All the talk is about ESG

Guarantees and letters of credit are part and parcel of many companies' daily business in the context of foreign trade or export financing (trade finance). However, like many other areas of treasury, this too finds itself in a state of flux due to increasing digitalization – ranging from the introduction of systems for managing guarantees and letters of credit all the way to process automation. 

So far, however, little attention has been paid to the environmental, social and governance (ESG) component. Banks are already required to act in accordance with ESG criteria when granting loans, for example by extending sustainability-linked loans, where the interest rate depends on the company's sustainability components. This has not yet been consistently the case for trade finance. As the importance of ESG will only increase, companies should definitely consider moving in this direction, as banks are already incorporating ESG criteria when issuing guarantees and letters of credit. This makes it all the more challenging to obtain trade finance (guarantee, letter of credit, etc.) for companies with obvious non-ESG-compliant products, such as machinery used in lignite mining.

Even though ESG is not yet mandatory in trade finance, we would like to outline some possible forms of ESG and the associated opportunities as well as challenges.

The first step is to look at the possible components of ESG criteria in the trade finance context, where it seems conceivable to implement both individual aspects as well as a combination of different elements.

The relevant ESG factors within the company itself serve as the basis for this. These include the organization's sustainability focus and the corresponding actions taken by the company, each of which is also documented in the ESG reporting system. Also, sustainable funding can make a difference in this regard. Corresponding reports are generally already mandatory for capital market-oriented companies – and if statutory thresholds are exceeded – (based on the requirements under the Non Financial Reporting Directive, sections 289b HGB et seq. and 315b HGB f.) and are also reflected in the reporting in the course of the annual financial statements. As a result, the company can draw on existing structures for this purpose, if necessary.

One ESG approach specifically suited to trade finance is evaluating the product or commodity to be financed. This essentially involves the specific impact on ESG aspects of the product to be financed. In this way, the focus can be placed either on the corresponding production process, including all relevant input factors required for production, or on the effects of the corresponding product after delivery to the customer. One example of the latter option would be an excavator that is used either for the construction of photovoltaic (PV) parks or in the course of lignite mining. Presumably, its use for the construction of PV parks will be rated more advantageous from an ESG perspective at first glance than its use in surface mining.

This approach relies on the respective business partners' classification according to ESG criteria. Both the company's own customers and its suppliers are relevant here. Under this approach, such classification should be performed along the entire value chain and consequently also include, as far as possible, any intermediate players (such as freight forwarders). However, the complicating factor in this context is the sheer number of actors involved. The more parties in the value chain there are, the more difficult it is to collect complete and appropriate data.

This is about making use of sustainably operating financing partners and sustainable trade finance products. However, given that such institutions usually only enter into business relationships upon proof of compliance with certain requirements, this is a chicken-and-egg problem to a certain extent. Organizations wishing to take advantage of sustainable products from these institutions must provide proof of sustainability. However, such proof is intended to be generated through the use of these products. A potential solution to this conundrum could be to start with the company taking the first steps towards a sustainable orientation. Once the first ESG-compliant strategies have begun to bear fruit, sustainable banks can be added to the list of sustainable projects.

As the illustration of these aspects to be taken into account makes immediately clear, implementing ESG reporting is not a foregone conclusion. The many and varied challenges in ESG comprise the areas of data collection, data processing and evaluation as well as comparability.

For data collection, companies can partly access the data from their own processes and production flows. However, when it comes to their trading partners, not all the required data is usually publicly available. Currently, it is up to the companies which data they publish for the ESG score. This means that each company decides which selected data points they disclose for certain variables (for example, water consumption). In any case, companies are not obliged to disclose confidential topics (for example, salary structure among employees). Another interesting aspect of this topic is when the purpose or use of the product is to be considered. Hardly any company can fully predict the use of a product over its entire lifetime. Usually, only information on the initial intended use is available. Of course, usage can be contractually stipulated to comply with the intended use – even in the case of resale of the product. Even so, monitoring the compliance with such a stipulation over an unspecified period of time is unrealistic. Another challenge is the validity of data from countries with less developed infrastructures or protectionist regimes.

In addition to collecting data, the processing of the collected data in an adequate model, which is the end results in a qualified ESG reporting, is a key task and also a challenge. In this context, selecting and weighting the relevant variables (for example CO2 emissions, water consumption, gender discrepancy, size of the Board of Directors) from the three overarching areas (environmental, social and governance) is the central design component of the overall ESG model. Other factors to be taken into account in this context are, for instance, the company's industry, the relevant operating regions and the number of employees. 

Once the parameters have been defined and processed, the next step is to interpret the ESG score obtained. In this context, it makes sense to coordinate the significance of the ESG values and the corresponding ranges with all parties involved (e.g. banks, suppliers and customers) in advance in order to avoid possible misinterpretations.

The third challenge is the comparability of ESG reporting and the ESG scores obtained. In the absence of uniform ESG market standards in the trade finance context, it is currently still difficult to compare the corresponding reports with one another. One option, though, is to define together with the partners involved, for example the banks included, a joint understanding of the ESG score or the bandwidths.. The data included, the variables selected and their weighting are all relevant in this regard.

Establishing ESG reporting and the corresponding standards in trade finance may seem complex and challenging at first glance, but with it also brings many advantages. On top of the most obvious benefit of demonstrating the compliance with sustainable standards, there are additional advantages that we’ll discuss below.

Introducing ESG criteria in export financing leads to a reputation as a sustainability-conscious company among customers, suppliers and banks alike. Being a relatively new field in the context of trade finance, this presents the company with an opportunity to position itself as a pioneer in this field and to underline its own innovative claim.

Under certain circumstances, setting up ESG criteria in the trade finance sector can give companies easier or more favorable access to export financing instruments. Special ESG guarantee lines are one possible form. As long as the agreed ESG criteria are met (see above-mentioned types), the discounted ESG credit line can be used for the corresponding product. These lower financing costs thus represent a recognizable competitive advantage and also increase the company's profitability.

The introduction of ESG criteria together with a corresponding process by the company can be included in its sustainability disclosures. Even though this is not yet mandatory for the trade finance sector, it cannot be ruled out that such a requirement will be introduced in the future. So, if companies already have this information available today, they are already well equipped for the future.

Addressing the issue of ESG in trade finance can strengthen a company’s resilience as well as that of one's own supply chains. As part of an ESG reporting process, a wide variety of procedures and processes are analyzed. As a result, all input factors can be critically scrutinized and adjusted if necessary.

Although ESG is not yet a regulatory requirement in trade finance, it is set to become increasingly important in the future, making it a highly relevant topic for treasury departments as well. Overall, it can be concluded that setting consistent ESG standards and corresponding reporting in trade finance will present treasury departments with a number of challenges. At the same time, however, this will allow treasurers to continue to drive forward any necessary process changes and also the topic of digitalization in the trade finance area and to take on a trailblazing role in the market by incorporating ESG criteria.

Source: KPMG Corporate Treasury News, Edition 32, May 2023
Authors:
Nils Bothe, Partner, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG
Maximilian Gschoßmann, Manager, Finance and Treasury Management, Corporate Treasury Advisory, KPMG AG