Lenders’ Environmental Monitoring: Evidence From Environmental Covenants in Private Loan Contracts

Abstract

We investigate the role of covenants in private loan contracts that place requirements or limitations on borrowers’ environmental actions (hereafter, “environmental covenants”). Utilizing a machine learning algorithm, we find that environmental covenants are highly prevalent, appearing in 54% of loan contracts in our sample. The use of these covenants is significantly associated with borrowers’ environmental risk exposure, borrower–lender information asymmetry, and key contract terms, such as collateral and loan maturity. The association between environmental risk and environmental covenants is more pronounced when borrowers face greater financial distress, lenders have a stronger reputation, and there is a higher risk of regulatory enforcement. Additional analysis shows that the presence of a board committee overseeing environmental matters reduces lenders’ demand to contractually address the borrower’s environmental risk. Collectively, our results provide novel insights into the contractual mechanisms addressing environmental risk and the factors shaping lenders’ environmental monitoring demand.