ESG – The X Factor for Sustainable Financing

The investment creed of today is no longer a simple statement of better returns, quality targets or sound financials. Increasingly, capital flows are being directed into businesses that are assessed to be “sustainable”.

Clearly, whilst investors still require metrics to evaluate the returns on investment or likelihood of repayment, dedicated efforts are being made ensure that corporates fulfil their obligations to their funders in a sustainable manner, backed by detailed quantitative information on how the business is currently run, and projections on how the business will subsist into the future.

Sustainable investing & ESG

If sustainable investing is the overarching ambition of financiers, then Environmental, Social, and Corporate Governance (ESG) is the data matrix for identifying and informing sustainable investment decisions.

ESG measures the long-term sustainability and the societal impact of an investment in a business. However, ESG factors do not lend themselves to a simple one-size-fits-all definition.

“Environmental” generally means the corporate’s performance as a steward of the natural environment. “Social” relates to the corporate’s relationship with its stakeholders, such as its employees, customers, suppliers and the community. “Governance” can refer to internal processes, leadership, board oversight or the policies and practices in place for risk management. Faithful reports on a corporate’s ESG performance or outcomes furnish investors with a comprehensive picture of the corporate’s financial viability and the quality of its management.

Assessments on ESG factors in sustainability reporting demonstrates the threats and opportunities faced by the corporate, providing a useful backdrop for investors to assess if the business strategy meets prospective business demands.

It should be noted that in the current-day environment, climate change merits special consideration as a global issue with manifold and lasting implications. Some sectors, such as energy, transportation, construction and finance are, according to G20’s Task Force on Climate-related Financial Disclosures (TCFD), most prone to climate change risks. Businesses in these sectors will likely need to actively analyse the impact of climate risks on their business activities and fortify their climate change resilience to maintain investor confidence.

Today’s financiers to work into the investment documents the necessary covenants to extract ESG information and updates on a regular basis. Financiers also incorporate stringent reporting requirements and undertakings to track decisions taken by corporates that impact on operational efficiency and strategic directions.

Green loans & ESG

Projects spanning renewable energy, climate change adaptation, carbon mitigation, and smart infrastructure are likely to be eligible for green loans. The financiers extending green loans tend to incorporate ESG principles by imposing an array of stringent undertakings on borrowers. These undertakings typically remain in force as long as any loan is outstanding or any loan commitment is in force. Breaches can (but not always) have financial consequences.

For instance, it is usually common for financiers to require that each borrower must comply, and procure any affiliated group company to comply, with all ESG law, maintain all ESG licences, take all pre-emptive action for anticipatory changes to ESG law and deliver a comprehensive ESG compliance report.

ESG can however slide into an unduly complicated web of scoring, weighting and analytics. For most cases, borrowers do benefit from a good steer in negotiating their green loans to enjoy maximum operational efficacy whilst staying faithful to the ESG principles. This can well start with a keen question on what is the exact definition of “ESG law” which can be drafted in an overly expansive way, leading to unnecessary compliance costs for tracking and reporting. It should also be noted that ESG permits should be clearly set out and defined and some effort made towards ensuring that only commercial reasonably permits should be obtained and maintained. Finally, both the financiers and the borrowers should be aligned on the depth and frequency of the compliance report lest the borrower be burdened with vast documentation which has little bearing on material financial impact and which do not contribute to value creation or risk mitigation.

The G or “Governance” in green loans also cannot be underemphasized. For instance, governance is required to retain the green aspect of the financing for the entire duration of the loan, be it a green building or a carbon mitigation project. A green breach will likely downgrade the green loan into a traditional loan and the financial fallout will likely be severe. Stringent governance is also required to ensure that green loan proceeds are clearly earmarked and carefully tracked either by a clear funds flow process or a designated banking account.

No-one- size- fits-all ESG

ESG is meant to keep the corporate nimble – alert to risks and alive to opportunities. Properly harnessed, it can clearly lead the corporate on the right track of being sustainable and fit for investment. However, there is no-one- size- fits-all ESG formula so the funder and the corporate have to be ad idem on how ESG principles can be effectively implemented so that the business can be assessed on the right qualitative metrics and be funded to perform not just for the now, but also for the future.

This article is produced by our Singapore office, Bird & Bird ATMD LLP, and does not constitute legal advice. It is intended to provide general information only. Please contact our lawyers if you have any specific queries.

Latest insights

More Insights