Over the past decade, regulatory pressures and investor preferences have succeeded in pushing factors related to environmental, social and governance (ESG) up the agenda towards sustainable financing in many organisations across the globe. The pressing need for sustainable financing has remained on the radar for banks and investors over a considerable period; and increasingly emerging as prioritised issue for banks and other actors within the financial sector and its related system; and across other sectors.
Sustainable Finance and Investment Drive
Sustainable finance remains a generic term that is employed to provide vivid description for financing and investment decisions with considerations for granular and specific issues related to the environment, social and governance. For many institutions within the banking industry, sustainability policies tend to focus on environmental risks and impacts; and assessments.
The concept of sustainable finance is believed to have already gained traction; and transitioning from the niche to mainstream within the global economy. Due to the dynamism and influential role of ESG, sustainable finance is now commonly referred to as social investment; responsible investment; socially responsible investing; and socially green, ethical or impacting investing. As at financial year-end 2020, total assets under the management of the signatories to the United Nations’ Principles for Responsible Investment were in excess of US$100 trillion (Farnham, 2021).
Some analysts argued, sustainability in finance is required to ensure investor’s expectations on ESG are met; reputations are protected; regulatory compliance is up-to-date; and the commercial benefits of sustainability are diligently explored, among others.
In practical terms, sustainable financing has proven to transcend considerations for the environment, social and governance to include providing critical financing to address issues related to corporate integrity, customers’ needs, community development; entire supply chain of organisations and the broader ecosystem. Banks have adopted an implementable strategy that ensures sustainability in their investment drive; and ensures best ethical business practices. The net effect of this strategy is tremendous improvement in banks’ attractiveness to investors, both local and foreign.
The European Union’s 2030 Agenda for Sustainable Development seeks to allocate €1 trillion to green investments during the next decade. Further, it seeks to create more consistency within the climate-related information financial-market; and to assist businesses that are genuinely addressing sustainability challenges to gain competitive advantage (Farnham, 2021).
Various terms have been introduced to the concept of sustainable financing and its application in the financial world. These include, but not limited to sustainability-linked bonds or loans; green bonds; social bonds; and sustainability bonds.
The major determining factor in categorisation of some bonds and loans as sustainability-linked is not based strictly on how the loan proceeds are utilised; borrowers in this category have the unique opportunity to leverage the loan proceeds for general corporate purposes; and could apply the proceeds to any sector within the broader economy. However, measurable targets and outcomes such as increasing efficiency in water and energy consumption are often created to practically express their economic relevance. Available statistics affirmed between 2017 and 2020, the range of products in this category grew in excess of 300% (Gorley, 2021).
Proceeds from the issuance of green bond funds are channeled towards initiatives that are green or sustainable in character; while proceeds from social bonds and loans are often allocated to projects with dedicated social benefits. Issuers of sustainability bonds utilise the proceeds for combined benefits that are characteristically social and environmentally-friendly.
Interest in sustainability-linked structures has witnessed dramatic improvements in recent years.
Moreover, demand for sustainability-linked loans remains the highest in Europe; it accounted for nearly 71% of the market during 2020. About 16% of the market for sustainability-linked loans was concentrated in the Americas, including the United States and Canada.
Sustainability-linked loans come into play when corporates are ineligible for social, sustainable and green bonds. These loans allow organisations to transition away from high-carbon activities. Corporates set specific targets towards reduction in the impact of high-carbon activities on the environment.
About nine years ago, green bonds were hardly found in the market. In essence, the market for ESG is still at the nascent stage, but maturing very fast. The sustainable financing market is currently worth more than US$30 trillion; this affirms its accelerated growth within a decade (Gorley, 2021).
Impact of Climate Change
The adverse impact (or risk) of climate change on banks’ balance sheets in the European Union is estimated at 15%. Further, more than US$1 trillion may be required annually to address climate change-related issues. The figure is estimated at US$3.5 trillion annually when the transition to green economy is considered, excluding financing for other ESG-related issues (Gorley, 2021).
Global recognition of the impact of businesses’ activities on the environment is growing; while the demand for responsibility towards tackling this phenomenon is at an accelerated pace. In order to drive forward the environmental agenda, banks consider financing for organisations and projects with positive impact on the environment. Stated in different terms, banks consider investment in companies whose activities and operations support and promote sound, ethical business practices.
The regulatory environment for ESG and sustainable financing is growing to cope with the pace of their increasing prominence and adoption in economies around the world. The following section presents brief explanations on the regulatory measures in vogue in selected global countries and regions.
Countries and regional blocs across the globe have developed and introduced frameworks to direct capital towards sustainable economic activities. This is facilitated through supportive regulatory environment for sustainable financing. To illustrate, during November 2015, the Bank of Ghana inaugurated a committee on sustainable banking principles to allow for consistent development of works on sustainable banking concepts, commonly known as the Ghana Sustainable Banking Principles; or simply, The Principles.
Licensed banks in Ghana and other Africa economies have developed strong interest in and provide funding for green financing. Banks are committed to financing 100% environmentally-friendly projects in strategic areas throughout the country. Investments in ESG-related projects could be quantified in millions of United States dollars. Further, Ghanaian banks collaborate with bilateral, multilateral and other international financing agencies towards providing funding for green and other sustainable economic activities in the country.
European Union and the Americas
Within the European Union (EU), economic activities that qualify as sustainable are defined in the EU Taxonomy for Sustainable Activities. During March 2021, the Sustainable Finance Disclosure Regulation (SFDR) of the European Union became operational. This Regulation underscores the need for financial services providers including banks, fund managers and insurers to ensure disclosure of their commitment to sustainability.
More importantly, the Sustainable Finance Disclosure Regulation forms an integral part of the pool of work by the European Union on the European Green Deal. In Russia, recommendations have been made by the Central Bank for emission standards and sustainable investment principles for efficient utilisation of funds from social and green bonds.
The ESG Disclosure Simplification Act of 2021 was earlier proposed in the United States. Under the proposed Act, publicly traded companies would be required to disclose ESG information in their filings with the Securities and Exchange Commission (SEC). Some of the positives expected to be derived from the proposed Act include banks’ ability to access important additional data on potential borrowers.
Sustainable financing is supported by recent legislation in countries such as Japan, China, Hong Kong and Singapore. In China, the Green Credit Guidelines requires a reporting system for green credit (Gorley, 2021).
ESG in Perspective
One of the identified megatrends with the strong potential of shaping the global business landscape over the next decade is ESG. Some analysts asserted, ESG could compel businesses across industries to transform their operating models drastically; and perhaps, even consider transitioning to net zero emissions in subsequent decades. However, success of the transition is contingent on massive investments; and this has the potential to create tremendous opportunities for banks. Conversely, the massive investments could pose significant risks to the business portfolios of banks, if due diligence becomes elusive (Vincent & McDowell, 2021).
Although ESG is not a new phenomenon, its implementation is now prioritised by business leaders across the globe. The change in attitude is attributed essentially to factors such as increased awareness of climate change, social inequality and the effect of COVID-19. Survey conducted by PwC during 2021 (as cited in Vincent & McDowell, 2021) in economies such as Brazil, Germany, India, UK and US revealed 92% of business leaders; 80% of consumers; and 83% of employees believed institutions that commit to ESG policies would outlast competitors that do not. A significant number of business leaders (87%) affirmed, sustained ESG performance formed an integral part of the key strategic objectives rolled out for implementation in their respective organisations.
Similarly, ESG dynamics in the Middle East Region are changing at an accelerated pace. To illustrate, between 2019 and 2020, green and sustainable bond issuances in the Middle East increased by 50%; while the first sukuk, Islamic law-compliant bond, was raised by the Saudi Electric Company (SEC) in international markets from Saudi Arabia. During the same period, Egypt raised US$750 million from green bonds; while the Dubai Financial Market launched its maiden ESG Index (Vincent & McDowell, 2021).
Some Factors to Consider
Many investors across the globe are developing growing interest in “indexing” their investment decisions to the ESG capabilities of targeted organisations. The stance of these investors in recent periods is indicative of the growing importance of ESG; and the need for its consideration and inclusion in any business strategy that is carefully designed to drive corporate success; and assure competitive edge. The ensuing factors are recommended for any winning business strategy developed by banks. Although banks are emphasised, these factors are equally recommended for organisations and institutions in other industries and sectors of the economy.
Identification of essential ESG factors: It is imperative for banks to identify factors that remain material to their business model such as those that could impact adversely on climate change and financial inclusion; and pose greater ESG risk. The success of banks in this context is reliant on their ability to comprehend the sensibilities of different key stakeholders to diverse initiatives; and the preferences of these key stakeholders.
Development of roadmap for each strategy: A roadmap, including timelines, owners, priority, and so forth, should be developed for each initiative. Further, the roadmap should align with management on the implementation plan. Banks would have to be pragmatic; some initiatives would be short-term focused; while others may require multi-year, phased approach. Short-term-focused initiatives may be driven by regulatory timelines. Irrespective of the approach, banks have the responsibility to communicate with stakeholders; and provide them with updates on timely bases.
Development of integrated strategy: In the process of developing an integrated strategy, it is essential for each bank to embed ESG opportunities into its overall business strategy and operating model. Identification and prioritisation of the necessary changes would allow banks to transform their business and operating models; while capturing the most promising ESG and business opportunities.
Non-reliance on value perceptions: It is necessary to consider the quantification or measurement of the economic impact likely to be generated by the ESG initiative. This would allow for the development of strategy borne out of the best combination to guarantee the avoidance of resource-consuming initiatives; and to achieve high returns. It is not advisable to rely on value perceptions (Vincent & McDowell, 2022).
The country’s reliance on fossil fuel is enormous. This increases the level of exposure; and creates tremendous investment opportunities for banks. The government of Ghana recently announced plans to ensure the country transitions from fossil fuel to renewable energy by 2070. Nonetheless, the announcement does not negate the great investment opportunities that beckon banks within the economy (The Vaultz News, 2022).
The accelerated pace of prominence and adoption of ESG imply banks have the unique opportunity to remain proactive; rollout pragmatic measures that would assure their competitiveness; and to always be ahead of and exceed stakeholders’ expectations. Lagging behind could connote loss of business; and possibly, minimal attraction to foreign investment. Thus, embedding ESG into the winning business strategies of banks remains paramount and inevitable in contemporary times.
Banks have the opportunity to introduce or sell new products and services; reduce operating costs; attract new customers; and effectively manage risks. The inference is, integration of ESG into banks’ business strategy creates room for capturing of incremental value; while avoiding value destruction.
Government could consider development of national carbon-offset-market to effectively enhance the interaction between carbon offsets and financing structures. Sustainability-linked products could form the basis of attracting capital or funding from banks for major projects in various parts of the country.
Corporate institutions seeking to transform their sustainable financing objectives into actionable and implementable policies could strongly consider ESG as the common language towards success. The tangible impact and benefits of green financing could be communicated to the market to facilitate decision making; and to assure significant reduction in physical climate risk.
Banks play a central role in financing. As a result, they are uniquely positioned to benefit from the exponential growth in the sustainable finance market, which is estimated to exceed US$50 trillion within the next five years. It however, remains the responsibility of banks to ensure effective demonstration of how they manage ESG-related risks through their funding activities.
Private sector actors need financing for ESG-focused projects to ensure improvement in their sustainability performance. Banks are expected to respond by offering new financial instruments, including products that provide access to borrowers in industries and sectors that traditionally were not considered green. Some of the derived benefits from the decision to prioritise sustainability performance are both financial and non-financial.
Implementable policies related to ESG impel banks to be consistent and transparent in their reports on sustainability; and how they integrate sustainable risk-mitigation into identified processes; while considering any adverse effects on sustainability of their activities. Banks are required to demonstrate how they respond positively to emerging opportunities to ensure long-term value that provides the needed satisfaction to all stakeholders; and contributes meaningfully towards the achievement of national and international Sustainable Development Goals (SDGs).
Financial sustainability is expected to navigate institutions in the banking industry towards ensuring self-sustenance; and although the imperative for more ESG-focused finance may appear altruistic, the benefits to be derived thereof could be enormous and tangible. Sustainable finance has transitioned from a fringe concern to mainstream; most investors make investment decisions based on the institutions’ ethical standards. It is therefore no surprise to observe environmental considerations transitioning to mainstream lending and finance.
Banks and institutional investors have been prompted by various international agreements such as the Paris Climate Agreement, European Union’s Green Deal and United Nations’ 2030 Agenda (with its seventeen (17) Sustainable Development Goals (SDGs)) to prioritise financing for projects that address pressing social and environmental issues. As at year-end 2021, more than 40% of the global banking sector had signed on to the principles (Gorley, 2021).
The need to ensure sustainability in finance is consistently emerging as core component towards building more sustainable ecosystem, especially when economic considerations remain central to national, regional and global development. Finance has consistently proven to be the lever that could truly drive positive change; and growing recognition of this phenomenon is fueling growth for banks that take proactive approach to ESG-led and sustainable finance.
Institutions in the banking industry have legitimate reasons for anchoring sustainability in finance; be it conservation, environmental-led financing, climate or investment which borders on ethical and social concerns. However, expertise remains critical towards the development of accurate and relevant economic estimates; and towards understanding the extent to which consumers would value good and presentable ESG image. Banks should consider setting targets that fairly reflect their ambition levels.
Reports on ESG and sustainability should be made public, consistent and comparable so as to prevent “greenwashing.” That is, banks must avoid the tendency to exaggerate environmental credentials towards ensuring improvements in institutional reputation; or gaining competitive advantage. Due diligence remains an important desideratum for the institution of robust governance and processes to drive corporate programmes and operations to desirable targets.
Stakeholders are consistently comparing banks on the basis of their sustainability pledges. Banks’ decision to rollout effective ESG strategy and targets is indicative of their commitment towards sustainability; and towards promoting credibility and reducing greenwashing risks. Thus, banks require strong sustainable financing frameworks and targets to avoid public criticism; and rather, maintain positive image and competitive edge.
Institutions in the banking industry are compelled to take proactive steps towards embedding ESG in their integral business strategy; and create the requisite structural changes within their operating models to pursue these new strategies. In essence, consistent improvement in ESG performance should form an integral part of their core strategic corporate objectives.
Banks’ exposure to ESG-related risks could be mitigated through sustainable financing; the latter has the potential to drive banks’ profitability. In China, policies related to green financing were found to have positive effect on non-performing loan (NPL) ratios of banks. Environmental, social and governance provide the requisite structure and framework for sustainable financing efforts. Generally, a more targeted approach is assured when sustainable financing is nucleated around ESG imperatives to elicit lucid parameters.
Market demands, stakeholder expectations, expanding awareness of issues related to ESG and regulations designed to address them remain some of the pertinent factors that impel banks to increasingly consider risks related to environmental, social and governance. Banks’ ability to take advantage of the market is contingent on their conscious efforts to build strong reputation based on credible commitments to sustainable banking. Consistent development in ESG and sustainable financing implies disclosures in the near and distant future would become increasingly standardised; while governments would develop strong interest in implementation.
Standard disclosure requirements would assure the availability of comparative data on organisations within and across industries; and assure improvement in quality. However, standardised definitions of the acronym E, S, and G are required globally to facilitate development of reliable market data. Within the European Union, the definition of E (environmental) is currently enshrined in law (KPMG, 2020).
Corporates’ ability to realise their decarbonised goals would be contingent on sustainable financing. The European Union (EU) currently has measures that increase the stringency of ESG regulations and standards for issuance of green bonds; and other regional blocs are expected to emulate and follow suit. ESG is envisaged to influence massive transformation in the global financial services landscape; while ESG credentials would be needed to balance improvements and manage issues related to consolidation, credit risk and cost reduction, among others.
Banks are expected to align their financing with the goals and timelines set in the Paris Agreement. Moreover, investors increasingly expect banks to transform their lending strategy; and drive the green transition plans of their clients. Banks that uphold these fundamental tenets are likely to improve their reputation; maintain and strengthen their credibility; and secure new long-term investments (Crown Agents, n.d.).
Regulators’ expectations in regard to stress testing and climate risk management consistently inform banks and insurers’ climate change management strategy. This is intently crafted to ensure effective mitigation of potential financial risks. Inarguably, banks remain major financiers within the larger economy. In view of the foregoing, they are committed to playing a crucial role in the transition to lower carbon economy as their urgent response to threats on the environment.
Sustainable financing remains one of the emerging concepts in the global financial market. It has come to stay; it is blossoming. Banks are strategically positioned to derive increased productivity and consistent surge in profits from the practical implementation of sustainable financing; while contributing meaningfully and effectively to the development of various sectors and growth of the economy. It is worth-reiterating banks are consistently striving to lead the campaign towards promoting meaningful and sustainable impact on the environment, society and governance. Although the developments thus far may be described as encouraging, it remains imperative for banks to accelerate the pace of their ESG initiatives; while making strenuous efforts to improve their bottom lines.
The above write-up also featured in Thursday, April 20, 2023’s Edition of the Business and Financial Times (B&FT). www.thebftonline.com