Banking and financial institutions’ instrumental role in allocating capital makes them a key influencer of sustainable and environmental, social, and governance (ESG) outcomes. These institutions hold a unique position to fund, bring awareness, and incentivize the transition to sustainable practices. The focus on sustainable outcomes can be traced to financial institutions’ net-zero commitments in the wake of global warming and the Paris agreement on climate change. It is now imperative to go beyond measuring performance and expand to an ESG target-setting model. This has to be done jointly with the business partners by devising a joint action plan and continuously monitoring it over fruition.
Systematic credit assessment
Sustainable impacts, whether positive or negative, take a long time to manifest after the completion of business cycles, regardless of the type of financial transaction – be it lending, investment, or underwriting. Traditional credit assessments include the ‘governance’ pillar of ESG as a part of the due diligence process. But for long-term value creation, ESG-integrated measurement must be woven into the credit analysis process beyond the current advisory or view mode in terms of decision making. It requires a clear understanding of how ESG should be integrated into both equity analysis and fixed-income analysis.
There is incongruence in the ESG-integrated creditworthiness approach amongst borrowers, lenders, investors, CRAs, portfolio managers, and ESG analysts. This inconsistency stems from the considerations of time horizon and the materiality of these factors at the sector, company, transaction, or project levels. With ESG evolving as a deciding factor in investments and financing, there must be a proactive way of raising the bar as an enabling ecosystem, wherein all the partners and associated stakeholders demonstrate their ESG performance metrics and work towards the same. A systematic and transparent integration might, over time, provide feedback to the policy and guidance units for framing financing strategies, in addition to processing business transactions.
At the outset, understanding ESG issues at various levels of the transaction or project under question is crucial. When assessing the materiality of credit risk factors, governance comes to the fore as a material factor for all organizations. Besides, the materiality of social and environmental risks varies for borrowers, depending on their operating sectors, location, diversification, and more. As a result, ESG issues can be classified at three levels – general, sector, and borrower – followed by an assessment of materiality to ascertain ESG relevance. For instance, a bridge construction project might consider environmental factors in terms of flood in the region, displacement of people in the area, and the financial prudence of the borrower in the use of funds. The materiality assessment must be merged into the overall credit assessment process with other credit ratings gleaned from either a third party or internal evaluations, or both.
Lead and lag indicators
Current ESG assessments mostly consider lag indicators that signify past performance. A more proactive approach will be to give credence to the efforts taken to improve ESG, predominantly, the lead indicators. In the above project example, the lead indicators could be the borrower’s rehabilitation plans for the displaced, people engagement, and afforestation measures. These indicators will predict a current ‘red’ turning ‘green’ or vice versa. The borrowers should self-evaluate these indicators, in addition to a third-party assessment.
Financial institutions can adopt a balanced approach to integrate ESG considerations into their credit assessment process. The tight integration need not necessarily be a combined score but separate scores, coupled with a curve fitting for ESG dimensions depicting the tolerance. This approach, in and of itself, will give the ESG factors the status they deserve in credit assessments and in taking ‘make or break’ decisions. An unmitigated ESG risk might result in financial losses and reputation damage. Here, it is necessary to reaffirm that certain sectors, countries, companies, and projects are not prohibited from investing, and that portfolio returns cannot be at the expense of ESG impacts. The question is: how can this be done during an evaluation? Any evaluation of this kind is identified through red, green, or amber indicators. Here, red means a clear no-go, and green means a clear go. But how can amber be dealt with? By introducing condition precedents, covenants, and memoirs on ESG in terms of efforts and performance before approval and further linking tranches to these. Introducing waivers, concessions, and penalties to make the funding remunerative or punitive on ESG performance or efforts will also help the cause.
More importantly, introducing a joint ESG action plan to improve the borrower's performance and reduce the risk of the lender, along with continuous monitoring over time, will be beneficial in achieving the desired impact. The action plan powered by ESG-integrated credit assessment can dovetail responsibilities on either side and raise the bar on ESG performance in the entire ecosystem.
Improved ESG performance across the financial ecosystem would deliver more authenticated ESG commitments rather than mythical ESG targets that lack substance and leads to greenwashing. In the times to come, the relative roles of all ecosystem players will evolve with more structured responsibilities.