Sustainable financing and responsible investing are more prominent now than they have ever been. Many companies across sectors are now making ESG a key pillar of their corporate strategy.
Impact of COVID
For some time, environmental concerns, from decarbonisation to marine bio-diversity, have been at the forefront of the growth of ESG financing. Indeed, key market participants, from the UK Government and the Bank of England to financial institutions and investors, have made it clear that the “green recovery” must be central to the continuing global response to the COVID pandemic. However, the pandemic has also brought social and governance challenges into sharper relief. COVID has created difficult trading conditions for many, and in such times, and perhaps because of them, many corporates have worked hard to protect workers and supply-chains, to combat inequality and racism and to support their communities and wider stakeholders. Indeed, the pandemic has increased focus on the well-being of employees, customers and suppliers and the interconnected nature of markets. Many are now of the view that building a more resilient and sustainable future is not just about reforestation and decarbonisation (as important as they clearly are) but also, at the same time, prioritising people’s futures, their job security and access to healthcare and social services. Indeed, it’s now clear that solutions to the significant challenges we still face require a unified approach which safeguards the world we live in and the people we work with.
Increase in sustainable finance issuances
Against this backdrop, a recent study by Refinitiv reported that global sustainable finance issuance is on the increase at unprecedented levels, particularly in the bond markets. Sustainable bond issuance totalled around $360 billion in the first nine months of 2020, up 96% on the same period in 2019. Of these sustainable bond issuances, 49% were made by corporates, which was a 35% increase on the same period in 2019. Picking up on the theme of the increasing prominence of the “S” in ESG, $84.5 billion of social bonds were issued in the first nine months of 2020, eight times as much as in the same period in 2019.
Green bond issuance also accelerated in 2020, with around $77 billion of green bonds issued in the third quarter alone, the largest amount since records began. On the loans side, global sustainable lending in the first nine months of 2020 amounted to around $115 billion (a slight increase on the same period in 2019), 60% of which were borrowed by corporates.
The role of investors
A key driver of the increasing prominence of ESG is the role of investors, many of whom are now requiring asset managers to fully integrate ESG into their investment processes. Indeed, a number of banks and asset managers have recently announced plans to divest away from carbon-intensive companies and to stop financing certain fossil fuel projects in the medium-term. One prominent global asset firm recently opted to exit investments in companies it judged to have lobbied against climate change policies and no longer invests in companies that earn over 5% of their revenue from coal. On a similar theme, Blackrock CEO, Larry Fink, recently wrote to company executives noting Blackrock would be placing sustainability at the very centre of its business and in consequence would be “increasingly disposed to vote against management and boards of directors when companies are not making sufficient progress on sustainability related disclosures and the business practices underlying them”. Indeed, a global survey from last December found that investors representing $25 trillion in assets under management, and particularly those in the UK and Europe, planned to double the amount of their ESG assets by 2025. A key trend emerging is that investors will judge companies not just on financial performance and generating value for shareholders but also on non-financial metrics and how boards protect and enhance the interests of all stakeholders.
Governments and regulators are also pushing hard on ESG. About a year ago, the EU launched its “Green Deal” and “Sustainable Finance Action Plan”. Aiming to encourage sustainable and resource-efficient economies throughout Europe, and to reform financial systems to create sustainable growth, these plans recognise that private investment will be needed, alongside public funds, in order to meet the EU’s sustainability goals. A key element of this is the EU Taxonomy Regulation which establishes a uniform system for the classification of environmentally sustainable finance and is due to be fully implemented by 2022. One of its aims is to combat so called “greenwashing” where products, services or corporate behaviours are presented as having environmental benefits which are in fact over-stated or illusory. To meet the eligibility criteria under the regulation, investments or products must meet one of six environmental objectives. These are: climate change mitigation, climate change adaptation, protection of water and marine resources, transition to a circular economy, protection and restoration of biodiversity and pollution control. Such activity must also do no significant harm to any of the other five environmental objectives, and must comply with minimum safeguards, for example, in relation to the Paris Agreement and the UN SDG Framework.
Another element of the EU’s Green Deal is its Sustainable Finance Disclosure Regulations, which, via disclosure of sustainability risks and targets, aim to promote the integration of sustainability risks into the process of making investments and selling financial products. These regulations are due to come into effect in March this year. Because the EU Taxonomy Regulation and the Sustainable Finance Disclosure Regulations have not come into effect before Brexit, they will not automatically apply to UK corporates. However, in November 2020, the UK chancellor announced that, as part of its Green Finance Strategy, the UK would be implementing its own green taxonomy which would contain even more comprehensive ESG disclosure standards for corporates and financial institutions and would make climate risk disclosures mandatory by 2025. This, together with developments such as the proposed amendment to the UK Pensions Schemes Bill (aligning pension schemes in key areas with the Paris Agreement) and the UK’s proposal to issue its first sovereign green bond later this year, shows that ESG is at the heart of the UK government’s near-term plans. Ultimately, as the Bank of England has recognised, climate change presents very real risks to the financial system and the need for an orderly market transition to a low-carbon economy is paramount. Taken together, there is real legislative and regulatory momentum in the UK for creating a sustainable economy and for sustainable finance.
The economic benefit of ESG
The rising prominence of ESG is not just driven by investors and governments. Many corporates are now of the view that ESG makes economic sense too; that generating revenue and prioritising ESG are not mutually exclusive. Both can be achieved together. Indeed, evidence points to the resilience of sustainable business practices. S&P recently reported that 14 out of 17 funds it looked at (each of which had more than $250 million of assets under management) outperformed the S&P 500 in 2020 to the end of July. Those funds rose by 1.8% to 20.1% as compared to the S&P 500 which was up 1.2% in that period. Indeed, three of the best performing funds in the UK in 2020 had a focus on sustainability. In a recent report, Blackrock shed some light on why this may be the case. According to their findings, outperformance of ESG companies in response to the pandemic was down to a range of sustainability characteristics including strength of customer relationships, satisfaction of employees and the effectiveness of the corporate’s board. Another factor was investor’s preference to rebalance portfolios with sustainable assets in response to the crisis. Indeed, Wills Owen recently reported that, on average, in the global sector, ESG funds delivered a return of 22.3% in 2020 as opposed to the global fund average of 13.2%.
Another economic incentive for corporates is that those who prioritise ESG can potentially have access to the large pool of ESG capital (the global market is estimated to be upwards of $30 trillion) and for some at least, there will be a link between ESG performance and access to capital. A number of large European banks recently confirmed that they plan to move to a net zero carbon business model in the medium term and while they will work hard to support companies in their transition journey, if customers are unwilling or ultimately unable to make that transition, they may need to exit relevant financings. For example, Barclays has announced that it will stop financing clients with more than 50% of their revenue from thermal coal, with that percentage reducing to 30% as of 2025 and 10% as of 2030. BNPP has committed to reducing financing of the coal industry to zero from 2030 in the EU and from 2040 in the rest of the world. Similarly, Societe General has committed to no new financing of coal-powered electric plants, coal mining or associated infrastructure.
Our corporate debt research
So what do UK corporates think about ESG financing? Last year, we asked over 100 UK corporate treasury professionals about ESG and over half said they planned to include ESG elements in their next financing. Thirty percent said they were currently reporting on ESG issues to lenders and other stakeholders and 26% said they currently use ESG financial instruments.
We also asked UK corporates what they considered to be the major impediments to undertaking ESG financings. Nearly a quarter of respondents identified a lack of standardised approach as a key impediment. Indeed, this was a point drawn out by Yves Mersch of the European Central Bank who recently said, “I see the risk of informational market failures if information on the sustainability of businesses and financial products is inconsistent, largely not comparable and at times unreliable or even completely unavailable. Definitions of what constitutes a sustainable investment are often subjective and inconsistent. The EU taxonomy is a promising initiative, albeit incomplete. Its practical usability remains a challenge. Plans are also under way for widely applicable industry standards.” Other impediments to ESG financing from our debt research were: (i) not knowing how it would work in the context of a particular business (21%), (ii) pricing not reduced enough to make it worthwhile (18%), (iii) increased reporting too expensive or time consuming (17%) and (iv) no obvious ESG metrics to use (15%).
The COVID pandemic is emphasising the need for markets to play their role in protecting and promoting the interests of all facets of society, from the natural world around us to all of those who live and work in it. Companies which have a broad focus on generating profit but also on minimising their environmental footprint while prioritising the interests of their employees, customers, suppliers, and wider communities will be the ones best placed to attract the sustainable investment they need to help their businesses flourish, particularly in these tough times. ESG is now a business imperative for many UK corporates and treasury professionals have a key role to play in helping deliver this through sustainable financing.
This is part 1 in a series of articles we will publish on ESG financing for corporates. Part 2 will be published in the coming weeks and will cover sustainable lending trends.
The contents of this publication are for reference purposes only and may not be current as at the date of accessing this publication. They do not constitute legal advice and should not be relied upon as such. Specific legal advice about your specific circumstances should always be sought separately before taking any action based on this publication.
© Herbert Smith Freehills 2021