What is driving the imperative for ESG alignment?

There has been a cultural shift in society as more and more individuals commit to leading sustainable lives. Those individuals – whether as consumers, employees or other stakeholders in industry – now expect the businesses operating in their communities to function in a more sustainable manner too.

The wider context

At an international level, the United Nations 2030 Agenda established 17 sustainable development goals (SDGs) requiring urgent action. The SDGs include a target of access to "Affordable and Clean Energy" and the development of "Sustainable Cities and Communities" but also emphasise "Decent Work" for all through "Economic Growth".

Those goals are having a direct impact on long-term policy decisions by governments and industry, and are driving the reallocation of global capital away from unsustainable activities and towards ESG-aligned businesses.

Why is ESG relevant to businesses?

ESG is a framework for benchmarking an organisation’s performance with regards to its environmental impact, relationship with local communities and adherence to applicable regulations.

Businesses that ignore the importance of ESG considerations do not just perform poorly when assessed against environmental, social and governance criteria, but will often be regarded by potential finance providers and investors as posing a greater credit risk.

In other words, business that are not ESG-aligned can find it harder to access bank loans or attract equity investors.

The link between ESG factors and credit risk is evident in a number of ways, for example:

• Environmental: businesses engaged in carbon-intensive activities are exposed to the risk of ‘stranded assets’, that is, where assets depreciate in value or become unable to produce viable financial returns as a result of changes associated with the transition to a low-carbon economy.
• Social: failure to align a business’s strategy and operations with social considerations gives rise to the risk of employee disengagement, loss of customers and alienation of other stakeholders (e.g. regulators or funders), all of which ultimately lead to lower revenues.
• Governance: any business without clear and focused goals risks financial decline, but, in addition, shortcomings in corporate governance pose a real danger that business units could be engaging in undesirable (or even unlawful) activities owing to a lack of due oversight or misaligned incentives, leading to the possibility of fines or other penalties.

With climate change rarely out of the headlines, the ‘environmental’ branch of ESG may appear to be higher on the agenda than the other strands of ‘social’ and ‘governance’. However, the three pillars of ESG are of equal importance. 

Businesses with a holistic ESG strategy that targets long-term sustainable financial growth, high stakeholder engagement and robust governance represent a much safer opportunity for a bank lender or equity investor and therefore enjoy better access to finance – and on preferable terms.

Financing ESG projects

One way businesses can use ESG to help raise finance is by identifying an ESG-aligned project that can be funded by external finance. As an example, if a manufacturing business wishes to upgrade its production facilities to replace single-use plastic packaging with an environmentally friendly alternative, a clear statement of how the loan proceeds or equity investment is aligned with ESG factors would make the opportunity more attractive to potential finance providers or investors.

After all, it is not just trading businesses that are implementing ESG strategies. Banks and other finance providers are also under increasing scrutiny from their own funders and regulators to ensure their activities are sustainable, as decisions are increasingly assessed through an ESG lens.

ESG financing for everyday business activities

For businesses that need to raise finance for general corporate or working capital purposes, it may not be practical to earmark or ring-fence the loan proceeds or equity investment for a specific ESG-aligned project.

However, ESG considerations have a role to play in financing everyday business activities too. For example, finance providers may be open to including ‘margin ratchet’ provisions linked to ESG-related key performance indicators (KPIs) in finance agreements.

Margin ratchets incentivise businesses to improve identified KPIs throughout the term of a finance agreement in order to benefit from reduced financing costs, e.g. a lower interest rate on a loan.

ESG-related KPIs are qualitative or quantitative measurements that should be capable of external certification or verification. They can be based on environmental benchmarks, such as carbon emissions, or on more innovative measurements such as increases in diversity and inclusion statistics across a workforce, reductions in gender pay gaps, or a lower volume of customer complaints.

Data and reporting

Embedding ESG in financing arrangements typically means increased reporting requirements and a need to share information with a finance provider about the non-financial aspects of a business’s activities.

Reporting is a two-way street and can highlight both successes and failures. Businesses need to be honest and realistic about their ESG alignment and resist the temptation to exaggerate their ESG performance.

Greater attention is being paid to cracking down on ‘greenwashing’ in financial services – where unsubstantiated claims are made about the environmentally friendly nature of a product, service or activity. In the same vein, businesses that report on the non-financial aspects of their activities need to ensure that any data they provide is accurate.

For more information on how an ESG strategy can help your business raise finance, please contact Zachary Stewart at [email protected], or a member of Shepherd and Wedderburn’s dedicated Environmental, Social and Governance Advisory Group.