Considering environmental, social and governance aspects (ESG) of an organisation might seem a simple thing to do for a lay person. If a company or organisation recycles, buys locally, hires from diverse groups in society, uses electric vehicles and puts in place robust procedures to deal with employee issues then it can claim to be fighting the good fight against environmental degradation and social injustice.
This approach is good as far as it goes, but it is far from co-ordinated and lacks vigorous feedback loops that can measure progress. Moreover, when judging the ESG quotient for a company it has to be taken into consideration which countries it operates in and how those countries view ESG. For example, a company supplying parts to a photovoltaic factory might think it is doing its bit for ESG and completely miss the fact that they are working with a Chinese company complicit with the subjugation of minorities such as the Uighurs.
For factoring companies wishing to only offer trade finance to companies with a good track record in ESG matters a way through the mire of complexity is needed.
How to be More Systematic in Assessing ESG Compliance
Initially ESG, in regards to trade finance, focused on excluding economic activities that were clearly ethically wrong such as cigarette and weapons manufacturing.
Over the last 5 years, factoring companies have found better ways to place sustainability at the heart of their decision-making processes. There is no single set of ESG criteria for deciding whether an invoice is suitable for factoring or reverse factoring. However, the following guidelines have emerged:
- Avoiding activities that lead to human misery such as financing companies making land mines;
- Integrating ESG factors into decisions involving buying and selling. Scrutinising suppliers for their ESG efforts as well as potential buyers;
- Encouraging owners and shareholders to take a more active role in championing ESG in their leadership positions;
- Engaging with investment groups to find out how they judge ESG factors;
- Looking to regulators for guidance in ESG matters; and
- Make ESG compliance a central tenet in investment decisions.
A big help in clarifying what ESG means and how it should be implemented has come from the United Nations who have produced a series of Sustainable Development Goals. These goals have led to a more scientific and uniform approach to ESG in business communities.
At the same time the UN has identified the crucial role that trade finance plays in ESG. SMEs in developing countries depend heavily on access to financial services such as factoring to stay afloat in the first few years of business, and then later to take advantage of business opportunities.
The World Trade Organisation has stated that improving trade in the developing world reduces poverty. Trade creates jobs and increasing employment figures raises families above the poverty line. This in turn improves the educational prospects of their children and gives people more disposable income to spend in shops and hospitality venues.
Prior to the World Financial Crash of 2008, the main supplier of capital to trade in the developing world were banks. However, new regulations requiring larger capital reserves to merit bank lending has seen banks lose their pre-eminence in this field to be replaced by managed funds and specialist trade finance companies.
These fund managers and finance companies have taken an active role in understanding the businesses of their SME clients in order to direct investment into ventures with the potential for ESG improvements. These close working relationships between funders and lenders leads to more co-ordination for the development of common goals regarding protecting the environment, improving working conditions and eliminating corruption in business practices. This is especially true of funders bound by ESG rules.
Banks and ESG
As stated, banks have reduced their exposure to the riskier debt represented by offering credit to small companies trading in the developing world. However, many banks have adopted ethical and environmental stances towards lending. Recently, we have seen banks offering preferential rates to those clients that reach carbon emission reduction targets.
HSBC has teamed up with Walmart to create a sustainable supply chain finance programme that offers better trade finance rates to companies that reach their goals for sustainability.
Blockchain and ESG
Technological advances have played a vital role in assessing ESG factors for a company. It is not enough to say your company is doing more to help the environment and its workers. Rather real-time reporting is needed for empirical evidence of commitment to ESG values.
This has been boosted by blockchain technology that provides low-cost and secure methods for storing and sharing data. Verification checks necessary for KYC compliance can be stored safely on a blockchain. Schemes to identify and track produce consignments by farmers have been successfully run using blockchain technology. This allows for real-time reporting on deliveries and quicker payments.
Moreover, the decentralised nature of blockchain data storage and retrieval means it is nearly impossible to tamper with records. This is a major bonus for funders looking to reduce vulnerabilities in governance – companies can’t change a blockchain ledger to hide malfeasance.
Data and ESG
One major problem hampering a co-ordinated global approach to ESG has been data. Trade finance if it is to offer monetary incentives for sustainable business practices has to be able to access independent data to show it is not wasting its money.
In 1990 the first ESG Equity Index was launched. In 1999 it was joined by a Global Equity Index. And in 2013 the ESG Fixed Income Index was introduced. These indices have been crucial in evaluating ESG efforts; they have helped set standards for categorising ESG factors and provide for performance analysis.
The Way Forward
There is still much to do to improve ESG factors globally and to harness the power of trade finance to help this cause. Investment companies have had difficulties recruiting fund managers qualified in making ESG-based decisions.
As climate change becomes more prominent in world news cycles, the environmental perspective will become more ‘baked in’ to professional qualifications. This in turn will address the current scepticism displayed by some investors to ESG. They wrongly see ESG as limiting profit making activities. The ideological battle to show being sustainable and environmentally friendly is more than just a fad, but a path to long-term survival is key in this regard.
A survey conducted by The National Bureau of Economic Research (https://www.nber.org/papers/w17950) looked at 180 US companies. They rated the companies as either high sustainability or low sustainability. The former meaning a company integrates ESG factors into their business model, the latter the opposite. The survey shows that high sustainability companies outperform low sustainability companies over time.
It is surveys like this that help dispel false stereotypes about ESG. Combined with standardised benchmarks, better data collection, guidance from important international bodies such as the UN, continued media pressure and advances in technology the field of ESG is developing a more empirical and evidence-based approach, and trade finance is benefitting from this new paradigm.