Banks are heavily invested in environmental, social and governance (ESG), and many have developed specialist ESG teams. ESG is core to most banks’ strategies and they have a real commitment to the E agenda to improve their businesses and to deliver against Scope 3 targets.
ESG and sustainable finance are here to stay and are becoming embedded in the institutional grade sector. A head of steam is building in the small and medium-sized enterprises (SME) sector, but there are challenges.
There are two main types of sustainable finance facilities that banks provide:
- sustainability-linked loans (SLLs): loans for general corporate purposes where the corporate signs up to certain ESG metrics, which, if met, lead to a step-down in the interest rate; and
- “use of proceeds” facilities for specific ESG projects, e.g. finance for green projects, converting fleets to electric vehicles, installing biomass boilers and smart building technology.
For ESG to have real impact, banks appreciate that ESG must become embedded in the “long tail”, i.e. mid-market businesses/SMEs. Data from the Federation of Small Businesses shows that, at the start of 2022, there were 5.5 million small businesses accounting for around half of the turnover in the UK private sector. Banks have tailored products for this sector but are finding challenges with the response of mid-market businesses/SMEs to ESG.
Mainstream banks are openly saying that if their clients do not engage with ESG then they will find it hard to access mainstream bank finance within the next five years. Related to this is the concept of “stranded real estate assets”. Many businesses rely on being able to raise ongoing finance against their factory or office premises.
If businesses do not invest in those assets to make them E efficient (smart building technology, insulation, etc.), then they will, over time, find it difficult to obtain usual commercial mortgage finance.
How to accelerate sustainable finance in the mid-market
SLLs are structured on the basis that the corporate signs up to certain ESG key performance indicators (KPIs) that are agreed at the outset. If these are met, the corporate benefits from a margin discount. The step-down is usually marginal at 2–5 basis points, but it helps fund the required internal monitoring and external verification and certification.
[if businesses] do not engage with ESG they will find it hard to access mainstream bank finance within the next five years
However, for mid-market businesses, the commitment involved in signing up to this can be a disincentive, especially as the cost of external verification and certification can be costly. So instead of businesses signing up to KPIs in SLLs upfront, meaning they then incur ongoing costs of verification and certification, could the banks leave it with the borrower to decide when they want to confirm their ESG performance?
If a borrower can demonstrate at a future point that it is complying with certain KPIs as evidenced by external certification, the borrower could receive a kickback, e.g. discounted pricing on a refinance.
As the sustainable finance market develops, it seems that the introduction of standardised, science-based KPIs is likely. That would have a positive impact in the mid-market because it will reduce the external verification and certification costs referred to above.
The step-down discount with an SLL is marginal compared to non-ESG finance and the same applies to “use of proceeds” facilities. However, a key benefit is brand enhancement for the corporate, because, by committing to such facilities, it is able to demonstrate in a tangible way to its stakeholders its commitment to sustainability.
But that benefit may not be enough for a mid-market business to commit. If the margin differential between a traditional finance product and an ESG-compliant one were to be widened by banks, that could lead to an uptick in the mid-market’s appetite to commit to sustainable funding.
A higher level of promotion of “use of proceeds” facilities to mid-market businesses could help grow the sector. But this promotion should be not in the context of “doing the right thing” (e.g. helping towards net-zero targets), but in helping business owners create more profitable businesses due to their increased sustainability. This could come about by, for example, taking on green finance to invest in renewables and a more reliable and cheap cost base for the future.
With ESG, the predominant focus of corporates is on the E agenda. But we are hearing of bilateral SLLs being negotiated with business professional services firms where the KPI focus is on gender and ethnic balance. The development of SLLs in the S area could be a real positive, as it could lead to further growth of this type of finance – especially at a time when recruitment and retention of people is such a challenge for businesses.
Similarly, “use of proceeds” facilities could develop further in the S space; for example, funding training in the care sector as part of a policy to improve retention and reduce staff turnover.
More on ESG
A final point is the possibility of increased collaboration between banks and tier 1 corporates/original equipment manufacturers (OEMs) so that the latter can provide facilities down through their supply chain to improve ESG performance.
By way of example, UK supermarket Tesco has a supplier finance platform with Santander that suppliers aligned to Tesco’s ESG targets can access. Large OEMs in the manufacturing sector with significant scope 3 objectives are pushing their E standards down to their component manufacturers.
Could sustainable finance lines from banks be provided to OEMs so that they can provide competitively priced finance to their suppliers to facilitate them bringing their processes up to the ESG standards of the OEM?
To summarise
ESG in the mid-market is accelerating, driven by various factors including the continuing development by the banks of their sustainable finance offering and the fact that over time affordable mainstream bank finance will inevitably become less readily available for businesses that do not engage with ESG.
The ESG future might not be quite here in the mid-market yet, but it is coming soon.
Paul Ray is a banking finance partner at law firm Browne Jacobson.
