The pace of change among corporates and financial institutions to innovate in a bid to transition away from carbon emissions and to improve social and governance credentials has stepped up a gear in the past two years.
COVID-19 and climate change have acted as amplifiers, galvanising corporates to set more ambitious targets or bring forward environmental, social and governance (ESG) goals.
November's Glasgow staging of COP26 – the influential UN Climate Change Conference that was delayed by a year due to the pandemic – is also focusing the minds of business leaders to take more decisive action.
“Far from being eclipsed by COVID-19, ESG issues appear to have risen in significance as the impact of the pandemic has become clearer,” says Rebecca Perlman, the UK, US and EMEA regional lead for the ESG Practice at law firm Herbert Smith Freehills (HSF).
“It’s made businesses and lenders more aware of the risks posed by black swan events, and the need for strong governance and resilience.”
The flow of capital flow over the next four years will be increasingly directed towards the more progressive and ESG-focused companies
Many organisations, public and private, have responded to the ESG challenge with ambitious targets, but depending on the sector or geographic spread of their operations, corporates are at very different places on the maturity curve.
What is more, there is no one-size-fits-all solution, so treasurers have been working hard with boards – oftentimes with no immediate substantial financial benefit they can promote – to develop financial structures that match corporate ESG targets.
“The challenge around ESG is that it is quite broad,” says Naresh Aggarwal, associate director, policy and technical, at the Association of Corporate Treasurers (ACT). “It’s got three different components: E, S and G, and so the one that most people have fixed on is the environment. Part of that is because we’ve got the Paris Agreement.”
That said, some organisations have been successful in the markets with so-called social bonds. For example, back in 2017 the National Australia Bank (NAB) issued a ‘gender equality’ social bond.
The NAB bond was oversubscribed, tapping into the trend for ethical investments and allowing the bank to borrow more cheaply and lend to clients with robust gender-equality credentials more cheaply.
NAB's bond issuance is one example illustrating how the markets and treasury functions are responding to ESG-focused products showing that they aren’t just the ‘right’ thing to do, but they make commercial sense, too.
However, overall the focus on new products remains fixed on the ‘green’ variety of loans and bonds rather than the social or governance aspects of ESG.
But what markets are increasingly looking for is the tone at the top of the organisation, and how well embedded corporates’ ESG targets are into the wider corporate strategy, as well as the culture of organisations, says Aggarwal.
Kristen Roberts, head of corporate debt at HSF, says: “Sustainability-linked loans are taking off because they’re one of the easiest to implement and one of the best techniques of moulding financing to a corporate challenge.”
Given that by 2025 more than half of funds in Europe will be ESG funds, according to research by PwC, the flow of capital over the next four years will be increasingly directed towards the more progressive and ESG-focused companies.
That should be incentive enough for any treasury function with a long-term profitable and sustainable vision.
“There was a sort of a historic understanding of ESG as being perhaps more a set of reputational, ethical or moral concerns, and therefore possibly dilutive to financial value. But now the predominant view is that ESG factors can be financially material to business,” says HSF’s Perlman.
Naturally, there are challenges ahead. ESG fundraising is a nascent business and evolving fast, so everyone is learning the ropes.
For the treasury team, the exercise of rewiring the capital structure to adapt to a wider corporate ESG strategy is not to be underestimated – for three, key reasons:
1. it is time-consuming;
2. the process of producing sustainability reports for verification and assurance is equally laborious, and
3. the initial financial gain may not be substantial.
Add into the mix the prospect of greenwashing, and the whole project may sometimes feel like a significant uplift in workload for little gain.
Investors are increasingly wise to greenwashing – but it remains a concern, according to Silke Goldberg, chair of HSF’s ESG Practice. “Greenwashing is certainly on people’s radar,” she says. “And one of the issues in this context is jurisdiction. In some jurisdictions I can go set up a fund that has oil and gas in it and three wind farms, and say ‘this is a wind-farm-inclusive fund; look, I’m green’. The absence of binding standards is a concern.”
Europe has now established an ESG taxonomy as a binding standard. The taxonomy continues to evolve, however. There are still gaps in regard to the social aspect of ESG.
Goldberg is optimistic that the EU standard will become a kind of ‘soft law’ irrespective of whether a company is EU-based or not. If a company wants to do business in Europe, ultimately it will have to comply with EU rules.
In terms of ESG standard setting, there are multiple organisations around the world working on different sets of standards. Europe is leading the way on ESG standard setting, but it is hoped a globally accepted set of ESG standards will be imminent.
The International Financial Reporting Standards Foundation is currently consulting on constitutional changes to set up an International Sustainability Standards Board.
Aggarwal says: “One of the things that we’re seeing is a bit more coalescing of standard setters. I think everyone recognises it’s a real problem.
“We’re seeing a gradual evolution to more consistent standards and ways of measuring. A lot of work is being done to look at how disclosure can be made easier for companies and more informative for the investment community.”
Corporate ratings are also a concern. Are rating agencies keeping pace? There are worries about the risk of downgrades arising from some unilateral change to a ratings methodology, because rating agencies are still developing rules. Methodologies can change from one year to the next and that can result in downgrades.
Goldberg says: “It depends on the standards, and how transparent the rating criteria are. What is acceptable to one rating, might not be acceptable in another one or they might focus on different KPIs. To be credible and reliant the criteria for ratings need to be public; they need to be transparent and follow ESG standards.”
Christopher King – group treasurer of renewable energy company Drax Group – says: “Credit rating agencies are doing a good job. They’re starting to enshrine ESG in their credit rating methodology today, and typically today, it is not a very big impact for most organisations. The bigger question is: what will it be in five or 10 years’ time?”
Whatever stage a business is at in terms of embedding ESG into the treasury function, the pressure is on and it’s coming from all stakeholders both internally and externally. We are at the beginning of a huge and evolving transition, and it is starting to prove fruitful to the most progressive organisations.
Crucially the clock is ticking. If corporates want to access well-priced funding in the markets in the coming years, their ESG credentials will have to be impeccable.
Treasurers can be at the forefront of helping embed that change.
As a renewable energy firm, Drax Group began its decarbonisation transition process from 100% coal generation to renewables around 10 years ago. The UK company, based in Yorkshire, has pledged to become carbon negative by 2030.
To begin the treasury’s ESG journey, group treasurer Christopher King began with a term loan – which are generally easier than bonds. The aim was to develop one clear metric into the financing structure that incentivised the organisation as well as enabling banks to design the appropriate funding structures to satisfy the ESG agenda, King explains.
“It was relatively simple. It was aligned to our sustainable reporting in our annual report, so that made it easier for verification and the audit process for the banks,” he says.
King says that the financial implications weren’t significant, but it drove change within the organisation to meet the target. The big change for Drax and the treasury team was to provide it with ‘a template of a methodology that made sense’.
King and his team then went on to apply that methodology across all its spheres of capital structure and working capital facilities. Later the treasury team enshrined the methodology within the company’s revolving credit facility, and more recently the treasury team has also become one of the first to enshrine it in its derivatives book.
A real gamechanger for Drax, and other organisations – including governments around the world – is how to incentivise banks to create funding models for bioenergy with carbon capture storage.
King says: “We’re very carbon intense, so therefore thinking about sustainability is key. But still you need to be front-footed to make sure you’re not caught off guard.”
Tesco is another example of a high-profile corporate taking a lead. In 2017 the supermarket chain became one of the first companies globally to set science-based climate targets for its own operations on the 1.5-degree trajectory of the Paris Climate Agreement.
Last year, Tesco brought forward its net zero climate target in the UK to 2035 from 2050. And in January the retailer launched its first sustainability-linked bond of €750m, linking its financial strategy to its long-term commitment to tackle sustainability.
Natasha Vowles, head of treasury for funding, led on the supermarket’s revolving credit facility and the sustainability-linked bonds that the supermarket chain issued in January.
Vowles says the market reacted well. “Investors are very engaged on ESG funding. The transaction was very oversubscribed, and we were delighted with how it went. We were using the proceeds to buy back some of our existing bonds.”
Tesco is also set to become the first UK retailer to offer its suppliers sustainability-linked supply chain finance. Under the voluntary programme, due to launch in September, suppliers will provide annual greenhouse gas emissions data that will be independently verified and assessed.
Alex Ashby, head of treasury markets at Tesco, says: “Suppliers can get paid on their invoices, if they choose to do so, early, so it means they’re able to unlock that at Tesco’s cost of funding or equivalent.
“It’s very cheap for some of them; not every supplier is interested, but what we’ve done is implemented a sustainability link there.”
Vowles explains that one of the critical starting points for the Tesco treasury team was consistency in the KPIs used and measurability of those KPIs.
“We’ve made sure that there’s consistency in how we’ve approached the ESG linked to our financing," she says. "That we’ve used consistent KPIs throughout and it has all been based on our sustainability strategy. That was our starting point, and just making sure that the KPIs we had were measurable, robust and ambitious.”
She adds: “As the market grows, it will indicate to others that having a really strong corporate social responsibility strategy is beneficial to your funding, and hopefully that will help people see the benefit.”
Michelle Perry is a freelance finance writer and editor
This article was taken from Issue 3, 2021 edition of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership