The pandemic is accelerating shift to environmentally-friendly technologies and approach not only in traditional industries but also in finance. Just last week Amazon founder Jeff Bezos pledged USD 10bn to fund climate change solutions, thus having set the trend for finance and investment. This is definitely in line with the Principles of the Responsible Investment, the first of which is incorporation of environmental, social and governance (ESG) issues into investment analysis and decision-making processes. Not surprisingly, as the integration of ESG factors into business ensures better performance, lower cost of capital, competitive advantages and access to more available financial resources, including green and sustainability-linked finance.

In the following article, the experts from Banking & Finance practice at CMS Cameron McKenna Nabaro Olswang Ukraine, Ihor Olekhov and Kateryna Chechulina, explain how the lockdown changes the focus on ESG from important to priority issues and why ESG compliance is no longer just a trend, but inevitable necessity . The adoption and coming into effect  in April this year of several major regulations relating to ESG compliance (EU Taxonomy and EU legislation on ESG related disclosure requirements) has a significant impact (not only on European capital market participants) and serves as a clear sign that there is no choice for any business now but to comply with ESG requirements to prevent financial exposure and get access to the external financial resources.  

What are ESG requirements?

What commercial impact climate change, sustainability and the ESG requirements have? Is a business/project compliant with those? What needs to be done to ensure ESG compliance? Getting a proper legal advice to answer these questions is a starting point in the transition process that businesses need to undergo toward ESG and relevant disclosure requirements compliance. Guiding clients (companies, board members, business owners, financiers, governments and other stakeholders) through rapidly developing ESG regulatory landscape for achieving their business, environmental and social goals is a not only part of the legal professionals’ role these days, but is also an important contribution to the sustainability targets set globally, locally and internally (for, CMS, a leading global law firm, such being the commitment to reduce emissions to net-zero by 2025).   

Global Stress-Test Lesson

While the media offers some interesting theories on what the COVID-19 pandemic in fact is (including whether it is a conspiracy and the virus was created in a laboratory, caused by 5G mobile network radiation, or planned by certain pharmaceutical corporations), the truth is that we will probably never know the right answer. What we, however, know so far, is that a lot of matters have grabbed our attention as a result of the global stress-test we are undergoing, revealing the risks posed by the way we live, the things we do, and, more importantly, the impact all of that has. Even if it might be the most unbelievable one, the theory that coronavirus is another ominous sign that the Earth is giving to humankind, is nevertheless worth the attention. This seems to be right, as 180 business leaders, lawmakers, researchers and NGOs just lately declared in a joint letter that the economy’s recovery from COVID’s impact should go hand in hand with climate objectives. It is evident from the issues that the countries and nations affected by COVID are experiencing that a great deal needs to change. While the list is long, what is common is the need to change the approach. Long-term sustainability must equally be among the other drivers of any business and stand behind the recovery process. So, it is indeed the right time to start taking environmental, social and governance (ESG) factors seriously and implementing those in business processes to ensure sustainable development. To put it simply: it’s time to become ESGetic!

Benefits of Being ESGetic

To demonstrate the benefits, especially those that can be monetised, is the most efficient way to encourage the integration of ESG factors into any business.

Better Performance and Lower Cost of Capital

While it is debatable whether consideration of ESG aspects in addition to a traditional financial analysis when making business/investment decisions may hurt performance, numerous studies prove that this is not the case. Companies with strong ESG practices are less exposed to volatility and are in better control of bribery, corruption and fraud issues resulting in fewer of those cases. The overall impact is that the cost of capital for such companies is lower, whereas the value of their business goes up. For example, IFC[1] recently looked at the performance of 656 companies in its portfolio and found that companies with good E&S performance tended to outperform clients with worse environmental and social performance by 210 basis point (BPS) on return on equity (ROE), and by 110 bps on return on assets (ROA.)

Prevention of Financial Exposure

Well-structured and properly implemented governance procedures may also save businesses from significant financial exposure, whether in the form of fines or reduced profits. Here are a few of the well-known cases:

2010: The Deepwater Horizon oil spill, for which BP incurred a USD 53.8bn pre-tax charge

2015: Volkswagen was exposed as having rigged 11 million diesel vehicles to pass emissions tests, resulting in costs including EUR 27.4bn in penalties and fines

2018: Facebook saw billions wiped from its market value after Cambridge Analytica was able to harvest personal data from 87 million users without its consent.

These examples demonstrate that the implementation of ESG factors is not just about ecological, social and ethical responsibility, but is also a valuable tool and efficient measure that can help companies avoid severe damages to both their reputation and finances.

Competitive Advantage and More Available Financial Resources

In addition, ESG compliance opens access to more financial resources and increases the chances of obtaining financing. Sound ESG practice is often seen by financiers as an additional competitive advantage when assessing whether to provide financing to a business. With further extension and strengthening of the ESG regulatory framework applicable to banks (including the EU taxonomy[2] adopted as a regulation on 15 April 2020 and coming into effect on 30 April 2020 of the EU regulation on ESG related disclosure requirements for benchmark administrators under the Benchmarks Regulation (BMR)), they tend to treat the risks associated with ESG factors as any other financial or legal risk. Thus, poor ESG performance may transfer into higher credit risk and thus more strict covenants and higher cost of funds

Access to Green and Sustainability-Linked Products

Those businesses who have already implemented ESG factors or have adopted a strategy on their integration may be eligible for special terms of financing and special products on green or sustainability-linked financing developed by banks. These may take different forms and structures.

Green loans and bonds (provided or issued to finance a specific green project) would obviously be more relevant to all types of RES (renewable energy sources) projects (solar, wind, biogas, etc) and those businesses making a positive ecological impact (water usage and supply, waste management, energy efficiency, etc). Sustainability-linked finance has a wider application as it focuses on the on-going sustainability profile of a borrower over time and envisages that the borrower has espoused a general corporate strategy which comprises sustainability, social responsibility goals and promotes positive behavioural change.

Thus, almost any business that has sustainable development objectives and strives to reach them as planned may be eligible for this type of financing. In each such financing, a borrower would be constantly monitored to verify compliance with the claimed targets against the set measures and criteria, to ensure that there is no greenwashing (the practice of making unsubstantiated or misleading claims about the environmental benefits of a product, service, technology or company practice).

Of all possible advantages of such financings, the most straightforward is margin decrease or discount on other payments under a loan. This may be immediate or subject to compliance with certain conditions, which are usually based on the fulfilment of key ESG performance indicators. If successfully complied with, the margin would decrease, which may also be in various forms; if not, it may either go higher and be paid or directed towards specific purposes. For example, under one financing on which the firm worked, the lenders undertook to donate a sum of money to charity as a reduction in the margin, and if the borrower failed to meet the sustainability targets, the margin would remain unchanged and it would have to make the charitable donation. Another type of RES projects support could be financings provided in lieu of payments from creditors. It is designed to support a borrower’s cash flow given the time aspect of the payment cycle of the receivables from the renewable electricity sales. 

Banks allocate billions to various schemes that offer discounted financing to commercial banking clients looking to invest to reduce their environmental impact as well as boosting their productivity. Investment purposes vary from reducing carbon and greenhouse emissions, increasing energy efficiency and making environmental sustainability improvements, to investing in electric vehicles, improving water efficiency, reducing waste and improving recycling rates. To support their clients’ transition to a more sustainable economy, financiers also partner with educational and science institutions to provide specialist training on the topic.

Transition is a Must - the Sooner, the Better

Importantly, while the integration of ESG factors is seen as an advantage at this stage, in the near future it is very likely to become a standard requirement to be complied with by all those that have or seek financing. This is already the case with all IFIs.

Whereas commercial banks adhere to this rule more on a voluntary basis, regulations which will introduce a ‘green supporting factor’ in the prudential rules for banks are on their way, meaning that the banks will very soon be obliged to take ESG-related risks in their risk management policies. Moreover, institutional investors, asset management companies, insurers and other regulated entities will be required, as part of their duty towards their clients, to disclose information on how they implement ESG factors in their risk management processes and follow those. Some banks and investors have already taken even more radical steps by having discontinued investments in certain businesses in high-carbon sectors. All of this means that the transition to a new model of business that integrates ESG factors and is based on sustainable development principles is inevitable. The sooner such transition begins, the better result it will have for businesses.

Developing Markets and Frontier Markets Perspectives

While green and sustainable finance and related regulations are rapidly developing in the UK and the EU, their relevance to developing and frontier markets like Ukraine is no less important or topical. With a huge share of financing being provided by IFIs and given quite low risk appetite of local financial institutions despite having sufficient liquidity, any Ukrainian business looking for financing needs to ensure it takes ESG integration seriously. Moreover, local banks, which have IFIs or European banks among their shareholders, are also following the EU’s ESG practices and pay more attention to them when assessing their clients’ businesses. Some banks (like Ukgasbank) have ESG compliance as a key priority and part of the brand, focusing on and proposing various financing programs for those aligned with the implementation of a sustainable development strategy.

Thus, there is no doubt that ESG integration into businesses’ processes, strategy and decision-making is no longer just a trend, but inevitable necessity. Those who are up to speed already enjoy the advantages

So now, it is indeed time to become ESGetic and enjoy these vast benefits!