Environmental, Social and Governance (ESG) finance funding in a new world of climate change

Introduction:

New rules and regulations are forcing the pace of change. COVID-19 has shown organisations can embrace new ways of working faster than we ever thought possible. Making sustainable finance a core part of the investment strategy is no longer a choice but an imperative.

This is because Customers’, employees’, investors’, regulators’ and the public are placing greater focus on Environmental, Social and Governance (ESG) than ever before. This is leading ‘a wind of change in options available to corporate borrowers to raise capital. The mechanics of ESG sustainable funding is simple, it rewards those who perform well on ESG factors that demonstrate a more resilient and sustainable business. Incorporating ESG factors into corporate debt transactions provides two primary benefits for borrowers, firstly, access to the broadest pools of capital and tangible debt pricing benefits if they can demonstrate that a positive ESG impact is delivered. Stepping back a little, there is however, one very crucial question before businesses can tap into this market, which I see as a secondary or indirect benefit, for me it is about making climate change work.

Question: Has your business got systems and processes in place to capture all the ESG data to make it work for them?

“If you can’t measure it, you can’t manage it.”

Chair of Task Force on Climate-related Financial Disclosures, Michael Bloomberg.

Sending a wind of change for ESG reforms:

Deal structures are evolving that looking beyond the traditional ‘green’ initiatives, with an increase focus on social or governance aspects, such as, employment practices, board diversity and access to education. Standard-setting bodies are seeking to enhance and align their approaches to corporate reporting, both financial and non-financial. Various global initiatives are underway, the International Sustainability Standards Board (ISSB) has issued guidelines on non-financial climate-related disclosures. Many financial services firms and some collective investment funds are subject to these requirements, which are focused on climate change but increasingly cover a wider range of ESG factors. The EU Taxonomy Regulation has created a direct regulatory link between corporate reporting requirements and wider ESG financial services regulation. The global Task Force on Climate-related Financial Disclosures (TCFD) set up in December 2015 by the Financial Stability Board (FSB) is tasked with monitoring and making recommendations on risks to the global financial system.

The TCFD’s disclosure recommendations are grouped into 11 principles and clustered into 4 pillars as shown below:

ESG funding- background and evolution:

Its origin first emerged from funding environmentally friendly projects, such as renewable energy plants, e.g., small modular reactors (SMR’s). However, of late with an ever increasing social and political demand to tackle social issues alongside environmental issues, green lending has evolved into ESG finance which, along with environmental concerns, also takes account of wider social and governance targets and KPIs.

ESG finance encompasses a range of products, but in terms of debt, there are two main types of ESG lending products available to borrowers; (1) green loans and (2) sustainability linked loans (SLLs).

The key differentiating aspect between green loans and SLLs is to do with the use of proceeds and the pricing of the loan. Green loans must be used for environmentally focused projects (such as the development of a recycling plant, reusing landfill sites, regenerating hazardous or contaminated land, etc..). While SLLs do not have specific requirements as to use of proceeds, instead the ESG-aspect is seen through the linking of pricing to the borrower's performance against specific ESG metrics. This means that SLLs borrowers would be incentivised with lower borrowing rates if they hit their ESG targets and penalised with a higher rate it fails to reach them.

Future trending:

Whilst SLLs are still in its infancy, I believe it will open more possibilities for ESG financing to borrowers across other industries, not just those involved in environmentally focused projects. Virgin Money, started to offer SLLs in 2021 as a part of its commercial bank offering, making it the first bank in Europe to offer SLLs to commercial customers. A new area, which will explode in coming years, which have the same characteristic as SLL’s, are sustainability linked bonds (SLB’s).

However, these SLB will involve a coupon step-up and step-downs, based on ESG KPIs now and beyond the ‘business as usual’ trajectory that is consistent with the bond issuers overall strategic sustainability/ ESG strategy based on a pre-defined timeline before the bond issuance. An external audit to confirm up-to-date information on the performance of the selected KPIs with external verification of performance level against each KPI by an external auditor, is inevitable.

Question that surfaces to my mind is, is it worth it? Where the ESG SLB effective rate of interest (treated under IFRS 9 as fair value or amortised cost is loaded with the additional professional audit costs to avoid greenwashing, including the usual bond issuance costs involved) is greater than a vanilla corporate bond rate? I am guessing here that over time corporate credit ratings, if not already being considered by investment banks have or are, will start to consider “inherent ESG specific risks of the issuer” as a part of the normal bond coupon setting and pricing, as banks are required to make a higher regulatory capital charge of those risker sectors and companies.

ESG Finance- Cost Vs Benefits:

Cheaper pricing is an obvious incentive for borrowers together with positive public relations impact. The benefits of being able to show ESG targets, commitments and credentials are clear to see with public sentiment for environmental and social issues being stronger than ever. Consumers are not only more interested in ESG issues, but they are also becoming more knowledgeable and more aware of corporate greenwashing. Borrowers accessing ESG financing will need to prove performance against their ESG targets not only to access cheaper pricing, but also to retain their consumers, no doubt.

Borrowers will also need to consider how business is conducted emerging from the covid-19 pandemic, especially where the pandemic has made all those more concerned about the environment. Utilising ESG-linked facilities could be a valuable tool for borrowers to show their ESG commitment to consumers too. The Green Taxonomy Advisory Group, launched by the UK Government; an independent expert group established to oversee the delivery of a common green investing framework and to crack down on greenwashing/ green sheen. Although, focused on green investing rather than lending, this clearly illustrates the growing demand for ESG claims to be substantiated and the need for borrowers to be responsible and transparent on their ESG claims.

Lenders also have PR considerations, particularly in the context of charging increased margins for poor performance against ESG metrics. If the goal of ESG finance is to promote sustainable development, then lenders can be in a difficult position if they are seen to be benefiting from a borrower's poor ESG performance.

On that note, I leave you with a thought-provoking quote from Ban Ki-Moon, former Secretary-General of the United Nations (2007-2016) on climate change:

“We must connect the dots between climate change, water scarcity, energy shortages, global physical risks and health, food security… and labour empowerment...

If we cannot all swim together, we will eventually sink, for sure. There is no plan B because we have no planet B.”

If you are contemplating a sustainability-related funding programme or wish to discuss a ESG related reporting requirements, please feel free to reach out to Kothari Partners.

Dee Singh Kothari is a senior partner in Kothari Partners

At Kothari Partners, we have worked with various UK and overseas listed and PE-backed clients across various industries to consider how their business and finance services can bring them both cost reductions and performance improvement. Our approach is to help our clients understand their current situation, identify the value and decide on the scope, vision and set of strategies for what they could achieve for their business. We help plan their implementation and support them and deliver the solution/ change needed, so it is properly and permanently embedded in their organisation. We aim to help past and future clients by delivering high-quality work to their organisation, generate real efficiencies and free up time to support better business decisions. For a confidential discussion please free to contact us, via our corporate website: https://www.KothariPartners.com