When the cost of finance is tied to sustainability performance, ESG metrics will become as important as the balance sheet.
- Climate change is starting to impact lending and investment behavior creating an increased focus on climate action by companies.
- New incentives are being developed to support decarbonization objectives and climate-resilient development agendas.
- Companies are being encouraged to get ahead of the curve by integrating decarbonization strategies as part of standard business operations.
As financial policy makers wake up to the damaging impact of climate change, the world is on the brink of a fundamental shift in lending and investment behavior. Eventually, the most important metrics lenders and investors will consider when agreeing finance terms will likely not only be assets, profitability or growth projections – but additionally climate action and an alignment to a 2°C scenario (2DS)1.
Many major trading blocks, including the EU, now have clear strategies for creating financial systems that support their climate change responses. New regulations are emerging that will encourage finance flows to support decarbonization objectives and climate-resilient development agendas. These strategies are proactively reorienting capital flows toward sustainable investment. Their aim is to manage the financial risks associated with climate change and to avoid locking carbon-intensive assets or processes into our economies. The practical result should be a dramatically increased focus on organizational climate action, with laggards not merely named and shamed, but actively at a financial disadvantage.
ESG linked directly to financial risk
Organizations are already aware that good environmental, social and governance (ESG) behavior is likely to reduce reputational risk, as is the screening out of investments in weapons, tobacco or thermal coal. But now, the EU and other regions, including the UK, are building an evidence base that proves financial risk is directly linked to ESG performance. These regions have developed tangible plans to require prudential regulators to report on whether sustainable lending should receive preferential treatment.
There is real potential that future regulations could reduce the amount of capital that banks are required to hold against loans for sustainable organizations. In fact, the Network for Greening the Financial System, an international network of 42 central bank members and eight observers, is explicitly looking at how to promote green investment through central bank regulation.
Climate risk disclosures are already becoming mandatory, with the financial sector basing investment decisions and credit ratings on data relating to greenhouse gas (GHG) emissions or climate risk. The Sustainable Finance Progress Report2 and Green Finance Progress Report3 in the EU, UK and Canada have all explicitly recommended clarifying fiduciary duties in relation to climate change and broader ESG issues. To this point, in July 2019, the UK announced that public companies and pension funds will need to report climate risks by 2022.
France is already a green finance front-runner. In 2015, it became the first country to introduce mandatory climate change-related reporting for institutional investors, and it is now pushing the EU to introduce compulsory environmental reporting standards for European companies. In Asia, the Hong Kong Stock Exchange (HKEX) has now included climate-related risks and targets in its mandatory “comply or explain” reporting requirement for listed issuers with effect from 1 July 2020. And, amid renewed economic priorities during COVID-19, countries (such as Canada) have found an opportunity to signal the importance of managing climate risks by making climate change-related reporting a condition for firms to receive COVID-19 bailout funding.
Regulations gathering steam
In 2018, the UK Department for Work and Pensions (DWP) clarified the fiduciary duties of trustees in relation to ESG factors. It requires trust-based pension schemes to have a policy on how they consider financially material ESG matters, including climate change.
In the European Banking Authority (EBA) 2018 Annual Report, the EBA announced that it is conducting market analysis and research on ESG factors, noting:
“EBA will take a proactive stance in … sustainable finance, including on how ESG considerations can be incorporated into the regulatory and supervisory framework of EU credit institutions.”4
In December 2019, the European Commission announced an agreement between the European Parliament and the European Council on the creation of the world’s first-ever “green list” — a classification system for sustainable economic activities to help “define the universe of activities that will remain in a net-zero emissions economy in 2050 and beyond, and the types of activities that can support the transition to a low emissions, climate-resilient economy.” An EU Taxonomy Regulation was passed in the European Council and the European Parliament in 2020, paving the way for implementation in the near term.
While the taxonomy will not become part of EU regulation on bank lending at present, it is likely that voluntary applications will happen in response to consumer pressure and any future regulatory requirements.
In the UK, a supervisory statement from the Prudential Regulatory Authority —Supervisory Statement 3/19 — makes it clear that banks and insurers should not only “fully embed consideration of climate change risks in their governance arrangements,” but also “develop an appropriate approach to disclosure of climate-related financial risks.”5 The Bank of England also announced that in 2021 it will undertake a biennial exploratory scenario (BES) to understand the financial risks posed by climate change.
The exercise is designed to examine the resilience of the largest financial institutions and the financial systems in relation to climate-related risks, and to understand the changes that need to be made to enhance resilience over the short-, medium- and long-term. It was originally expected to launch in 2020; however, the COVID-19 pandemic has caused a delay in the launch until mid-2021. Nevertheless, the Bank of England has stressed the importance of the exercise to understand the vulnerabilities of the UK and global financial system.
It is only a matter of time before this type of regulatory expectation is extended to all organizations. As more companies report their ESG targets and performance, lenders will likely repurpose this data to offer sustainability-linked loans. As an early indication of what is to come, the uptake of ESG-incentivized loans has increased around the world in recent years, including in Europe, Australia and Singapore. And, banks throughout Europe and China are already integrating environmental metrics into their lending criteria.
How to prepare for sustainable lending practices
When the cost of finance does become tied to sustainability performance, ESG metrics will no longer sit on the margins of a business, supporting PR or compliance functions. Instead, monitoring and reporting of ESG metrics will become an integral part of every organization’s finance function and performance management KPIs — similar to how an organization’s balance sheet is important to its bankers and shareholders.
Just as some tax offices can now see into payroll systems, a prudential regulator will likely want access to sustainability performance systems in the near future. To prepare for the moment when banks and regulators start asking for ESG data, organizations should:
- Develop robust internal monitoring and reporting systems
- Add ESG performance to governance and risk frameworks
- Understand the integrity of the data and comparative performance to peers and other economic sectors
- Establish sustainability as a key element with the core business strategy
These actions will not only prepare a business for likely regulatory action, but also better position it to compete in an increasingly ESG-aware market.
Climate change is beginning to impact lending and investment behavior, which is leading to an increased focus on climate action by organizations. Major trading blocks are also developing strategies, regulations and financial incentives designed to support decarbonization objectives and climate-resilient development agendas. With the cost of finance being more closely linked to sustainability performance, it is likely that the importance of ESG metrics for both bankers and shareholders will increase. Organizations are encouraged to get ahead of the curve by building, measuring and disclosing decarbonization strategies as part of standard business operations.