The news of Ford receiving a $15.5 billion credit based on its ESG goals raised eyebrows in the market and taught that ESG could not be undermined.
With ESG gaining momentum with each passing day, something that is emerging as an exciting development is ‘sustainable finance’. Where everyone, including investors, regulators and the general public are scrutinising ESG behaviour, how could lending institutions be out of its sight? Sustainable finance simply means either opting for finance for sustainable segments or lending to companies based on good ESG performance. According to S & P Global Ratings 2021, Sustainable lending jumped from $5 billion in 2017 to $120 billion in 2020. Reports say that global sustainable lending rose to $322 billion in September 2021 from $6 billion in January 2016 and the growth is estimated to continue. It is a noticeable rise making sustainable lending one of the most talked about topics globally. Banks now want to make their lending purposeful and impactful. Many countries are putting their best foot forward to build sustainable economies.
The mounting pressure on financial institutions (FIs) to open their eyes to climate change and ESG concerns is the need of the moment. Times demand that FIs redefine their lending practices. Sustainable lending within its ambit includes green loans, social loans and sustainability-linked loans. Green loans only finance green projects that have “environmental objectives”. Social loans cater to dealing with social issues and challenges. And lastly, sustainability-linked loans could be associated with any of the ESG factors. These loans are coupled with incentives such as lower interest rates, making an attractive prospect for companies to embrace sustainability.
Increasing regulations have also compelled this practice. For instance, the European Banking Authority has asked banks in the EU region to publish GAR (Green Asset Ratio) beginning next year. The intention behind the publication is to make an assessment of green loans, securities and advances easy for banking customers and investors. The Securities and Exchange Board of India is also examining ESG disclosures from listed companies and opinions of credit rating agencies. State Bank of India (SBI) strategises to give a percentage of its loans based on ESG ratings and incentivise companies that have a good ESG score. It has also launched green car loans. The RBI joined the Central Banks’ and Supervisors’ Network for Greening the Financial System (NGFS) as a member in April 2021 and formed SFG (Sustainable Finance Group) to launch a legal framework around ESG lending.
Banks that adopt a forward-thinking approach want to stay ahead in the game by integrating sustainability into their risk assessment models. It helps lending institutions to identify the long-term sustainability of a business. As sustainability will be the touchpoint to stakeholder demand, climate change, good governance, regulatory compliance, and better business and profits, it will make financial sense to provide loans to companies that are on the path of sustainability. These companies will enjoy higher credit ratings. Providing loans to ESG-aware borrowers will automatically minimise credit default risk. Lending institutions have started infusing ESG considerations in their entire lending process right from lending decisions to across their value chain. They have started building an ESG data platform, wherein a company’s ESG data is collected and scored to help them in decision-making. The borrower’s performance on ESG metrics is assessed and measured to come up with an ESG rating.
ESG-linked loans push a company to integrate sustainability because the terms of the loans are based on its predetermined sustainability performance targets (SPTs). These targets are measured through relevant key performance indicators (KPIs). The achievement of SPT is connected to margin, fee or commission. Commonly used models are one-way pricing and two-way pricing. Under the former model, if the pre-set criteria are satisfied by the borrower, the lender’s margin decreases; under the latter model, the margin also increases if pre-set criteria are not met.
However, even though an exponential increase in green finance paints an ideal picture, the reality begs to differ. Multiple banks are still hesitant to flag off green finance. And this hesitance is not meritless, owing to concerns such as risk assessment, greenwashing, customer maturity and payback period. According to a survey conducted by SFG in January 2022, even though the journey of sustainable finance has begun, concerted efforts and further actions are required.
We believe ESG-based loans are a great incentive for companies to switch to ESG. Sustainable lending will significantly facilitate a transition to a low-carbon economy. Institutions that fail to adapt to the ESG agenda will fall much behind in the race. On the flip side, companies having a strong ESG proposition will stand on the priority list of FIs for the purpose of lending.
You can now educate your board on this concept and its role to play with CPD-Accredited ESG Expert Certification assisted by the recognised Directors’ Institute - World Council of Directors.