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Author: Sofia Kasidova

Institution: Center for Development and Policies

Date: July 2022

 

BANKS ARE THE MAIN MECHANISM FOR FINANCING THE GREEN TRANSITION AND ESG MEASURES. STANDARDS WILL RESTORE CONFIDENCE IN THE ESG INDUSTRY

 

ESG factors (Environmental, Social and Governance) are shaping a new industry and standards of behavior for financial institutions and banks. Investors and banks apply these non-financial factors in their analytical processes to identify material risks and growth opportunities. The topic also has controversial aspects.

  To understand the process, we need to take the facts surrounding negative climate change back a bit to the not-so-distant year of 2006, when former US Vice President Al Gore (January 20, 1993 – January 20, 2001) presented „The Inconvenient Truth.“ The film shook the world with startling facts about climate change and the climate disasters that await humanity. A new industry has emerged that invests in environmental, social and governance programs in order to make the world cleaner and the future safer for all of us, and to prevent climate catastrophe. The topic has been activated. The ESG sector is going through a turbulent time. Leading Western analysts announced during an international conference that the climate risk is not a financial risk and has been exaggerated. Although due to his speech, Al Gore was fired, his claims carry some weight because they reveal the difficulty and near-impossibility for banks to assess long-term financial risk in terms of ESG. The assessment of this risk as a component of the overall financial risk includes multiple dimensions and factors that are elements of an overall rating. Therefore, if from the perspective of investors and banks the assessment of ESG risk seems a very complex process requiring consistent historical data and the involvement of all borrowers, from the point of view of all of us as individual consumers the focus is one – how much the air is polluted by the means of transport; whether a company makes an oil transfer spill; whether it throws away or recycles plastic and toxic waste. That is, the challenge for the industry is about the universal approach, the term ESG which is transparent, clear and can be identified, tracked and evaluated by all parties in the economic process. This is how the whole attack against the industry began – investors, funds and consumers who buy shares on the stock exchange began to doubt the credibility and usefulness of ESG ratings, how far they correctly, accurately and clearly assess whether a company or an investment is in line with the ESG standards.
The other level of complexity in evaluating a green investment or green project arises from the dynamics of regulations that provide rules and technical criteria for assessing the risks and ESG compliance of investments.
Over the last ten years, the financial sector and the market have accumulated a lot of experience and practice, often ahead of the regulators. Regulators stepped in, realizing the danger of watering down the green criteria and misjudging that mutual fund and pension fund investments are ESG -compliant and “green”. The practice and the term greenwashing (fraud with investments sold as green and sustainable – Ed.) appeared. Politicians and regulators are preparing massive legislation to regulate this process. Naturally, in an environment of opposing processes, the market does not like to be regulated, disputes and turbulence arise, which explains the current, albeit temporary, skepticism towards the sector.

Currently, ESG regulations mainly affect large public companies. In a year or two, they will become part of the agenda of smaller companies as well.

Small and medium-sized enterprises (SMEs) are not the first to introduce new and complex legislation. At the moment, it is not mandatory for them to apply the ESG regulations. This requires a huge financial, technological, informational and human potential and SMEs need help in defining, evaluating, determining the technical criteria applicable to their sector for structuring their investments and projects in accordance with ESG legislation (the main block of the legislation is the EU Green Taxonomy, adopted at the end of the last year). A particular challenge is the preparation of the SME sector, which is almost 99% of the Bulgarian economy. Small and medium-sized enterprises are not prepared for this transition. The results of recent surveys conducted by commercial banks show that enterprises are partially informed, have a misunderstanding, no knowledge of how to apply the legislation, how to structure these investments. Green regulations are here to stay. The taxonomy and related accountability and other regulations regarding compliance with climate targets are the path to climate neutrality. This is the way to the future where we all want to go. The taxonomy is applicable to almost all economic activities – 75 sectors or economic sub -activities from 8 main industries.

Banks are the main channel for spreading ESG practices and the future of non- ESG crediting is impossible.

Banks are at the beginning and end of the credit process and green financing. It is their responsibility to assess how „green“ a project is, to create this knowledge, to accumulate information databases, to prepare registers of how companies perform; what are the indicators showing whether the company or the investment is „green“. It is the business of banks to assess financial and general risk. But a „green“ investment can have a very long realization period, and assessing this risk over time is very difficult, almost impossible. For example, investment in a gas transmission network: the sector is temporarily included in the Green Taxonomy, and after 2030 it will be excluded; the realization of the project is almost as long as the inclusion. With what assumptions and conditions will a bank put money into this sector? The financial sector and investors also face other risks. To date, it is expected that many of the assets will not be able to be decarbonized or will be decarbonized very slowly, i.e., ESG legislation will not apply to them, they will be classified as stranded assets, assets that will have almost zero market value and return. Will it be the same in 5 years, because obviously there will be fossil fuels and assets that produce them, without which we will not be able to move forward at least for some period of time. The banking sector will have to help companies that are not green but have a decarbonization plan. To the extent that the financial world looks ahead, when a sector or project has a clear path of how it will develop and it is convincing enough, banks can support it. That is, their role becomes more complex in terms of evaluating these green projects and investments.

The green transition and investments in it seem unorthodox because it is not a priori certain that they can bring profit to the shareholders.

ESG investments are expected to contribute additional, hard-to-measure value, and the financial logic is cold: looking for profit, yield, return. The added financial value of ESG cannot be assessed now and immediately, it is in the future opportunities for the company, in the benefits to the environment and from adaptation to climate change. The investments we will make for the future – the environment in which we can live better – do not bring immediate profit. This complicates the ESG concept and the green transition. For a more intuitive perception of the green trend, the concept of impact investing can also be used (investing with the aim of positive impact – Ed.). Here the added value is assessed a priori. The market will evolve and choose the best regulations and practices as standards. International standards will be the other pillar of the ESG industry, which will bring back trust, transparency and pragmatism in sustainable financing.

The accumulation of crises and the decarbonization of the economy.

The overlap of multiple crises has complicated and delayed the transition to a carbon-free economy. Green investments suffer temporary investor skepticism, but sustainable and green projects are the ones that will add value, preserve the environment and natural capital that will be invaluable in 20 years, when 20% of the planet will be uninhabitable due to heat and drought. Decarbonization is a long process and depends on good preparation, good planning and financial resources.    

Business card

Sofia Kasidova is the head of the Strategic and Sustainable Development department of the Bulgarian Development Bank. She was vice president of the Black Sea Bank for Trade and Development and chairman of the Supervisory Board of Biochem Bank (now part of UniCredit Bulbank), she also worked at the Credit Suisse First Boston investment bank. She held the positions of Deputy Minister of Economy and Deputy Minister of Transport and Communications in the government of Simeon Saxe-Coburg from 2001 to 2005. She was a member of the Board of Directors of the National Electric Company. He has a master’s degree in economics from the University of State of New York & CEU, Prague, and an MA in International Finance from the University of Reading, UK. She also holds a degree in finance from the Oxford University Said Business School.