By Joseph Neu
“Treasurers should be preparing for a tsunami of sustainability-linked finance products,” one NeuGroup member treasurer told me recently in response to market events of the last year. To underscore the importance of that notion, Hervé Duteil, chief sustainability officer for BNP Paribas in the Americas, presented his view to NeuGroup’s Tech20 Treasurers’ Peer Group last month. He described three big waves, or “revolutions,” in sustainable finance:
1. Labelling the “use of proceeds.” This wave is most famous for green bonds, and it continues with Apple’s sizable euro-denominated green bond issue last month, but also includes other labelled or “thematic” bonds (or loans) for green, social, sustainable, sustainable development goals (SDG), and now transition financing. The guiding principle is that the use of proceeds from these loans is identified, or labelled, as being used for something specific to sustainability.
2. Linking returns with sustainability performance and impact. This wave’s focus is on sustainability impact and performance (with measurable KPIs) and originally driven by bank lenders.
- Supply chain finance: This wave likely began in 2016 with sustainable supply chain financing, where the discount factor applied to supplier invoices is linked to sustainability performance verified over time—i.e., do right and you get paid earlier for less of a discount.
- Loans and credit facilities: The wave has further extended to longer-term financing (mostly revolving credit facilities) in the form of sustainability-linked loans (SLLs), where the interest rate moves up or down in line with the achievement of sustainability performance targets, such as ESG score, greenhouse gas emissions, water intensity, waste intensity or gender ratios.
- Swaps: The concept of a variable coupon tied to sustainability performance was also embedded in a swap derivative in August and more recently when BNP Paribas structured the first ESG-Linked FX forward swap for Siemens Gamesa.
3. Linking cost of risk (and funding) to sustainability performance and impact. The subtle difference between this and the second wave is that while in the former banks are accepting a lower return for sustainability gains, in the latter it is about investors asking to be compensated for the increased risk—credit or operational—from poor sustainability performance.
The risk-cost argument is likely to have an increasing impact. For one, rating agencies are starting to speak to a more formalized integration of ESG risk factors into credit assessments. This sets up a tension for them that was revealed at our Tech20 Annual Rating Agency Breakfast:
- To what extent can issuers say that ESG is embedded in their normal rating as opposed to paying for a separate ESG rating? There is not yet a clear answer, other than that ESG factors have always been part of your credit ratings and they will continue to be a factor.
Banks have another risk-cost consideration. While banks have the same inclination as investors to steer the world in a more sustainable direction, they also are looking to strengthen the resilience of their corporate lending model and hedge their loan portfolios against systemic risks such as the emergence of carbon taxes or higher capital adequacy ratios for credit extended to carbon-intensive sectors (see BIS white papers and other central bank research for discussions of putting a higher RWA on credit products for unsustainable or so-called “brown” counterparties).
- An asymmetric risk profile: This raises the point about the asymmetric nature of sustainability risk, i.e., providers and users of capital will increasingly be penalized from a cost of capital standpoint for brown activities more than they are rewarded for continuing to promote sustainable policies, supporting high ESG scores and acting green.
It will be interesting to see how quickly sustainability-linked finance shifts from rewarding do-gooders to imposing costs on firms that need to transition to become better ESG citizens. Such a move may create something of a catch-22, especially for capital-intensive businesses like oil and gas, mining and heavy industries.
Accordingly, BNP Paribas’ Mr. Duteil sees transition finance as a necessary extension of green finance. It would apply to sectors that (1) are not green today; (2) cannot become green tomorrow; (3) but can and need to get greener (by which we mean less brown) faster; at a pace likely in line with recognized sustainable development scenarios; or at least within the scope of a disclosed comprehensive strategy road map that will get them back in line within an acceptable time frame.
It’s either this or making laggard firms easier targets for disruption by increasing their risk-adjusted cost of capital.