In the past few years, the financial sector started acknowledging the important effects of ESG-related problematics in their long-term investment and credit portfolios. Starting with the alarming pace of climate change, lenders and investors realized the amount of power they had in their hands to help prevent further issues related to this matter. As a response, the industry began developing solutions that promoted better resource and funding allocation. The first initiative was the well-known green bonds; however, now the menu includes several variations, in both bonds and regular lending, based on topics such as social, sustainability, SDG and gender, catering to a broad range of companies and values.
Many people believe this is absolutely revolutionary. Transition finance, the name under which this revolution is more formally known, started with the “labelled use-of-proceeds” financing. An example is the aforementioned green financing (loans and bonds), through which monies must be used in funding clearly identifiable and traced green projects (i.e., projects that provide clear environmental benefits). Social financing, another example, is subject to the use proceeds in facilitating economic activities that mitigate social issues and challenges. Realizing that this sort of instruments had reporting limitations, the industry created the next step in sustainable financing: performance-linked (or sustainability-linked) financing. With this option, discount factors in the borrower’s rate could be obtained, conditional to the achievement of ambitious, pre-determined sustainability-performance objectives. In contrast to labelled use-of-proceed financing, the use of proceeds is not categorized, and funds can be used for general corporate purposes.
The shocking fact about transition finance is that despite of being a relatively recent innovation, volumes have risen dramatically. In 2020, green, social, sustainable, and sustainability-linked bond issuances nearly doubled those of 2019, reaching US$ 600 Bn globally. This rate of growth is expected to continue in 2021. Transition financing has been boosted by recent events that have impacted the world as a whole, such as the USA re-joining the Paris Agreement, the COVID pandemic and social movements such as Black Lives Matter, and it definitely came to stay. Moreover, it is being fueled by clearer rules and the embracing of several financial actors such as the ECB, which communicated the acceptance of green bonds as collateral, and credit rating agencies, who are gradually integrating ESG criteria in their evaluation methodologies.
Moreover, international regulators have been outlining initiatives to promote sustainable finance, such as the European Banking Authority and the European Commission. Both entities have issued ESG-related action plans for financial and non-financial institutions regarding, among others, disclosure and reporting; risk definition, monitoring and management; and general ESG supervision. The final goal is to reorient capital flows towards sustainable investments and delineate clear rules, leaving no room for ambiguity.
What does this mean for companies? Businesses seeking funding must have a clear ESG strategy as banks, institutional and private investors integrate ESG matters into their business as usual. Companies that fail to integrate environmental, social and governance metrics and KPIs into their business models will risk being less eligible for financing, as well as having a harder time when looking for investors. Transition Finance is also a tremendous opportunity for the early incorporation of the Environmental and Social dimensions into a company’s strategy as well as strengthening its governance. At Ernest Partners, we are continuously tracking trends in the lending and investment sector, including sustainable and transition finance. We make sure to accompany our clients and advise them regarding their best approach in this matter, with the objective of allowing them to obtain the best and most suitable financing solution, with the widest range of choices possible.