New Record High and More Transparency Thanks to an EU Initiative
Just as expected, the market for green finance (i.e. financing that may be used exclusively for sustainable projects or where the interest expenses are linked to the key sustainability figures of a company) is heading towards a new high this year. On a global scale, “green bonds” alone were expected to reach a volume of USD 250bn in 2019, and that is without including loans that have a sustainability component and green notes payable. Even if actual numbers will probably fall short of these forecasts, an increase of around 20% in comparison to the previous year still makes green finance a driving force. The number of corporations (as opposed to financial institutions and government institutions) involved in this kind of financing is getting closer and closer to 50%. Even German corporations that had been rather inactive in this market segment in 2018, called attention to themselves with some transactions (for instance, Porsche with its green bond, Voith with its green loans and Baywa with its green bond).
The numbers as well as current surveys show that more and more companies are also considering ESG (Environment, Social, Governance) factors in their financing activities. What’s crucial here is that they change the perception of a company. The public increasingly expects that companies meet their social and ecological responsibilities (especially related to the climate protection goals). Surveys showed that the majority of companies involved with green finance are not necessarily in it for a pecuniary advantage due to better conditions. The main reason for engaging in this type of financing are expected marketing advantages.
A further reason is investors’ great demand as many investors include sustainability components in their investment decisions. Research in 2019 showed that 78% of institutional investors include sustainability factors in their investment process (globaltreasurer.com). In comparison to the previous year, this is an increase of nearly 15%. In part, the drive to include ESG criteria is no longer a purely company-internal decision related to risk and profitability aspects. Rather, it is influenced by EU law. For instance, the European Directive on the Activities and Supervision of Institutions for Occupational Retirement Provision (IORP II Directive) prescribes that these institutions shall provide information to what extent ESG aspects have been taken into consideration in their investment decisions. Apart from the fact that investors are increasingly demanding green investment possibilities (thus augmenting the potential for green financing at corporates), in the future, treasurers should also be prepared to meet regulatory requirements which may necessitate that investments are also scrutinized for sustainability factors.
Whilst the development is rapid, it could become even faster. Ever since the ESG criteria have become a part of investment and financing processes, one of the main pain points is that there are few standardized criteria in order to make green financing (bonds, debt instruments, loans) more comparable. ESG ratings provided by agencies, such as MSCI, ISS Environmental & Social Quality Score, RepRisk and Sustainalytics, are good indicators but in view of their individualized yardsticks used to measure the concept “sustainability”, they are not necessarily comparable. The same is true for admission criteria to sustainability indices, such as the MSCI World ESG Index, the Dow Jones Sustainability Index (DJSI) and the FTSE4Good Index. Another general problem is the fact that ratings as well as indices only become relevant for companies of a certain size.
The G20 and the European Commission also recognized this problem some time ago and decided to tackle it with the help of several initiatives and technical expert groups. The goals of these initiatives are:
- realigning capital flows to sustainable investments in order to create sustainable growth;
- managing financial risks caused by climate change, environmental deterioration and social aspects;
- pushing for transparency in financial activities and making these more long term.
Specifically, these goals were addressed in the following initiatives:
- the development of a classification system valid across the EU (the so-called taxonomy) in order to determine whether an economic activity is sustainable;
- an EU standard for green bonds;
- benchmarks for climate-friendly investment strategies;
- recommendations to improve ESG-relevant data in companies’ financial reports.
Especially the first two points have come a long way:
The report published in June is the base for future EU legislation used to classify companies’ activities that is binding. It contains criteria to determine whether entrepreneurial activities in the sectors production, agriculture, forestry, energy, transportation, water management, garbage disposal, information and communication technologies and the building and construction industry are sustainable. This comprehensive view of the various sectors in connection with the use of scientific methods to determine the impact on sustainability, including the use studies, is without parallel at this time - not even any of the use cases are comparable to this. Moreover, the report not only scrutinizes trades that are already deemed sustainable but it also takes a look at where investments would make the most sense to bring about a change to a more sustainable economy.
EU standard for green bonds
The EU standard for green bonds currently under development goes hand in hand with the taxonomy described above. The proceeds must benefit one or several of these goals (e.g. the avoidance of pollution) described in the taxonomy and should not be to the detriment of another goal. In doing so, defined social standards have to be adhered to. Furthermore, the company must publish a framework, which states in detail how it intends to ensure the achievement of its goals. The decisive element in this process will be the binding use of an allocation report (how the company intends to use profits) as well as an impact report (what kind of impact the action has on the environment). Both the framework and the allocation report must be verified by an external verifier. It is expected that after an initial transitional phase, the ESMA (European Securities and Markets Authority) will be mandated to do this. These requirements are not fundamentally new and to a large degree already applicable today. However, Corporate Finance should consider the specific criteria of the taxonomy and think about getting an accreditation for EU Green Bond in order to mitigate any market disadvantages that could arise due to a lack of certification.
Corporate Finance departments and treasurers that do not consider green financing just another fad should examine the EU initiatives on improved comparability of green financial instruments carefully. Studies made with asset managers showed that they will be using the EU taxonomy when implementing their investment strategies. Whilst the taxonomy is geared mostly to bonds, the criteria may also be used by banks when granting so-called green loans. The taxonomy is not yet complete by far and focuses mainly on the E in ESG. However, this is a work in progress and will continue over the coming years and as such, should remain on the radar of treasurers. It has been known already for some time that treasurers will have to become more aware of demands for and the monitoring of ESG factors. The development of the taxonomy means that standardization has come a step closer, possibly allowing for more meaningful and comparable ESG KPIs and benchmarks.
Source: KPMG Corporate Treasury News, Edition 96, November 2019
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