The growth of the ESG financing market has been nothing less than extraordinary. Just two or three years ago, it was mainly perceived as a niche market for large industrial corporates looking to finance projects with an environmental angle. Today, it is one of the first topics of conversation in most financing discussions with a wide range of lenders and borrowers.
According to the FT, the total assets in sustainable funds was almost US$1.7tn at the end of 2020, up 50 percent over the year (“ESG funds defy havoc to ratchet huge inflows”, Financial Times, 6 February 2021). Similarly, research from Morningstar shows that ESG funds in Europe attracted net inflows of €151 billion between January and October 2020, up almost 78 percent on the same period in 2019 (“EU rules promise to reshape opaque world of sustainable investment”, Financial Times, 17 January 2021).
So, what exactly is ESG financing and what is behind its exponential growth?
The terminology can certainly be confusing. Green financing, green bonds, sustainability-linked loans, social and ethical finance – there are almost as many terms for ESG financing as there are solutions. But as Marc Finer, ESG finance specialist and a director in KPMG’s Debt Advisory Group, explains, “these days ESG finance is seen as an umbrella term that captures a diverse range of debt finance products and solutions, for organisations of all sizes, applicable in a wide spectrum of situations.”
On the lending side, banks, private and public capital markets, investors and credit funds are all increasingly active in the ESG financing space. On the borrowing side, demand is rising from listed and privately-owned corporates through to private equity-backed businesses, in both the large-cap and mid-market space. Nor is it confined to typical ESG sectors like utilities, oil and gas or mining. Contemporary ESG solutions can cover businesses of all types, in all sectors.
“If you’d have asked me 18 months ago, I would have said that our work in this area was occasional, focused among large, industrial corporates, and with ESG rarely being a key driver of the company’s refinancing strategy or the credit market’s appetite. But today, nearly every conversation we have with our clients across every sector – and with all types of lenders - involves a discussion about ESG,” says Marc.
Today, nearly every conversation we have with our clients across every sector – and with all types of lenders – involves a discussion about ESG.
There are two main drivers behind this unprecedented growth, he says: regulatory pressure and market sentiment on the part of both providers and borrowers.
Reflecting growing awareness of the urgency of the climate crisis, there has been a rapid increase in general market sentiment that businesses should be more responsible in the way they conduct themselves. This manifests itself in growing pressure from stakeholders, including customers, employees, lenders and investors, that businesses should be accountable for their actions.
Finance providers themselves face similar pressures to lend to businesses that can show themselves to be operating responsibly. In fact, this year, the Bank of England will be rolling out the first climate change stress test exercise to assess different combinations of physical and transition risks over a 30-year period.
So, on one side, when corporates are looking for financing, they are increasingly seeing value in taking the ESG route in order to keep their stakeholders happy. While at the same time, more providers of capital are being pushed towards lending in line with ESG principles. This creates a perfect alignment between providers and would-be recipients of ESG finance.
The second major catalyst in the growth of ESG finance is the regulatory framework, which is itself linked to the climate change agenda. The EU sustainable finance disclosure regulations, for example, introduced in March this year, require fund groups to provide information about the ESG risks in their portfolios for the first time. A central element of the EU’s green deal, they aim to strengthen ESG financing by injecting more discipline into the ESG market.
Closer to home, the UK government’s plans to transform the City of London into the global centre for green finance include the introduction of new corporate disclosure requirements.
“The regulatory framework is developing fast. It will eventually mean that if you’re a lender of money or an investor of capital, it will become increasingly more expensive and riskier to lend to businesses that are not on a clear, committed path to decarbonisation. Ultimately, it’s a question of sustainability. Why would you want to lend to a business whose lack of commitment to ESG means its long term future could be uncertain?” says Marc.
The government’s plans to transform the City of London into the global centre for green finance include the introduction of new corporate disclosure requirements.
Approaches to ESG finance
Broadly, there are two approaches to achieve an ESG financing. The ‘classic’ approach is linked to use of proceeds. That is, a specific project or projects that fit under the ESG banner, for example a business that wants to install solar panels to power a factory. Use-of-proceeds ESG funding can be retrospective for up to three years and forward-looking for two years. So, if a business invested £20m two years ago to upgrade its facilities to make them more energy efficient, it may be able to use an ESG financing solution to refinance that project.
The second, arguably less understood approach, is through incorporating commitments to ESG-linked KPIs within the borrower’s ordinary financing arrangements. For example, a food processing business refinancing its general purpose revolving credit facility could commit within the loan agreement to reduce its factory’s carbon emissions by 50 percent, or increase the amount of recyclable packaging it uses by 75 percent, within a certain time period.
In both approaches, there may be pricing incentives within the loan agreement if the company achieves the commitments it has made.
“It’s potentially a win-win for companies,” says Marc. “Given the global focus on climate change and responsible business practices, these are the kinds of initiatives that many businesses are looking at anyway, so it’s an opportunity for businesses to get rewarded for actions they are already taking through greater appetite for their credit, and potentially better terms.”
It can also be seen as a part of a broader effort to align the corporate agenda with the capital structure, which is how well-run corporates have always looked at capital structure. Not to mention the PR benefits.
Businesses that cannot comply with the ESG requirements of finance providers will find it increasingly harder and more expensive to raise capital.
‘S’ and ‘G’, not just ‘E’
It is often the ‘E’ for environment that captures the ESG headlines, reflecting the sharp focus on the climate change agenda across society as a whole. The framework and standardisation around environmentally-focused ESG products like green bonds also tends to be more clearly defined, making it easier to monitor and verify compliance.
Nevertheless, the ‘S’ (social) and ‘G’ (governance) should not be overlooked, particularly in terms of KPI-linked ESG financing. And as standardisation around social and governance factors has begun to firm up, it has become an increasingly viable option for businesses to commit to social and governance metrics, such as increasing board gender diversity, reskilling the unemployed, enhancing compliance or access to education.
Such is the speed at which the ESG finance market is developing that in due course, it is conceivable that the notion of ESG finance as a specific type of finance will cease to exist. In time, all finance will, by default, be ESG finance. Those businesses that for whatever reason cannot comply with the ESG expectations of finance providers will find it increasingly harder and more expensive to raise capital.
“Even if your loan or bond is not formally an ESG product, you will still need to show a commitment to ESG in your business. Otherwise, lenders will find it hard to view your application positively. Put another way, borrowers with a strong ESG framework have an opportunity to strengthen their credit attractiveness and deliver a stand-out deal, but the pace of growth in ESG finance, and ultimately its normalisation, means that opportunity won’t be here forever,” says Marc.
To discuss any points raised in this article and how you can seize the ESG financing opportunity please contact Marc Finer.