practices, Diversified has reached a point where it can start building on its goals, says Crain. It’s a progressive approach he commends to others. “It’s not possible to go from a zero-level of ESG work and baseline information to putting a sustainability-linked bond or loan in place in a couple of months. You must take stock of your commitments, the data you have gathered, and the effort you are expending to achieve it. But if you do that, then you will find your progress is fairly natural.”
While most sustainable finance programmes are necessarily adaptable to different businesses, goals and objectives, Crain urges those considering this path “to do the due diligence and work with companies like Redbridge that know this space and which can give you an honest assessment of how ready you are to move ahead”.
For those already on the journey, he says treasurers should be prepared to explain to their banking partners what is being undertaken within the company. “Sustainability-linked loans are going to grow in importance. As more banks start setting ESG targets, if you’ve already made that commitment, it will really help them to have it defined in your underlying loan documentation,” he comments. “But there are also still many banks yet to connect all the facts, and so you may find providing a little education on what you are doing, and why, may be needed.”
With help from an experienced adviser and ESG-focused banks, Diversified’s treasury is well on its way to supporting the business with a finance programme that not only meets the needs of its ESG-focused investors but also those of a great many more stakeholders.