ESG is on everyone's lips

Guarantees and letters of credit are part of the day-to-day business of many companies in the course of foreign trade and export financing (trade finance). However, like many other areas of treasury, this is also undergoing change through digitalisation - from the introduction of guarantee and letter of credit management systems to process automation.

However, the environmental, social and governance (ESG) component is a factor that has received little attention to date. Banks are already required to act in accordance with ESG criteria when granting loans, for example by granting sustainability-linked loans, where the interest rate is dependent on the company's sustainability components. This is not yet consistently the case in the area of trade finance. However, due to the expected increasing importance of ESG, one or two ideas in this direction cannot and should not be ruled out, as banks are already incorporating ESG criteria when issuing guarantees and letters of credit. This makes it much more challenging for companies with obvious non-ESG-compliant products, such as machinery used in lignite mining, to obtain trade financing (guarantee, letter of credit, etc.).

Even though ESG is not yet mandatory in the trade finance sector, we would like to highlight some possible forms of organisation and the associated opportunities and challenges below.

The first focus is on the possible components of ESG criteria in the trade finance environment, whereby the implementation of both individual areas and a combination of different areas appear conceivable.

The basis here is formed by the relevant ESG factors within the company itself. These include the company's sustainable orientation and corresponding actions, which are also recorded by means of ESG reporting. Sustainable financing can also make a contribution. Corresponding reports are generally already mandatory for capital market-oriented companies - and if they exceed statutory size thresholds - (based on the requirements of the Non-Financial Reporting Directive, Sections 289b et seq. and 315b et seq. of the German Commercial Code (HGB)) and are also included in the reporting in the annual financial statements. The company can therefore utilise existing structures for this if necessary.

One ESG approach that can be used specifically in the course of trade finance is the evaluation of the product or commodity to be financed. This is essentially about the specific impact of the product to be financed in an ESG-specific context. The focus can either be placed on the corresponding production process, including all relevant input factors required for production, or on the impact of the corresponding product after delivery to the customer. An example of the latter option would be an excavator that is used either for the construction of photovoltaic (PV) parks or in the course of lignite mining. From an ESG perspective, use for the construction of PV parks will presumably be considered more favourable at first glance than use in opencast mining.

This approach is based on the categorisation of the respective business partners in accordance with ESG criteria. Both the company's own customers and suppliers are relevant here. In this approach, such categorisation should take place along the entire value chain and therefore also take into account any intermediate actors (such as freight forwarders) as far as possible. The complicating variable in this context is the number of actors involved. The more parties involved in the value chain, the more difficult it is to collect complete and appropriate data.

This involves the use of sustainable financing partners and sustainable trade finance products. However, as such institutions usually only enter into business relationships in return for proof of compliance with certain conditions, this is to some extent a chicken and egg problem. Companies wishing to utilise sustainable products from these institutions must provide corresponding proof of sustainability. However, this proof should be generated through the use of these products. A possible solution could be designed in such a way that the first step is taken by the company, by setting a sustainable direction. If the first ESG-compliant strategies are already bearing fruit, the step towards sustainable banks can be taken subsequently in order to incorporate corresponding sustainable projects.

As the exemplary presentation of these aspects to be considered makes immediately clear, the implementation of ESG reporting is not a sure-fire success. The many challenges associated with ESG include the areas of data collection, data processing/analysis and comparability.

When collecting data, companies can access some of the data from their own processes and production workflows. However, not all of the data required from trading partners is usually publicly available. It is currently up to the companies to decide which data they publish for the ESG score. Each company decides which selected data they make public for certain variables (e.g. water consumption). However, the company is not obliged to provide information on confidential topics (e.g. salary structure among employees). This topic also becomes interesting if the intended use or utilisation of the product is to play a role. Hardly any company can fully predict how a product will be used over the course of its entire service life. As a rule, information is only available for the first use. Of course, use in accordance with the first use - even if the product is resold - can be contractually regulated. Effective control over an uncertain period of time seems unrealistic. Another challenge is the validity of data from countries with less developed infrastructures or protectionist regimes.

In addition to data collection, one of the main tasks and challenges is processing the collected data in an adequate model that produces a qualified ESG report as the end result. In this context, the selection and weighting of the relevant variables (e.g. CO2 emissions, water consumption, gender discrepancy, size of the supervisory board) from the three overarching areas (environmental, social and governance) is the central design component of the overall ESG model. Other factors to be considered in this context are, for example, the company's own industry, the relevant location regions and the number of employees.

Once the parameters have been defined and processed, the next step is to interpret the ESG score achieved. It makes sense to coordinate the significance of the ESG values and the corresponding ranges with all parties involved (e.g. banks, suppliers and customers) in advance in order to avoid possible misinterpretations.

The third challenge is the comparability of ESG reporting and the ESG scores calculated. Due to the lack of uniform ESG market standards in the trade finance context, it is currently still difficult to compare corresponding reports with one another. However, one possibility is to define a common understanding of the ESG score or the ranges together with the partners involved, for example the banks involved. The data included, the selected variables and their weighting are important for this.

Establishing ESG reporting and corresponding standards in the trade finance sector may seem complex and challenging at first glance, but it can also bring a number of advantages. In addition to the most obvious advantage, the establishment and verification of sustainable standards, we would like to discuss some of the other possible advantages below.

The introduction of ESG criteria in the area of export finance leads to a reputation as a sustainability-conscious company among customers, suppliers and banks alike. As this is still a relatively new field in the trade finance context, there are opportunities to position yourself as a pioneer in this area and to emphasise your own claim to innovation.

Establishing ESG criteria in the trade finance sector can, under certain circumstances, give companies easier or more favourable access to export financing instruments. Special ESG guarantee lines are one possible form of organisation. Provided that the agreed ESG criteria (see the aforementioned forms) are met, the subsidised ESG line can be used for the corresponding product. These reduced financing costs can thus contribute to a recognisable competitive advantage and also increase the company's own profitability.

The introduction of ESG criteria, including a corresponding process, can be included in the company's sustainability disclosures. Even if this is not yet mandatory for the trade finance sector, a corresponding requirement cannot be ruled out in the future. If companies already have this information available today, they are well equipped for the future.

Addressing the topic of ESG in trade finance can strengthen the resilience of your own company as well as that of your own supply chains. As part of the implementation of appropriate ESG reporting, a wide range of procedures and processes are analysed. As part of this process, all input factors can be critically scrutinised and adjusted if necessary.

Although ESG is not yet a regulatory requirement in trade finance, it will become increasingly important in the future, making it a relevant field of activity for treasury. In general, it can be summarised that the establishment of uniform ESG standards and corresponding reporting in the trade finance area will present treasury departments with a number of challenges. However, this will also enable treasurers to continue to drive forward any necessary process changes and the topic of digitalisation in the trade finance area and take on a pioneering role in the market by incorporating ESG criteria.

Source: KPMG Corporate Treasury News, Issue 132, May 2023

Authors:

Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG

Maximilian Gschoßmann, Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG