Climate change, increasing pollution, decreasing resources, and growing poverty are not merely social but contentious business issues that decide whether corporations survive or disintegrate. Banks cannot shy away from their responsibility of including environmental and social (E&S) risks into their credit evaluation framework, which familiarizes them with direct, indirect, and reputational risks.
Environmental and social risks: Include them at the risk of damaging credit profile?
83% of the major European banks (that participated in the survey) take E&S measures incidentally, on a case-to-case basis, making it evident that it is done solely to address reputational risk. It is worth adding that only 58% of such European banks have risk-and-opportunity-driven sustainability strategies, often lacking systematic approaches. 84% of these EU banks do not even monitor the risks at the portfolio level. The representation of E&S risk as a part of disclosure in the pillar 3 is low.
The direct risks arising out of treating commercial land as collateral can affect the bank substantially, especially if the commercial history of the land is tainted, veering toward environmental contamination even. An indirect and bigger risk is if the borrowers creditworthiness is questioned due to environmental issues. Stricter environmental regulations can also result in incremental expenses, such as investing in cleaner technology and paying fines, or even abandonment of operations for the borrower, halting loan repayments altogether.
Establishing the Case for Sustainable Lending
Sustainable lending has started taking the form of impact investing, that is, for-profit investments having a social impact. French bank Credit Agricole recently announced a $3 billion impact deal, involving the shift in risk assets off the books to US-based hedge fund, Mariner Investment Group. Notably, Credit Agricole was one of the founding members of the Equator Principles, the once-discussed, little-implemented, so called gold standard of sustainable lending.
The Equator Principles: Coming Together, Falling Apart
The Equator Principles, based on the International Finance Corporations Performance Standards, was introduced as a voluntary code of conduct and a risk management framework for banks to assess and manage E&S risks in projects. The idea was to bring the banks onto a common platform. With big names like ABN AMRO, Barclays, Citibank and Royal Bank of Scotland having adopted it, the Equator Principles was a promising standard.
While a major step in the right direction (84 financial institutions across 36 countries have adopted it currently), the Principles have failed to evolve. These are criticized for imitating the IFC Sustainability Framework.
The utility of the principles became questionable when signatories began funding projects like the BTC pipeline and the paper pulp mill in Uruguay. Although the principles have drawn FIs to the sustainability debate, the consensus approach predictably results in minimalistic adoption. Even the third iteration hasnt made much difference, with adopting banks remaining non-committal on key issues of transparency, human rights, accountability, and climate change. These continue to evoke wrong actionsto legitimize project finance and enhance reputation, rather than being a beacon to ensure sustainability of projects.
Sustainable Lending: From Here to Where?
The Equator Principles will remain a guiding light towards sustainable lending, because the need for it is real. The moves, however, need to be bold. The EPIII is quoted as saying, We recognize the importance of climate change, biodiversity, and human rights, and believe negative impacts on project-affected ecosystems, communities, and the climate should be avoided where possible. Going by that, banks must step towards following it in spirit. Further, projects being funded under the principles must be disclosed, as a standard condition of the loan agreement. This will provide external agencies and NGOs the transparency and ability to track the compliance of the said projects.
Additionally, a common framework under a global regulator must monitor and measure the environmental and social impact of the approved projects. IT systems can help gain oversight of E&S risk exposures in the banks credit portfolio. Advancements in regulatory compliance through RegTech can promote efficiency and rein in costs. Banks committed to the principles can associate to use predictive analytics to identify potential risks. This can become an industry-wide practice, with best performers incentivized to encourage further participation.
Banks can thus work on an advanced IT platform from transactional to the portfolio level and make it more robust in terms of compliance. This would help them incorporate E&S risks to the pillar 3 report and hence ensure transparency.