What is ethical finance?
The term ethical finance, or sustainable finance, is used to describe finance that takes into account environmental, social and governance (ESG) factors affecting a borrower and/or its assets.
Environmental factors are those affecting the natural world and include climate change, energy efficiency and treatment of waste.
Social factors concern local and global communities and include working conditions, health and safety and diversity and inclusion.
Governance factors concern the internal workings and decision making processes of the borrower, including board independence and transparency, as well as its relationships with its stakeholders, including shareholder rights, anti-bribery and corruption and political lobbying.
Ethical finance in 2021
Ethical finance is not a new concept, but has long existed and been offered in various forms via entities such as credit unions and lending circles. Ethical principles are also already applied in some specialist financings, for example by certain providers of international project finance to determine, assess and manage environmental and social risk arising from the project(s) (often via the 'Equator Principles').
However, the global financial crisis underscored the primacy of responsible lending and in the dozen or so years since, political and societal will to tackle the threat of climate change has increased, with the signing of the Paris Agreement at COP21 in December 2015 evidencing a firm commitment to action. Most recently, the coronavirus pandemic has reemphasised community, society and the importance of universal access to essential services.
Three key categories of ethical finance:
1. Green finance – where debt is made available for a specific ‘green’ project with clear environmental benefits, such as renewable energy production.
'Green loans' are the product generally associated with modern ethical finance. Their use and popularity are however constrained by the availability of investments, and so we are seeing volumes remain steady.
2. Social finance – where debt is made available for a specific ‘social’ project which aims to address or mitigate a specific social issue or seeks to achieve positive social outcomes for target beneficiaries, such as programs designed to alleviate unemployment or improve access to essential services.
More familiar perhaps in and to funders operating in international markets, we expect to see more UK projects being funded via social financing products in the short to medium term partly to address issues identified as a result of the coronavirus pandemic.
3. Sustainability-linked finance – where debt is not made available for any particular project, but the ultimate use of funds and/or the borrower entity are assessed and measured against an agreed, documented list of ESG metrics, with positive, metric-compliant behaviours rewarded, usually with a reduction in the cost of the finance.
We are seeing a significant increase in new financings incorporating ESG metrics, including from the UK clearing banks, and expect these provisions to soon become ubiquitous.
Sustainability-linked finance is clearly aligned with the commitments of the UK government and Scottish government to achieve net zero by 2050 and 2045, respectively. This will require wide and early engagement across all sectors, including the financial sector, and positive behavioural changes of the kinds encouraged by sustainability-linked financial products.
It also addresses key stakeholder considerations, with investors using ESG factors to assess the asset base and behaviours of finance providers they are considering investing in.
Finally, the flexibility afforded by the structure, which as non-prescriptive is easily adaptable to different borrowers, sectors and assets, is a key strength. Once suitable and realistic metrics are agreed, these and the pricing or other implications are able to be incorporated in existing debt products rather than being funnelled via new specialist sustainability-linked products.
Political focus on sustainability, with its strong climate change pillar, is acute in the lead up to COP26, now scheduled to take place in Glasgow this November. Funders are therefore under pressure to maintain sustainability standards within the UK in order to both meet political expectations and to remain attractive to potential investors. For both reasons, the focus on sustainability-linked finance will undoubtedly continue, with ESG metrics soon seen as fundamental provisions of any debt document.
This article was first published in the Q2 2021 edition of Scottish Business Inside