With climate change increasingly near the top of the agenda for governments and corporates across the globe and COP26 approaching, the provision of finance is also in transition.
Larry Fink of BlackRock, the world’s largest fund manager, has spoken of a “fundamental reshaping of finance” with reallocation of capital away from businesses that are not making sufficient progress on sustainability.
The key word is transition. Many financial institutions (FIs) are well advanced in adapting their businesses, accelerated by the significant pressure from their numerous stakeholders such as shareholders, investors, regulators, consumers and employees. In contrast, many non-financial businesses large and small, across multiple sectors, are at varying stages on the road to becoming fully sustainable, with some only just embarking on their own sustainability journey.
The good news is that most businesses recognise that a sustainability strategy is necessary to staying relevant, remaining competitive and creating long-term value. As such, many businesses are adopting an approach of transparency and greater cooperation with respect to their sustainability efforts, in tandem with their capital providers, to marry the push of finance with the pull of business.
Sustainable finance, where the availability of debt capital from banks and other financial institutions is intrinsically linked to sustainability efforts, is booming. The two most common forms of such financing are, firstly, where the debt is provided specifically for particular green or social purposes, such as ‘green loans’ or ‘social loans’, and secondly, where the costs of regular lending are linked to the achievement of sustainability targets which can ‘reward’ the borrower with pricing incentives for progress made – ‘sustainability-linked loans’. Sustainable finance is now a $700bn market globally with lenders and borrowers expected to drive continued growth in the future, and in the neighbouring bond markets environmental, social and corporate governance (ESG)-related debt issuance is set to pass $1 trillion. Suggested market principles and guidelines are being issued and updated by industry bodies such as the UK Loan Market Association (LMA) and the US Loan Syndications and Trading Association (LSTA) in preparation for greater standardisation in the market.
So, as we look ahead and as sustainable finance becomes a staple product for lenders and borrowers, what are the key issues that we believe are paramount to consider?
Credit selection. There is no doubt that investors and credit committees are hungry for assets that demonstrate sustainability, which is about businesses making more conscious choices about manufacturing, sourcing and supply chains, social and technological factors and looking at how they can better serve and thrive in their communities on an enduring basis. Indeed, many credit committees and rating agencies are now embedding sustainability as a method of selecting assets and opining on credit risk, in a similar way as to how they assess other factors such as management, sector risk or the quality of financials. Most commentators predict that over time, sustainable businesses will become better businesses and it may be that unsustainable activity will struggle to access funding readily.
Driving real change. There is a plethora of guidance and principles for the different types and aspects of sustainable finance, but one key message is that the finance product must encourage a positive change. In sustainability-linked loans, sustainable performance targets must be ambitious and represent a material improvement in sustainable behaviour, measured using key performance indicators which are relevant and core to a borrowers’ wider sustainability strategy. Inserting targets into a loan agreement to obtain a pricing reduction without a supporting strategy elsewhere in the business, completely misses the point of sustainable finance. Instead, lenders and borrowers should work together to ensure stretch targets are agreed, which would evidence incremental progress if achieved, with the option for any pricing benefit channelled back into sustainable causes to create a virtuous cycle. In green or social loans, the loan proceeds can only be used in application toward the project which has a clearly identifiable green or social benefit. Parties’ behaviour cannot merely pay lip service to or seek to replicate what is already happening in the business, and lenders and borrowers are looking to push further than what is likely to be achieved easily.
Greenwashing. While FIs are highly motivated to drive the transition to more sustainable lending portfolios, this cannot be at the expense of good governance. Greenwashing is the term used to describe situations where claims on sustainable credentials are misleading, inaccurate or inflated. Such activity may occur in sustainability-linked loans when targets are not challenging or meaningful enough or are not disclosed or monitored correctly. Consequently, a push for greater transparency and verification has emerged in sustainable lending transactions. Alongside the emergence of these trends, lenders should adopt a carrot, rather than stick, approach by being good stewards but leaving the companies they lend to, to decide whether and when they are ready to embrace sustainable lending. To combat this risk, many financial institutions will insist on external verification by appropriately qualified consultants to help companies identify and define their targets, then review and verify progress made against them and report to the lenders on an annual basis. Again, an engaged yet nuanced approach allowing a company the opportunity to develop its own internal expertise and methodologies or engage the service of experts should be adopted by lenders while pursuing required transparency and verification.
Relevance. Clearly, sustainable finance is not for everyone. When the market first evolved back in 2017, it was the preserve of large investment grade companies that had well defined ESG strategies and were keen and ready to adopt sustainability more widely in their businesses by making their external finance lines sustainable. From these origins, and as products such as sustainability-linked loans make the market more accessible, more companies have come into scope, including not only public entities, but also mid-sized businesses backed by private capital too. That said, the market is still not easily accessible for smaller, independent private companies where lending is often standardised rather than tailored to each individual borrower. Similarly, sustainable and transition finance is more prevalent to businesses operating in certain sectors, such as oil & gas, energy or the fashion industry, where the green benefit can be clearly identified, than it is in some areas such as technology or the wider services sector. That said, given that sustainability embraces social as well as governance factors, pretty much every business can reflect changes in society in its policies or in the decisions it makes.
Given the considerations involved and the efforts required by both parties, sustainable finance works best and better benefits those involved where there are matched desires to engage with ESG principles and ambitions. The pressure to behave more sustainably will only increase as regulations are introduced, and while lenders are primed to offer their expertise, borrowers must be the catalysts of change. Borrowers cannot be expected to fuel the evolution entirely organically, and as markets grow, third-party resources available and consultants’ appetite to be involved will need to scale up to match demand. Transition is the correct description where balance will be required to steadily navigate change.