ESG in Financial Appraisals

The guidelines on what constitutes ESG-acceptable business practice are beginning to standardise, which in turn means the reporting requirements, credit processes and onboarding requirements for borrowers will get progressively stricter. The key is to maintain close and active relationships with lenders while working hard on a sustainability strategy that will produce verifiable and reportable outcomes

Financial appraisals with ESG in mind

Banks and other lenders are increasingly expected to do the right thing when it comes to lending. They still have to put their funds to effective use, but regulators are issuing new ESG regulations and guidance that clearly set the mood for the future. The expectation is that banks and other lenders will use transparent ESG benchmarks and standards as part of financial appraisals, to encourage ESG improvements.

The Sustainable Finance Disclosures Regulation (SFDR) is a clear example of this, with precise requirements on content, methodology and presentation of the information to be disclosed, thereby improving its quality and comparability. Banks and other financial markets will be required to explain how the negative impacts of their investments on the environment and society will be addressed. The need to analyse data and report positively on these issues will steer the future tone and practice of lending. Criteria will favour those businesses and industries that help banks and other lenders tell a positive ESG story, while achieving target returns on lending. The lenders that get ahead of this greening transformation within the sector will also achieve a reputational boost.

Borrowing in this climate

Borrowers need to be aware that lenders must present a stricter regime for lending. If a borrower’s business doesn’t score well against established ESG benchmarks, then its future profitability and even viability may come into question. Beyond credit risk impact, lenders also want to keep their own credentials and brand image green and clean when viewed by their shareholders, depositors, regulators (direct and indirect) – and society as a whole.

For black industries, liquidity will become increasingly challenging, and certainly the cost of money for those industries will rise. In the middle-of-the-spectrum industries, where ESG harm is less clear cut, the key will undoubtedly be for borrowers to have active and close relationships with lenders –particularly when they operate complex groups of businesses.
In addition to conventional funding, there are also emerging and specialist sources of finance exclusive to borrowers meeting ESG criteria – notably, green and ESG-linked bonds. A green bond is where the funding amount is used to finance activities that are specifically categorised as green, whereas an ESG-linked bond is where the issuer promises to use the raised funding to transition towards more green or more sustainable activities.

Getting on board for transparent reporting

When it comes to transparency, banks will be expecting customers to report on ESG matters, and will be doing the same for their own stakeholders. The sooner all businesses show that ESG issues matter, the sooner they can satisfy those scrutinising business activity from an ESG perspective – including regulators. That reporting requirement in itself presents an issue for businesses where data and information management (and/or its underlying technology) requires investment to meet the standard required. Greenwashing, or the overstatement of any element in the information chain, from intent to outcome, will increasingly be found out, and banks are attuned to this in their lending reviews.

The bottom line is that many of today’s voluntary standards will soon become mandatory, and all businesses must recognise that this is a one-way street of increased ESG reporting and transparency, and an integral part of any lending process. Lenders will re-evaluate their client relationships – both old and new, and across all industries, good, bad and grey. The question you need to ask yourself is, is your funding secure.