Green rush

Madni based his thesis on an analysis of more than 300 companies over the last decade. He runs Panarchy Partners, one of Singapore’s newest funds for accredited and institutional investors; the fund is committed to investing in companies that have strong sustainability targets in addition to financial performance. About 9% of the fund is in banks, which in the last few years have come under increasing scrutiny by investors to get more sustainable assets on their balance sheet.

“Banks are not like other corporations. They have dual challenges — not just to be sustainable themselves, but their loan books are coming under scrutiny,” explains Madni. “The rules of the game have changed; there are now risks [for banks] if they just focus on financial performance.” Panarchy will not hesitate to remove banks from its portfolio if they fail to meet pre-set sustainability targets, such as a reduction in loans given to companies involved in fossil fuels over a specific period of time.

Importantly, Panarchy’s investors are in it for the longer term. “Our investors are not looking to beat the benchmark in 18 months. They want to see environmental and social impact while [reaping] long-term financial returns in three to five years,” Madni says.

Madni is not the only fund manager pushing banks to relook at what constitutes financial performance. Jerry Goh, the Asian equities investment manager at Aberdeen Standard Investments, pushed Maybank in Malaysia to set guidelines for borrowers to improve their sustainability practices. Part of the reason for that move was that Aberdeen’s own investors were pressuring it to do so. The other reason is the fear that assets involved in what are seen as unsustainable practices today could end up being stranded, or become liabilities or written down, if and when regulations kick in, which would in turn affect the funds’ performance.

It is the resolve of these investors that has put pressure on banks to take sustainable financing more seriously in the past few years. For decades, banks had been accused of paying lip service to responsible lending. In 2018, sustainable debt, or loans that were linked to sustainability activities or goals, totalled US$247.7 billion ($341.3 billion), still a fraction of the vast US$244 trillion global debt market.

In the last two years, however, a new breed of sustainable lending has been growing rapidly. The value of the loans, dubbed ESG-lending or sustainability-linked loans, jumped more than seven times last year from the year before to reach US$36.4 billion, according to BloombergNEF’s research. ESG lending accounted for about 15% of global sustainable debt in 2018. In comparison, green bonds, or loans for environmentally friendly projects, grew only 5% last year to US$182.1 billion, though they still made up 74% of the sustainable debt market.

A major difference between an ESG-linked loan and a green or social loan is how the money can be used and the interest rates tied to the loans. Green loans must be used for the development of environmentally friendly projects. The pricing is also fixed. Some argue that such conditions for the use of proceeds limit the growth of green loans.

In contrast, ESG-linked loans provide borrowers with more flexibility, as they can use the funds for any purpose. Virtually any company can apply for these loans, which opens up a much bigger market. But, while such loans work just like any other, they come with a caveat. If borrowers meet pre-set ESG targets, they will be offered a discount. Conversely, depending on the loan structure, they may be penalised if they do not meet the targets.

One of the first of such loans, a €1 billion facility in 2017, was inked between ING Group and Dutch technology company Philips. Other banks such as Rabobank, BNP Paribas, DBS Group Holdings, Standard Chartered and HSBC Holdings have also been involved in such loans. One of the latest is a TWD2 billion ($87.3 million) loan from DBS Bank to Taiwanese manufacturer AU Optronics Corp. In Singapore, Olam International, Wilmar International, CapitaLand and Chew’s Agriculture have taken ESG-linked loans.

According to industry observers, most of these loans have a discount of five to 10 basis points on average, which is not significant on its own. In any case, as an industry insider says, companies are interested in ESG-based loans as a way to appease stakeholders of their commitment to do good — rather than the financial incentives.

But one borrower, Olam, says it is looking for more ESG-linked loans, and taken together, they would offer substantial cost savings.

Indeed, the market for sustainability-linked loans is expected to surge. Some observers expect it to be a mainstream product soon, given the pressure that investors and regulators are applying on financial institutions to increase their socially and environmentally conscious assets.

Yet, there is no real way to measure the positive impact of such loans. And this could very well be the biggest hurdle that stands in the way of the sustainability of this particular segment of the debt market. Without real impact on communities and the environment, the risk is that the ESG-linked loan industry would die out, much like the ethical investing trend in the 1990s.

To begin with, there are no universally accepted requirements or standards on the targets set for sustainability-linked loans. What is needed are criteria that are agreed upon by borrowers and lenders. Some loans use measurable targets such as carbon emissions, others rely on ratings given by one of the many agencies, including Sustainalytics, RobecoSAM and MSCI, which have very different methodologies to assess sustainability, making it hard to determine the impact of these loans.

A new study by the American Council for Capital Formation (ACCF) found that ESG ratings tend to be better for bigger companies or those in countries with greater disclosure. This raises the worry that loans that depend on third-party ESG metrics and ratings do not reflect the true efforts of “doing good” but are reflective of companies’ ability to comply with reporting requirements.

As sustainability-linked loans take off and significant funds are channelled there, the industry can benefit from standards to ensure the efficient and sustainable allocation of resources.

Great expectations

Even before today’s versions of sustainability-linked loans were formally devised, some banks were already heading in that direction — though not necessarily with the incentives that current facilities offer. More than a decade ago, Standard Chartered told one of its customers, a shipbreaking firm, to revamp its entire yard and provide new workers’ accommodation, a waste facility and other amenities to create a safer working environment. It cost the ship-breaking company more than US$5 million. The bank did not finance the changes.

“In the beginning, I think [the ship-breaking firm] did it because it just wanted access to financing from an international bank,” says Roger Charles, the bank’s director of environment social risk management. “But now, they see value in it because shipowners [such as Maersk] today have a mandate [from their shareholders] to use responsible yards.”

Last year, the Bangladeshi government implemented new rules for ship-breaking yards. But the bank’s customer was not affected because of the changes made earlier, following the bank’s request.

“Shipowners would sell the ships [to our ship-breaking customer] at a [substantial discount],” Charles says. “[The ship breaker] is on its fourth green contract.”

While there are many borrowers who would comply with, and benefit from, sustainability-linked requirements — as in the case of Standard Chartered’s ship-breaking customer — industry insiders say it would be harder to introduce such requirements in emerging markets. “Banks are in a difficult position,” says a banker who asked not to be named. “They need to tap the growth in emerging markets where environmental priorities are not the highest, [while] pushing for sustainability performance.”

One way would be to incentivise companies to adopt sustainable practices through ESG-linked loans. Such incentives typically take the form of lower interest rates. According to the banks that The Edge Singapore spoke to, the interest among corporates in Asia is growing, although ESG-linked loans are still a relatively new product.

At this point, however, some banks concede that there is not much money to be made from these loans yet. “It is more of reputational risk, which has been amplified by social media in the last 10 years. There is an expectation from investors for banks to do the right thing. Banks need to protect themselves,” Charles says.

In fact, regulatory pressure that would hurt the banks’ balance sheet is their main worry. “Every financial institution in the world, especially the European ones, is undergoing significant regulatory review under Basel IV and the EU Sustainable Finance work streams,” says Herry Cho, head of sustainable finance, Asia-Pacific, ING. “We don’t want stranded assets on our balance sheet. By future-proofing our clients’ businesses, we are naturally future-proofing our own.”

So far, ING has been involved in more than 50 ESG-linked deals. In 1Q2019, it participated in 16 loans. About half of its borrowers have hit pre-set targets and received discounts. None have been penalised by the bank yet.

Not a desktop exercise

The driver of sustainability-linked loans is the argument that companies with stronger ESG performance will do better financially over the long term. Yet, quietly, some bankers and industry insiders concede it is still difficult to measure how specific ESG factors affect corporate risks.

Measuring impact would be necessary for corporate lending for good to grow — and do so sustainably. “Investors are looking for sustainable targets because they want something [more]. They want investments to have a good impact. This type of loans is viable only if it [can be] convincingly proven that the product can establish good outcomes,” says Bo Becker, professor of financial economics at the Stockholm School of Economics.

“In the 1990s, in the equity fund space, there was interest in ethical companies. It is not so different from what we have now,” Becker says. But investors were eventually disappointed because the outcomes of what amounted to ethical investing then were unclear. “No one questioned the financial performance, but no one understood the [social and environmental] outcomes either,” he adds. “It would be better for the market to grow slowly and honestly.”

Banks are nevertheless putting in place safeguards to secure their investments, using only ESG criteria that are measurable and, according to some, “ambitious”. Most banks handing out sustainability-linked loans use metrics set by independent assessment firms such as Sustainalytics. The targets for borrowers are also audited by these independent bodies. These targets could be as specific as the precise amount of greenhouse gas emissions reduced per tonne of products produced.

“The rule of thumb is that we set targets for customers that are ambitious but achievable — something that can be earned rather than implicit and given,” explains Yulanda Chung, head of sustainability, institutional banking group at DBS Bank. The bank has given out four such loans worth $688 million since last year.

“We do not want to be involved in transactions that are self-certified without ­adequate third-party reviews. Typically, we would want to look at companies’ existing reporting and assurance framework, to see whether they have a reputable third-party assurer in place,” says ING’s Cho. “We want to see if [sustainability efforts are] part of their strategic vision and correctly measured with third-party input.”

Meanwhile, as demand for third-party assurance rises, it is generating new business for assessment firms and rating agencies. The number of firms assessing companies’ ESG performance is also growing. In January this year, Fitch launched its ESG scoring system. In April, Moody’s acquired a majority stake in sustainability assessment firm ­Vigeo Eiris.

Manjit Jus, head of ESG ratings at RobecoSAM, says he is beginning to see some companies using RobecoSAM’s corporate sustainability assessment to get an ESG-linked loan. Last year, 993 companies participated in RobecoSAM’s sustainability-focused questionnaires that aimed to evaluate sustainable practices across industries.

Starting point

Despite the growth, the sustainable debt industry is still nascent. One of the most common methods of assessment is to look at a company’s operations. But Jus says RobecoSAM is beginning to look at the “unintended consequences” of the company’s operations. “It is very difficult. For instance, if a company is environmentally positive, but it produces drinks that have high sugar levels, what is the impact?” he says. RobecoSAM is also looking at the concept of a living wage, but Jus says there is a lack of data needed to create standardised scores in this aspect across industries; it might be a few years more before assessments can be made available to investors.

In fact, the banks were among the first to push for more standards to enable these loans to grow. “There has to be a clear connection between [the ESG targets that we set] and the borrowers’ [long-term] sustainability strategy. If we are talking about transition, what are they transitioning to?” notes DBS’s Chung. This is also to ensure that the companies are serious about lasting environmental and social commitments.

In March, the Loan Market Association, the Loan Syndications and Trading Association, and the Asia Pacific Loan Market Association unveiled a framework for these sustainability-linked credit lines. Borrowers should provide up-to-date information relating to the targets set for the loan at least once a year and are encouraged to disclose this information publicly. Targets have to be more ambitious than what the companies have achieved and must be assessed by independent firms.

But, even with such guidelines in place, industry players still cannot agree on what counts as a company’s social and environmental responsibility. For instance, the impact of an agricultural company’s activities would be vastly different from that of a construction firm’s. In addition, agricultural companies with different business models do not share the same risk, according to ACCF, making them harder to compare. There are no universally accepted ESG scores that would have a material impact for various industries. Even then, measuring social impact on communities has historically been costly, challenging and time-consuming — it can take years before the outcomes can be assessed. And, companies are likely to baulk if the conditions stipulated are too onerous, and consider the small discounts dangled by the banks hardly worth the trouble.

The guiding framework by the loan associations is a good first step. But as the industry grows, future frameworks are likely to be more prescriptive as well as industry-specific for companies to take ESG targets or ratings more seriously, and for lenders to make the most impact with their loans. An argument can only be made that lenders may need to raise their incentives for corporates to really invest in meeting ESG targets.

“There are no teeth in any framework, as far as I know. For teeth, you might need to have one or two big transactions scrutinised,” says a global sustainability consultant. “To be fair, there is no one measurement that can provide a solution to this issue. Take the palm oil industry: There are things we should not compromise on, such as burning on peat land. We need [to define these rules].”

For now, Panarchy’s Madni sees the industry as still evolving. But he also does not see the need to rely on the rating agencies for his investment calls. “At this point, it is still [too early] to say there is a direct link between sustainable impact and financial returns,” he says. “But, intuitively, you know you won’t get into trouble with regulatory changes if you are lending to companies that use more [sustainable] resources.”