By Marc Naidoo, sustainable finance partner in the London office of international law firm, McGuireWoods
It would be trite to assume that the readers of this piece are unaware of the issues facing the environment and, sometimes forgotten, the people therein. Historically the custodians of sustainability within financial markets have been developmental finance institutions. Their role has been that of king and kingmaker, in the sense that they have directly funded sustainable projects and/or used a combination of blended finance and de-risking structures to push capital where it was needed the most. However, as the challenges facing our planet intensify, so to does the spotlight around it, and as we all know, spotlights can be dangerous.
The buzz word is ESG.
I’ve also purposely described ESG as a word, given that the 3 building blocks of what ESG is supposed to be seems to have fallen away to just matters that involve the environment. Which is probably the reason behind the lack of over-the-top branding from development finance institutions with regard to ESG, as this is business as usual for them and they truly understand that sustainability is a multifaceted solution to many global challenges.
The same cannot be said for the private sector, with regard to financiers and advisors alike. Unfortunately, everyone would like some time in the spotlight (or a piece of the ESG cake as you will), but sometimes the means does not justify the ends. For advisors that have been working on sustainable finance matters for several years, there was no clamour to suddenly be seen as the Robin Hood of their respective fields, however there was a concern that the market is becoming saturated. Competition is good in any sector, but it needs to be a case of quality over quantity. Advisors and financiers need to be adding value to the current market, and treating sustainability as a long term problem to solve, and not a lottery ticket. The issues that arise with a sudden influx of experts are many, but in particular: (i) retrospective portfolios do not offer a fair reflection of an institution’s ability to handle sustainability correctly; (ii) advisors are untested and run the risk of upsetting a relatively stable market; and (iii) an almost secondary market exists of “ESG Clubs”, which are just rebrands of existing networks which are being repurposed as ESG.
$200 billion in deals done. $100 billion in renewable deals concluded. These are but a few of the tag lines used when market participants advertise their ESG credentials. But what do these numbers and claims actually mean, and how to they translate to a credible stable sustainable finance market? One has to examine the data on which these claims are made, and how they fit into the broader sustainability matrix. It seems the power of ESG, lies in the power of controlling the narrative around it. Market participants are falling into the trap of trying to create an ESG narrative by retrospectively filling portfolios with previous deals that can be considered as sustainable. There are of course some financiers and advisors that are justified in this approach, and they should not be chastised for pointing this fact out in a market which is becoming murky with the influx of so-called experts. The issue lies in the market participants who are seeking to share the spotlight and enjoy the gold rush. Perhaps robust definitions of what sustainable finance is has contributed or enabled this strategy, or even a very simplistic reading of the UN Sustainable Development Goals. The perils of this approach are that the fundamentals of what sustainable finance is: do good, but, do no harm. This juxtaposed position must be followed religiously when approaching sustainability.
The flaw in retrospectively filling portfolios with past achievements is that by relying on broad understandings of what sustainability is, no attention is paid to the second half of the sustainability equation, which is to do no harm. For instance, a renewable energy deal done 20 years ago is listed as part of the “ESG” credentials of a market participant, but what was the actual net impact on the environment or communities around the project in question? Were the materials used for the power generating asset long-dated and/or easily recyclable? These are very relevant questions that can’t be answered by virtue of looking at a fact sheet provided in marketing material. Similarly, transactions are far greater regulated now than in the past, which means the scrutiny applicable to modern sustainable deals are greater and accountability is actually to third party consultants who can determine whether a deal is sustainable or not. Perhaps the easy option is to go back to a simpler time, the Wild West so to speak, where you can do something relatively good with nobody looking at the nuts and bolts of a transaction to determine whether you can actually use those numbers to bolster credentials. The trap has been set for these retrospective fattening up of portfolios with the ESG craze taking over finance, which leads into the next issue to discuss which is the emergence of the rebranded ESG market participant storming into a market which development finance institutions spent decades stabilising.
Imagine a golfer. Who plays on a certain course by himself / herself, and is very good at that course. Historically he/she always shoots great scores and makes a point to enter a competition on the back of those scores. The catch being that the golfer in question has never had any scorecard signed or verified by anyone else. To casual players, the golfer’s score is believable and impressive and they have seen the golfer hit some good shots at the driving range. To the seasoned players, immediately a red flag is raised that the golfer in question has not had their past achievements verified. The tournament commences and our golfer has an abysmal round and their team loses. The analogy seems simplistic, but is in fact apt. Relying on past achievements that have not been verified only works when the other participants are doing the same. However, when a market participant starts transacting with credible parties, there is a glaring mismatch in understanding of what sustainable finance is. The consequence of this is that negotiations tend to be one-sided, which then creates a skewed impression of what market terms should be. The effect is then a market that cannot regulate itself with wild deviations from what sustainable finance terms should look like. Forget sustainable finance for a moment, but this should not be the case with deal making generally. Deals should always be between willing participants who reach a compromise for a mutually beneficial outcome. Nobody wants to see one-sided negotiations that then change the landscape of the market for the worse. What tends to happen is that the new “ESG experts” then try to build up market presence and validation through other means.
Working groups within the finance world are not something new. They are valuable in having like-minded professionals working together to solve for a market issue. To go back to our golfer, they then decide that playing against the seasoned players is probably going to damage their reputation, so they decide to form a team with all the other newer players so that they can play at a similar level. What then follows is an almost secondary tier of players who believe their entry into more tournaments can be hastened by producing new rules and guidelines on how to play the game better. A case of quantity over quality, but these rules and regulations produced by these side associations seem to pop up in numbers, thus diluting the credibility of future tournaments as nobody knows which rules to play by.
This is the current state of affairs within sustainable finance at the moment. Industry groups that have rebranded themselves as ESG advisors, who then use their network to create a secondary market of financial participants who find it incumbent on themselves to create rules and guidelines around sustainable finance, but without having the requisite experience to do so. These rules and guidelines are flooding into the market at an alarming rate, and then creating the situation where a sustainable finance term sheet starts looking like a checklist of terms that nobody really knows the origin of. The only consequence of this is confusion, and possibly irritation from development finance institutions who will struggle to understand where potential borrowers are getting these terms from. I am by no means saying that industry working groups are a bad thing. Quite the opposite, so long as the leaders of those groups are qualified (currently). Advisors that have been working in the sustainable finance sphere are empathetic with the needs and requirements of their counterparties, but like everything, that empathy comes from understanding.
Each institution is on their own sustainable finance journey, and it is not about how far you are into that journey, just starting it is good enough. A market participant’s role is to guide the market into being credible and stable, irrespective of where on the sustainable spectrum they may be. In order to do that, sustainability needs to be approached as doing the right thing and being patient, and not spotlight grabbing and panic marketing so as not to miss the boon. It is my hope that sustainable finance, just becomes finance. That is still a fair bit down the road, but what is important is that we allow ourselves to start that journey. There is no teleportation device that is going to get us there. A patient approach, where we allow ourselves to learn will ultimately result in a stable and credible market where everyone can participate and add true value. Until then, we should not look at ESG as the fashionable thing to do, ESG is the right thing to do for the planet (including the corporate landscape) and its inhabitants. Eventually we will all be on the same team, but even when that happens we should ensure we keep each other in check.