Sustainable Finance: No longer an option but imperative for lenders & borrowers

Sustainable finance prompts the integration of ESG issues into corporate activity.

Sustainable finance is becoming more mainstream due to increasing thrust by investors, requirements by regulators and expectations from stakeholders. A global investor survey that PWC published in 2022 suggests that 82 percent of investors were exerting pressure on their portfolio companies to set and aim at sustainability objectives. The year 2022 saw a near record $500 billion invested in renewable energy. Further there were over 1,000 venture and growth equity investments into climate start-ups, with over $40 billion deployed.

Devastating effects of climate change including an increase in global temperature by up to 2.2 percent have led to mounting resentment among the general public against polluters. In fact, as risks associated with environmental, social and governance (ESG) increases, and as their implications on sustainability become critical, companies have become increasingly conscious of the national and global requirements for emissions reduction targets, human rights and integrity. They are increasingly incorporating ESG-related targets and commitments into their management processes and decision-making. The backlash of stakeholders has made it imperative for them to think about what they do that affects sustainability, what their targets should be, what they are trying to accomplish and how they would.

ESG-Corporate Activity Integration

Sustainable finance is a process of taking due account of ESG considerations when making investment decisions in the financial sector, leading to increased investments into sustainable economic activities and projects. Sustainable finance prompts the integration of ESG issues into corporate activity. It can take the form of sustainability-linked loans (SLL) or green financing. SLLs incentivise the borrowers for the achievement of predetermined sustainability performance objectives with predefined key performance indicators (KPIs) or metrics — which link economic outcomes to sustainable practice. Unlike green financing, the proceeds need not to be used for a specific project or a green project. SLLs provide concessional interest rate and/or increase in repayment period along with relaxation in terms and conditions for borrowers to improve their overall sustainability performance. Importantly, borrowers have the flexibility in deploying proceeds of the loan in achieving ESG objectives.

Green financing requires borrowers to use the proceeds to fund specific projects that make a substantial contribution to environmental objectives. These projects typically include the development of renewable energy, clean transportation, environmentally sustainable agriculture and the construction of green buildings, which meet prescribed standards or certifications. Further, it requires a clear process for project evaluation and selection; for management of proceeds for ensuring utilisation in a specified manner; and for reporting on qualitative and quantitative aspects. Disclosures are mainly focused on the capacity of the project, the level of generation or utilisation, contribution to emissions reductions, environment protection and preservation, and mitigation of social impacts.

For existing companies, green loans may provide for the utilisation of funds exclusively for projects or new assets necessary for the transition to milestones and achievement of agreed targets. In fact, a green loan or bond scheme itself lays down the eligibility criteria, process and framework following which funds should be used and managed.

Lenders’ Priorities And Obligations

Sustainability finance is also imperative for lenders as companies while responding to their ESG requirements will need funds to support activities. For example, a company that aims to reduce emissions would need finance for decommissioning their GHG emissions-intensive liabilities or in the alternative to construct a renewable energy project. Given the limitations of the capital markets, banks and financial institutions are the only available source of finance. Further, lenders have to set and target their own commitments for sustainability objectives. They themselves have reporting obligations under applicable regulatory norms and are subject to stakeholder scrutiny. Typically, the ESG policy of lenders focuses on the priority they give to ESG — objectives, targets, challenges, risks, mitigation, resilience and adaptation. These will include diversity, equity and inclusion, and good governance as well.

The focus of lenders on ESG compliance earlier was limited to box-ticking to meet back-to-back conditions of the line of credit of bi/multi-lateral institutions. The terms and conditions of loans normally included a standard stipulation requiring borrowers to comply with the related industrial, environmental and social laws. The focus has now shifted to a more formalised approach, though much more needs to be done for ensuring substantive compliance. The terms and conditions now increasingly stipulate KPIs including those for reduction of scope 1 and 2 emissions, treatment and disposal of waste, gender pay equality and social inclusion and governance aspects.

Challenges In Setting Up KPIs

There are, however, challenges both for lenders and borrowers in setting up meaningful and credible KPIs. For borrowers, the challenges include setting up of clear milestones relevant to their business, implementing those in qualitative and quantitative terms (in a manner that does not cause confusion and disputes later) and reporting on their KPI frameworks. The lenders on the other hand need to ensure that the agreed KPIs are aligned with their own sustainability-related targets and commitments, and these are capable of being appropriately monitored. In the case of failure to achieve targets, there should be clarity on when and how the default clause will trigger and with what consequences.

For setting targets there are no best practices evolved so far. The practice generally followed is to set targets based on past performance and industry trends. The SEBI’s recent framework for KPIs and reporting thereon provides key parameters, without being industry-specific. Lenders and borrowers should under the circumstances attempt to strike a balance between what is required to create a positive change while being realistic to ground realities and challenges involved in implementation and monitoring. Failure to do so can cause commercial and legal risks to both lenders and borrowers. This also tempts them to resort to deceptive practices like greenwashing or bluewashing. As per PWC's global investor survey, 87 percent of investors lacked trust in monitoring mechanisms and disclosures made by corporates and lenders. It is expected that the phased implementation of the recent SEBI framework will improve the credibility of monitoring and reporting on sustainability. Gradually the regulators will start cracking down on misleading ESG claims.

Corporate borrowers who don't position themselves appropriately and implement respectable ESG targets may encounter difficulties in obtaining finance or may have to obtain finance on less favourable terms. The SEBI framework provides them adequate preparation time to address challenges currently being faced and be ready as ESG KPIs become as important parameters as financial parameters in the emerging financing model.

Ashok Haldia is the past secretary of the Institute of Chartered Accountants of India. Views are personal, and do not reflect the stand of this publication.