By Marc Naidoo, finance partner in international law firm, McGuireWoods’
Ignorance is sometimes bliss, especially in the context of being an end consumer. A verification here, a badge there, and suddenly a product can have the affect of allaying the need to be, and be seen, as environmentally and socially conscious. In no way is this intended to be a slight on those consumers who are trying to do the right thing, but rather a platform to ensure that those good intentions are being channelled into a more accountability driven goods and commodities ecosystem.
As with any structure, accountability starts and is driven from the foundation. In this instance, I would regard capital (debt or equity) and use thereof as a suitable foundational point on which to build a framework for ESG accountability. Private sector financiers are relentlessly driving the ESG movement through the use of sustainable finance instruments. The task has been made somewhat easier (or challenging depending on how one looks at it) due to more robust credit evaluation criteria as well as internal and external stakeholder pressure. Pleasantly surprising, is the increase in number of social and governance linked instruments, which shows a maturity in the market as market participants migrate to other issues besides environmental concerns which has been dominant in the sustainable finance landscape. The ever-present conundrum is the approach to finance where there is an element of unsustainability in the underlying product or business. My view is that by mitigating harmful actions across a structure, the less desirable ESG outcomes of a business’ operations may be mitigated as well. ESG must be looked at within the context of an ecosystem, and not ring fenced with a purist view that would either shun existing businesses, or drive those businesses to financiers where there is less accountability.
The flexibility around mitigating the negative impacts across a business’ operations can be fully realized through trade finance instruments. The principle extends to both hard and soft commodities, as an analysis needs to follow the journey of the goods from source to end consumer. Similarly, and possibly controversially, the principle also extends to “dirty” goods, such as coal and oil, as there is merit in using trade finance instruments to enhance accountability. Just because a product or resource is not strictly ESG compliant, doesn’t mean that the entire supply chain relating to that product or resource can’t be. That is the first issue with the current approach to trade finance. Market participants are too quick to write-off businesses that deal with goods that previously formed the backbone of the trade finance economy, an approach which is short sighted and self-defeating through virtue. The extraction of these resources provide employment for much of the developing world. Separately and equally as important, these resources (for example coal) are needed in the developing world to allow those economies to grow and provide a better standard of life for the people therein.
Trade finance is a method of working with these businesses to create value across a supply chain as well as accountability. By introducing ESG financing terms and technology into the supply chain, businesses are incentivised to “clean up” their respective supply chains which would mitigate ESG concerns on the entire structure, as opposed to a ring-fenced solution which isolates one component of a supply chain and disregards the rest. This is the way where true ESG value can be realised by an end consumer. The benefit of sustainable finance is that financiers and trading houses have the flexibility and freedom to agree on trade finance terms, which can be as boring or creative as the parties desire. Here are a few terms that may be worth noting, which show the importance of trade finance commercial terms in providing true value to the end consumer.
The inclusion of technology related terms within financial instruments is becoming more popular as the world moves to a digitised method of information validation and recording, especially through blockchain technology. Financiers are including undertakings relating to these types of technologies in financial instruments, although we have not seen this concept migrating to a lowering in pricing terms, yet. Trade finance instruments, some would argue, are the perfect platform to expand on these concepts as well as create new information undertakings that could impact the entire supply chain as opposed to just the business operations of the borrower. For instance, whilst a company may deal in a resource such as coal, they could ensure that the process of the goods to end consumer is sustainable enough to mitigate some of the harmful consequences of the coal itself (as mentioned earlier some economies still require coal as a source of power). Blockchain technology can be used to digitise the supply chain and bills of lading, ensuring that at each point in a commodity’s journey there is a set of criteria that need to be met (whether signed off by collateral managers or port officials). The criteria could include carbon footprint on transport, labour practices in extracting the commodity, labour practices in transporting the commodity or even grading levels depending on what is being transported. The information would be tracked on the goods or commodities in question throughout the supply chain, thus creating a clearer representation on the sustainability of the item as a whole, as opposed to a snap call at extraction stage. The requirement to use this kind of technology can be built in trade finance instruments, both as an undertaking and a repeating representation. Better information on supply chains can also help in setting pricing ratchets which incentivise the borrower to continue to monitor the supply chain.
Another possible solution would be to include more robust due diligence measures within a trade finance instrument as they relate to the borrower’s business and counterparties. The enhanced due diligence can be set as an over-arching requirement in a trade finance instrument, which allows lenders to have a look through right on the fundamental operations of the borrower. This would represent a more accurate gauge on the sustainability of business operations, given that the focus would not be exclusively on environmental concerns, but would focus more on social and governance issues. For instance, measuring local procurement, board and ownership composition, review of labour practices and on-site visits to ensure that basic worker needs are met. These are components of a business operation that need to be measured, and which sometimes fall through the cracks given the superficial nature in which some ESG transactions are measured. By moving away from pure environmental concerns, an analysis of the supply chain as a whole can depict the true cost to the World of a product. Trade finance is uniquely positioned to allow that analysis.
Possibly the most novel way to use trade finance to facilitate sustainability, is to allow borrowers to do the right thing while still conducting business in less fashionable sectors. I will re-iterate that there is a need to change the way that the World relies on hydrocarbons, unfortunately that change needs to be measured and with a view to protecting those on the planet who can’t be left in the dark, both literally and figuratively. In this regard, if a corporate must engage in extraction of fossil fuels, or trading in the same, they should be allowed to address other areas of the ESG spectrum to mitigate for this. ESG is not binary, and doing the perceived “wrong” thing should not preclude one from also doing the “right” thing. Addressing these other ESG concerns is already prevalent in sustainable finance transactions. Borrowers contribute to community upliftment, mitigation the damage of their operations as well as adhere to local procurement rules. These usually are covenanted in the finance documents, but may also link to margin ratchets. The beauty of this approach is that there is a large amount of creativity afforded in setting these KPIs, which in turn ensures that the actual needs that need to be addressed are addressed. In this regard, trade finance instruments offer borrowers and lenders the ability to set these KPIs across the entire supply chain. The possibilities are endless, with a few examples being: worker upliftment on transport routes, sustainability awareness training for affected communities and streamlining shipping routes. These can all be linked to ratchets, or could also be simple covenants. The value of trade finance is that a greenfield solution can be provided across an entire supply chain, which in my view is the only sector within finance that can implement this.
There is a role for all financing in making the World a more sustainable place. However, ring fencing sectors and processes within commerce will only partially achieve this. For the average consumer of goods and services, an emphasis on sustainability should look at the big picture, which in turns requires an analysis on the finer details. True value can be realised where there is an understanding of micro and macro economic factors as well as an appreciation of all aspects of ESG. Trade finance in my view is the perfect landscape to create this value and understanding, as no other sector within finance offers more exposure to a supply chain and the nuts and bolts of how end consumers interact with goods. With trade finance instruments acting as the lens under which the finer details can be monitored and mitigated, it allows the sustainability landscape to start painting the bigger picture.
Marc Naidoo is a finance partner in international law firm, McGuireWoods’ London office. His practice focuses on emerging markets, with a particular emphasis on Africa and sustainable finance. Marc can be contacted at firstname.lastname@example.org
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