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FINANCE

What green criteria sustainable finance houses look for when conducting due diligence, and how businesses seeking to attract investment can get their house in order

  Christina Tsiarta

Laurent Le Pajolec

 

What green criteria sustainable finance houses look for when conducting due diligence, and how businesses seeking to attract investment can get their house in order

By Laurent Le Pajolec, Board Member at Kreston Global Member Firm, EXCO A2A Polska 

Christina Tsiarta, Head of Sustainability, ESG and Climate Change Advisory Services at Kreston Ioannou & Theodoulou

 

Introduction 

In a world that has committed to fulfilling its mission of change to prevent global temperatures from exceeding 4 degrees Celsius, as this would lead to an uncontrollable future for the business world, it is essential to adopt and promote active measures that will lead to a reduction of greenhouse gas (GHG) emissions being produced. The alternative, a case of inaction, means passively accepting a series of inevitable consequences, such as water scarcity, flash floods, famines, extreme fires, rapid depletion of natural resources (e.g. fossil fuels, minerals), armed conflicts, internal disputes within countries, extreme temperatures leading to death and/or diseases (e.g. Lyme disease), accelerated melting of polar ice caps and glaciers and rapid loss of biodiversity. 

Green criteria employed by finance houses as part of their due diligence operations (whether that’s for bank financing, insurance, bankruptcy acquisitions, or other services), are one piece of a giant puzzle to compel businesses to operate and grow sustainably. 

In this article we explore green criteria and key performance indicators (KPIs) used by finance houses in their due diligence process currently, as well as green criteria and KPIs that should be ideally used by investors to become change leaders. We also outline how businesses can get their houses in order to attract investment from finance houses. 

Green criteria currently being used by finance houses in their due diligence process

As revealed by the CMS study (2023), ESG issues have risen up the M&A agenda: 90% of respondents expect ESG scrutiny in their dealmaking to increase over the next three years, compared to 72% in 2021’s survey. However, what are the criteria that investors are taking into account today and which ones could they employ in order to make a real impact and move the needle in the business world?

When it comes to evaluating sustainability and environmental considerations in the financial sector, by insurance companies, banks, and venture capital funds, several criteria are commonly used today. The specific criteria may vary depending on the institution, but here are some general categories and factors that are often taken into account:

  1. Environmental Risk Assessment and Stress Tests: This involves evaluating the potential environmental risks associated with the activities and investments of the institution. It includes assessing the impact of operations, investments, and lending on areas such as climate change, pollution, deforestation, biodiversity, and resource depletion. 

Environmental risks include temporary or permanent atmospheric, marine or terrestrial changes caused by human activity that can have significant reversible or irreversible effects. The extent and severity of the risks vary according to the type of sector, the scale of the activity, the type of practices and the location.  The Rio Declaration on Environment and Development (1992) serves as a reference framework for identifying the main environmental risks: climate change, air quality and atmospheric pollution, water resources and water quality, sustainable land management, preservation of natural resources, biodiversity, waste production and management. For example, Societe Generale applies the Equator Principles and the standards that underpin them for transactions of business customers, expecting its customers’ actions to have no harmful impact on society or the environment or, where applicable, to do everything possible to mitigate and then compensate for this harmful impact. 

For stress tests, central banks can refer to the Network for Greening the Financial System (NGFS) which conducts events and research related to climate change. In 2021, the NGFS identified nine policy options for central banks to align their monetary policies with climate objectives, focusing on micro prudential/supervision, macro financial, scaling up green finance, bridging data gaps, and research. It has also developed climate scenarios based on integrated assessment models and data provided by various institutions. These scenarios include current policies, Nationally Determined Contributions, below 2°C target, net zero 2050, delayed transition, and divergent net zero scenarios.

2.Climate Change Mitigation: Institutions are assessed on their efforts to mitigate climate change through various means, including reducing greenhouse gas emissions, promoting renewable energy, supporting energy efficiency initiatives, and adopting sustainable practices in their own operations.

3.Sustainable Investment and Lending: This criterion focuses on the institution’s commitment to investing in sustainable projects and supporting environmentally friendly businesses. It involves assessing the proportion of investments or loans directed towards sustainable sectors, such as renewable energy, clean technology, sustainable agriculture, and eco-friendly infrastructure.

For example Societe Generale Bank decided to stop financing coal in 2016, and in 2017 prepared a financial envelope of 100 billion EUR to finance the energy transition by 2020. It also ended its funding for oil from the tar sands and from the Arctic in 2018 and made a commitment in the same year to measure the alignment of its portfolios with climate change issues through open source tools with other banks.

On the flip side however, PwC prepared a report on green finance in Poland in 2022, which outlined that this stage, none of the banks surveyed plan to increase the costs of financing for what are referred to as “dirty” investments/activities for their clients. For reasons related to the structural challenges in Poland’s economy (including the high share of energy from fossil fuels in the energy sector), banks are refraining from overly restrictive implementations of ESG requirements, such as penalising both producers and users of non-renewable energy through higher loan prices. So there is still a lot of work that has to be done. 

  1. Environmental Compliance: Institutions are evaluated based on their adherence to environmental regulations and standards. This includes assessing their track record in complying with laws related to pollution control, waste management, and environmental protection. 

Here again financial institutions will be more involved to ensure that their activity or investments won’t be touched by legal risks and environment or will correspond to a legal frame. In this category companies will not be judged on their real impact. 

  1. Corporate Social Responsibility: This criterion examines the institution’s broader approach to social and environmental responsibility. It includes factors such as transparency in reporting, stakeholder engagement, employee practices, community involvement, and support for social initiatives.

CSR policies in companies today predominantly target low hanging fruit that are less costly or require limited, if any, behaviour change. There are no criteria requiring companies to focus on actions that will have bigger impacts (i.e. greenlighting). The proposed EU Green Claims Directive targeting greenwashing and misleading claims in the EU, could speed up change in this area. 

  1. Green Innovation and Research: Institutions can be evaluated on their commitment to develop efforts focused on sustainability, promoting green technologies and solutions, and encouraging collaboration with academic and scientific institutions.

These criteria can vary in importance and weight depending on the specific context and industry. Some institutions may focus more on specific areas, such as climate change mitigation, while others may take a broader approach encompassing multiple dimensions of sustainability.

Green criteria that should ideally be used by finance houses during their due diligence process

While these are the criteria that are most commonly used by finance houses currently during their due diligence process, how can these finance houses go further to convert good or bad environmental and social performance into financial terms? 

Some consulting players use tools such as triple capital accounting, which considers natural and social capital, alongside financial capital, in a company’s balance sheet, so that they’re treated equally as strategic assets and properly valued, whereas others use a scoring system to assess the company’s performance using a series of ESG criteria.

Some investors have gone even further by employing disruptive solutions. Two examples of great practice in this space are from a citizens’ venture capital firm called “Team for the Planet”, and a NeoBank called “Green Got Bank”.

Good practice example 1: TEAM FOR THE PLANET – a citizens’ venture capital firm:

 

Team for the Planet considers the following issues in its assessment for venture capital: 

  • The planting of trees is not a sure solution (consider fires, limited amount of CO2 captured by each tree, the timing needed for trees to grow to full capacity, which can be decades vs the need for an immediate solution, the location of tree planting, etc.)
  • The purchase of carbon credits does not answer all needs  (carbon credits are based on predictions and lack transparency and traceability, leading to fluctuating prices and uncertain quality. Furthermore, the increasing cost of carbon credits, potentially reaching 200-300 EUR per tonne, poses challenges for companies’ affordability.)

 

They also offer their investors a series of new tools: 

    • A new financial tool: Climate dividends. The Climate Dividend is a non-financial shareholder right that rewards investments in companies contributing to decarbonization. Each dividend represents one tonne of CO2 emissions avoided through the investment. 
    • A new way to duplicate and maximise their impact: All innovation is prepared as open-source deployment, which is a needed criterion during due diligence to ensure that innovation can be scaled up; 
  • A new way to conduct due diligence: A first approach is done by the evaluators from their community (around 5,000 persons), then the project is presented to a committee of scientists. Team for the Planet’s investment criteria for scientific issues are based on six evaluation criteria: impact on greenhouse gas emissions, feasibility, externalities, replicability, market demand, and disruptive potential. The selected issues must have a measurable global impact, demonstrated technical feasibility, minimal negative external effects, potential for rapid replication, customer demand, and the ability to significantly disrupt existing solutions.

 

Good practice example 2: Green Got – a NeoBank:

NeoBanks such as Green Got have decided to exclude fossil fuel assets from their portfolio and to invest the bank’s money (investment and loans) from customer deposits and savings to: 

  • Educate and inform its customers about their own expenses and impacts. For example, for each expense,  they calculate how much CO2 is produced by that activity and what its impact is), 
  • Work with Arkea to ring-fence its funds for green actions. Arkea is a bank with a green mission, with policies excluding investments and activities in coal, gas, oil and tobacco sectors.
  • Directly finance the economy and invest in companies involved in the green transition (e.g. renewable energy, clean up, reforestation) using the savings deposited in Green-Got’s life insurance plans. 

An approach more global from investors is necessary that will take into account all of their assets and investments using the following nine planetary boundaries approach from the Stockholm Resilience Centre (see Figure 1). This approach incorporates all relevant stakeholders across Scopes 1, 2 and 3 for a company, focusing not just on a risk management, but on promoting proactive actions for a transition to more sustainable practices. To support green financing and to ensure this green financing leads to material change, we need “new state and global rules” so that a green investment is more profitable than the ‘business as usual’ investment. 

Figure 1: Nine Planetary Boundaries

Licenced under CC BY-NC-ND 3.0 Credit: “Azote for Stockholm Resilience Centre, based on analysis in Persson et al 2022 and Steffen et al 2015”. 

Other approaches would be to insert sobriety and a degrowth strategy in business plans and investments portfolios, or to employ double entry accounting to account for materials used (such as rare materials), in order to determine the extent of our dependency on external rare materials. A durability of the products produced or a circular economy index could be additional options to present assets. 

How can businesses get their houses in order to attract investment? 

It is no secret that the world of investing has also slowly been changing as a result of the new business focus on ESG, with finance houses leading the charge on sustainability expecting companies to look beyond just their financial bottom line, to also promoting corporate responsibility in governance as well as socio-economic improvements. For businesses to attract and retain new capital, they need to get ‘their house in order’ and that means taking action on material ESG issues, whether that’s climate change, sustainable energy and pollution prevention, diversity, inclusion and equity, corporate transparency, accountability of senior management and board, stakeholder engagement or anything other consideration under the sustainability umbrella. Companies can see their ESG efforts making them more attractive to employees, customers and investors, as they move towards long-term sustainable growth, which positively impacts their brand value. 

So what can businesses do to ‘get their house in order’? 

One useful framework for investors to consider on ESG in order to fulfil their duty to act in the best long-term interests of their beneficiaries are the United Nations Principles for Responsible Investment (UN PRI). We summarise below the UN PRI’s six principles, as well as some other key principles that companies should employ in the realm of ESG:

  • Undertaking risk assessment and mitigation on ESG issues and incorporating ESG in decision-making: Identifying and assessing risks across the ESG spectrum, including on biodiversity and habitats, and considering ESG issues in decision-making processes can help companies take appropriate action to mitigate these risks and become more stable;
  • Adopting corporate values of transparent and strong governance and accountability: Investors need to be confident that the board and senior management can be trusted and have integrity in their leadership practices; 
  • Investing in human capital: Companies must be able to retain employees through social credibility, by providing safe and healthy working conditions and by boosting employe motivation, thereby decreasing turnover, increasing productivity and positively impacting their brand reputation;
  • Achieving cost reductions in operations: By engaging in resource efficiency measures that reduce companies’ consumption of energy and water and production of waste and carbon, and by investing in renewable energy production and in the use of sustainable materials (e.g. for packaging), companies can reduce their operating costs and signal their commitment to operating ethically and consciously; 
  • Promoting innovation and adaptability: Providing products and services that have green and social credentials, and adopting voluntary standards, charters and principles in the sustainability space, can help create market demand, differentiate companies from competitors and shift the needle away from unsustainable alternatives. 
  • Optimising portfolio performance: Investing capital to more sustainable products and services and divesting from investments that are environmentally, socially or otherwise damaging, companies can enhance investment returns; 
  • Improving relations with all stakeholders, not just shareholders: Strong sustainability practices across a company’s supply chain, by opting for sustainable products and services in procurement, through strong community and government relations and by upholding and promoting human rights, can lead to better access to resources and can help companies attract and retain high-quality loyal B2B and B2C customers. 
  • Reducing regulatory and legal interventions: Strong performance on ESG issues can ease regulatory pressures and help companies achieve greater strategic freedom, which has a direct positive impact on corporate profits.
  • Giving back to the community: Corporate social responsibility achieved through corporate philanthropy and targeted social investments can greatly enhance brand perception, reputation and value.
  • Developing an ESG strategy and reporting: Companies that have identified their ESG material issues as well as implemented actions to address them as outlined in their ESG strategy with relevant KPIs, and which are disclosing and reporting on their performance and improvement journey, show their dedication to sustainability initiatives and to operating and growing sustainably. 

While each company should undertake a materiality assessment to determine exactly which ESG issues are material to them to manage in order to be viewed more favourably by investors, there are some ESG issues that apply across the board and need to be addressed urgently due to their global impact. Climate is in fact the leading ESG consideration for the 325 investors surveyed in a study conducted by PwC in 2021, for companies to prioritise. 65% of investors noted that companies should prioritise reducing Scope 1 and 2 greenhouse gas emissions. 82% of investors said it is important that ESG reporting explains the rationale for environmental commitments, and outlines actions and KPIs on how to reach them. 44% of investors cited worker health and safety, and 37% cited improving workforce and executive diversity, equity and inclusion as other priority ESG considerations for companies. Considering that the last report from the Intergovernmental Panel on Climate Change noted that  “limiting warming to around 1.5°C requires global greenhouse gas emissions to peak before 2025 at the latest, and be reduced by 43% by 2030”, these investor priorities come at no surprise.

It is not only investors but also insurers that are looking at companies performing well on ESG with more favourable terms. Henri de Castries, the CEO and Chairman of AXA, one of the world’s largest insurers, has set the bar high for investors when it comes to acting on climate risk and opting for divestment. With the insurance industry being one of the only industries with a role to play in both the adaptation and mitigation aspects of the climate issue, he says “a 2°C world might be insurable, but a 4°C world certainly would not be”. So the time to act is now.

Conclusion 

According to the MSCI – a leading provider of indices on ESG for corporations – there are studies that have shown that companies with lower ESG scores have a higher cost of capital, higher volatility due to controversies and other incidences (e.g. spills, labour strikes and fraud), as well as accounting and other governance irregularities, which impact their ability to secure investment and continue to operate and grow successfully. On the contrary, high ESG-rated companies are more stable, resilient and competitive, often leading to higher profitability and dividend payments. They also experience a lower frequency of idiosyncratic risk incidents and lower systematic risk exposure, evidenced by less volatile earnings and 

less systematic volatility. As a result, high-performing companies will always have the confidence of investors, a greater pool of investment options to choose from, along with better interest rates and financing terms. 

The study conducted by PwC further suggests that almost half of the 325 investors surveyed want to divest from companies not taking sufficient action on ESG issues. Investors, whether these are banks, funds or individuals, are increasingly understanding that implementation, compliance and reporting of ESG issues by companies can be treated as an investment, with the returns measured by many variables such as: the price premium that’s payable; the company’s better performance driven by more productive and motivated employees; cost savings due to improve resource efficiencies and future savings in pollution and other environmental taxes; positive brand image; favourable responses by consumers and other stakeholders; and less government interventions. Furthermore, a consistent set of metrics for measuring ESG performance is of significant benefit to investors as it allows them to be able to compare ESG performance across companies. 

According to the CEO of AXA, “Finance is no longer seen as an ‘enemy’ of sustainable development, but rather as a key driver of the shift towards a low carbon economy. Finance is part of the solution.” And this statement includes public finance institutions, commercial banks, asset owners and insurers. Sustainable finance has a key role to play in shifting traditional business norms to more sustainable practices, and businesses need to keep their house in sustainable order to continue securing investment and be able to stay ahead of the competition in the long-run. 

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