ITFA > Newsletters > THE INCORPORATION OF ESG IN THE TRADE FINANCE ASSET CLASS, Oct 2020
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By: Charlotte Prior, Trade Finance Analyst at GIB Asset Management
Contents
•What is trade finance?
•What is ESG and how is it incorporated into investments?
•Why trade finance suits the ESG philosophy
•The challenges associated with the integration of ESG within trade finance
•View of the future – trade finance to widen adoption and the positive impact ofESG
•Blending ESG with trade finance – a force for better returns and a better world
•GIB AM’s approach to incorporating ESG into trade finance investments – a casestudy
Tradefinance has an undeniable role to play in the development of a more sustainableworld. The incorporation of Environmental, Social and Governance (ESG)considerations in trade finance brings widespread benefits to the goods’ andservices’ supply chains.
Focusingon ESG factors also strengthens the trade finance sector. Their incorporationinto investment decisions enables a more comprehensive review of the risks andopportunities that specific activities or products bring to a portfolio.
However,many challenges lie ahead due to the widespread and concurrent intricacies of:
•the management of ESG factors; in particular the scarcity of data, and therelative infancy of techniques to identify, measure and analyse materialfactors
•existing limitations of the trade finance asset class – no benchmark index, afragmented market, multiple stakeholders and the need to overcome technicalhurdles
Nevertheless,there is significant scope for trade finance to help achieve sustainabilitytargets, such as the UN’s Sustainable Development Goals (SDGs), and to provideimpactful results where most needed and problematic.
Whatis trade finance?
Trade finance solves the most common trade dilemma. When engaging in the sale and purchase of goods and services, especially at an international level, sellers demand payment before shipping their goods. In contrast, as buyers want to only pay when they receive the goods. This uncertainty around payment and receipt of goods is an inherent risk associated with trade. Trade finance resolves the uncertainty by bridging the gap between working capital cash flows.
By financing the trade cycle at various points of the transaction, trade finance precisely reconciles buyers’ and sellers’ needs. It also enhances participants’ management of the capital required for trade, while mitigating or reducing the risks involved in an international trade deal. It is an essential part of the global economy. Some 80% to 90% of world trade relies on trade finance.(1)
Whatis ESG and how is it incorporated into investments?
ESGrefers to the three central factors (ESG Factors) used to measure thesustainability and ethical impact of an investment. This measurement includesthe companies and countries involved within the underlying transaction.
Thedata collected using these three factors can be integrated into the investmentdecision-making process.
Inits earliest forms, ESG typically used exclusionary criteria. For example, theavoidance of controversial industries such as tobacco and weapons.
Ashighlighted later, ESG is no longer about avoiding companies in theseindustries, although that remains a common approach. Instead, it is morefocused on engaging with these companies to ensure they conduct their businessin a sustainable and responsible manner. ESG has considerably developed overthe past 5 years, and as considered below, different asset managers integratesustainability into their decision-making process via different methods.
ESGis especially being driven by millennials – the next generation of investors.The mind-sets and priorities of this generation are very different to previousgenerations.
Millennials prefer to invest in a similar way to the way they live. According to a study by Schroders (2017), 86% of millennials stated that sustainable investing was important to them versus 67% of baby-boomers (2).
Therole of ESG in modern day portfolio management cannot be downplayed. Doingnothing is no longer the default option for asset managers and owners alike.
Assetowners recognise the risks and opportunities of ESG considerations in theirinvestments. Increasingly, they emphasise the importance of factoring in thoseconsiderations across their portfolios. The asset management industry, in turn,has become highly motivated to address investors’ sustainability demands.
Institutionalinvestors typically implement ESG considerations in a number of ways:
•Negative screening or exclusion of certain products, such as cluster munitions;
•Integrating ESG factors into investment buy/sell/ hold considerations;
•Stewardship or active ownership – engaging
•actively with the boards and/or management of investee companies;
•Engaging in less formal dialogue with regulators and other standard-settingcorporations to help
•standardise the integration of ESG factors into the investment decision-makingprocess.
Differentinstitutions take different approaches. They blend the three elements above indifferent ways, to reflect their different investment styles.
Manyinterchangeable terms have emerged in the lexicon of ESG. A limited listincludes responsible investment, ethical investing, socially responsibleinvesting (SRI) and thematic investing. Although the term ‘impact investing’can also be used, it is important not to confuse this with the other termsdescribed above. As ESG becomes more mainstream, efforts are being made tostandardise its different meanings.
The following chart highlights the conceptual differences between the different approaches.
(1) https://voxeu.org/article/challenges-trade-financing
(2) https://www.schroders.com/en/insights/global-investor-study/2017findings/sustainability/
Figure 1: ESGinvestment styles
‘’We are in a world offinite resources, which we are consuming at an unsustainable rate. We have todrastically change our behaviour and steer ourselves down the path ofsustainability.’’ Tony Cripps – Group General Manager and Chief ExecutiveOfficer, Singapore, HSBC
TheUN’s Sustainable Development Goals SDGs have catalysed the expansion of ESGconsiderations within the financial industry, with SDG 17 highlighting the needfor the global community to get on-board.
‘’The journey towardssustainable development will only be successful if we all play our own part.’’Roy Teo, Executive Director and Head, Financial Centre Development Department,Monetary Authority of Singapore.
Thereis no doubt that financial institutions and businesses have a key role to playin the transition towards a sustainable economy. The UN’s Declaration onfinancing for development specifically identified short-term trade finance asan important means to achieve the SDGs, in particular SDG 1 (no poverty) andSDG 8 (decent work and economic growth).
‘’Trade finance plays a key role in helping developing countries participate in global trade. Easing the supply of credit in regions where trade potential is greatest could have a big impact in helping small businesses grow and in supporting the development of the poorest countries. The availability of finance is also essential for a healthy trading system. Source: World Trade Organisation (3)’’
Whytrade finance suits the ESG philosophy
According to the World Trade Organisation, “trade can play an important role in boosting economic growth and supporting poverty reduction”.(4)
At its simplest, trade finance is a funding mechanism to finance and facilitate trade. It finances the supply chain for goods and services. Ten years ago, international banks dominated trade finance. The 2008 financial crisis drove a tightening of regulations. Banks adopted enhanced financial controls, elevated due diligence requirements and stricter risk assessments. The adoption of Basel II and Basel III also led to increased capital requirements.
Theinherent risks involved with cross-border trade made traditional lendersreluctant to finance some companies, especially SMEs. This reluctance hascreated a wealth of opportunities for specialist fund managers as the tradefinance gap grows.
Throughactive engagement, trade finance drives the implementation of ESG
Trade finance has a direct impact on the real economy. Through both direct and indirect lending, trade finance providers such as funds, merchant companies and banks are able to build relationships on the ground in key commodity markets. This provides “invaluable insight and market intelligence, which [in turn] leads to better lending decisions”(5) , therefore meaning “better returns and fewer losses for underlying investors”(6).
Throughthese relationships, lenders are able to engage actively with borrowers,especially with the smaller SMEs.
Practitionersof trade finance can drive the implementation of ESG at the operating levelthrough active engagement. Asian and African trade involves the highest usageof trade finance. African and Asian countries also have the highest need forESG investment. Trade finance practitioners are in a prime position to providefunding where it is most needed. They can influence corporate governance andtransparency, help eradicate child and slave labour, and improve genderequality. Trade finance can be a significant contributor towards meeting the UNSDGs.
Activeengagement between lenders and borrowers is already driving positive change.Lenders are incentivising borrowers with reduced lending rates if they achievecertain ESG related milestones. Recently, some revolving facilities provided bylarge banks, have offered tranches enjoying preferential pricing if lendersmeet “green components” or “reduced carbon” targets
In April 2019, HSBC and Walmart joined forces to roll-out a sustainable supply chain finance programme. The programme pegs a supplier’s financing rate to its performance against sustainability targets (7).
Theglobal programme allows Walmart’s suppliers, demonstrating progress in Walmart’sProject Gigaton or Sustainability Index Program, to apply for improvedfinancing from HSBC.
Inanother example, Rabobank have set specific ESG KPIs for their borrowers. Theywill then monitor the progress of these KPIs over a year and, if on target, theborrower will receive a reduced financing rate. On the other hand, if theborrower does not meet the KPIs they will increase the financing rate.
‘’ Sustainable supply chain finance is an unrealised opportunity to improve supply chains while also achieving sustainability goals. Business for a Better World (BSR)”. (8)
(3 & 4) https://www.wto.org/english/res_e/booksp_e/sdg_e.pdf
(8) https://www.bsr.org/reports/BSR_The_Sustainable_Supply_Chain_Finance_Opportunity.pdf
Blockchaintechnologies
Technologywithin trade finance is capable of supporting smaller businesses in theircapacity to export.
According to the WTO, around 58% of SMEs’ financing requests are rejected. This compares to only 10% of requests by multinationals. (9)
This is especially the case in Africa and developing Asia. In part, this disparity is linked to the high costs of initial KYC checks required to on-board new customers in these geographies. The size of these costs penalises smaller transactions. Adoption of blockchain technologies could reduce the costs related to identification documents. Customer data is also easier to share securely on block chain platforms.
Justone example of these blockchain systems is Halotrade. When piloting their idea,Halotrade tested it out on tea farmers in Malawi. They gathered information onthe individual farmers and were able to create accounts for each farmer. Thismeant that Sainsbury’s and Unilever (the buyers) were able to trace exactlywhere their tea had come from. Halotrade were then able to trigger payment tothe farmers once they had delivered their tea to the warehouse, speeding up thepayment cycle for all parties using blockchain technology.
Thismeant that cost savings were achieved in the supply chain for Unilever andSainsbury’s. Once the cost savings had been identified and quantified,Sainsbury’s and Unilever both agreed to use these savings for furthereducation, training and other social services. Instead of the funds beingdirectly returned to the farmers, they are used to help farmers attend classesand training, enabling them to improve their businesses as well as employingsustainable practices.
Over-turninggender biases
Gender issues are pervasive within the asset class. A 2017 survey found that female-owned firms “were 2.5 times more likely to have 100% of their trade finance proposals rejected by banks than male-owned firms.” (10)
TheADB report stresses that those rejections stem from KYC concerns (29%), theneed for more collateral or information (21%) and lower profit margins forbanks (15%).
Tradefinance funds or alternative investors could have a direct impact on addressingthe gender imbalance at play. Through collaboration with local organisationsand development banks, smaller financiers are able to provide financialservices to SME’s and female owned firms.
Thechallenges associated with the integration of ESG within trade finance
Someof the challenges to the adoption of ESG within the trade finance industry arecommon to many other asset classes. However, trade finance exacerbates thesechallenges, and brings its own unique ones. Key amongst these are a scarcity ofdata, a lack of standardisation of approach, an ESG knowledge gap and fewcommon measures to compare performance.
InsufficientESG data
Asthere is no public ESG data available to Trade Finance parties, the methodologyused in gathering such information is critical to ensure an adequate andmeaningful incorporation into their impact analysis. It also determines theimpact associated with their investments. This differs materially from managerto manager, and points to the need for heightened diligence when selecting aPortfolio Manager able to meet the objectives of an investment mandate.
Thegrowth of ESG indices has supported the development of ESG in other assetclasses. The first ESG equity index was launched in 1990 followed by a globalESG equity index in 1999. The first ESG fixed income index launched in 2013.The availability of indices and their data is important. They help to setstandards for categorising ESG factors and provide benchmarks for performanceanalysis. However, trade finance is a highly qualitative business. No ESG tradefinance indices exist due to the lack of data, lack of standardisation andlower amount of regulation in the sector.
Hurdlesto a standardised approach
Oneof the most active challenges within ESG investment is identifying specificissues that are genuinely material to a sector and company.
Thereare substantial differences between sectors. There are also differences betweenwhat is most material to individual companies within a single sector, given thespecificities of their business model, operations and geographical exposure.
Manycompanies are now thinking about implementation of ESG into theirdecision-making process.
Investorsare increasingly looking at incorporating ESG policies into their portfoliocompanies, especially given the increased focus on climate change. Complicatingmatters, investors use a number of different sustainable investment styles,including negative screening and positive screening. Negative screening is theact of rejecting stock such as alcohol, tobacco or weapons.
Apositive screen would be to select companies that set positive examples ofenvironmentally friendly products and socially responsible business practices.Impact investing or thematic investing are among some other sustainableinvestment styles. Companies are also using very different methodologies asthey try to address the varying ESG demands of asset owners.
Althoughthe lack of standardisation and common framework is a challenge across allasset classes, investment managers exposed to public securities and largerissuers can rely on a wider set of data points. Many use the services of ESGresearch providers such as MSCI or Sustainalytics.
Onceagain, there is no harmonised approach across these providers. They usedifferent methodologies to determine the issues that are material for eachsector.
To read more about these data indiscretions, please visit our previous thought piece entitled “A Sanity Check on Practicality”
(9) https://www.wto.org/english/res_e/booksp_e/sdg_e.pdf
(10) ADB’s trade finance Gaps, Growth, and Jobs study of 2017
Additionalimpact of light regulation
Thelight touch regulation applied to the trade finance sector is an additionaldriver of the lack of standardisation. There is some standardisation acrosstraditional trade finance transactions, via the use of Letters of Credit orother negotiable instruments.
However,the bulk of trade finance business is in Emerging Markets involving SMEs mainlythan larger companies.
Thesejurisdictions often have lower levels of governance, and there are no specifictrade finance regulators or designated exchanges to trade finance instruments.
Althoughtrade finance instruments have been used for a long time, trade finance as anasset class is still recent, dating back around ten years. This means thatexisting trade finance Funds are not hom*ogeneous and often only have a shorttrack record.
Lackof transparency and reporting
Thereis no dedicated exchange for trade finance instruments. Nor are there ESGbenchmarks against which asset owners can measure performance.
Assetowners’ concurrent requests for bespoke ESG reporting with greater transparencyand standardised benchmarking creates difficulties for investment managers.
Whilstthere may be a lack of transparency and reporting on ESG in other assetclasses, there is a near absence of transparency and reporting in tradefinance.
AnESG knowledge gap
Withthe negative consequences of ignoring ESG principles becoming increasinglyobvious, ESG is more and more prevalent.
Manycompanies are implementing ESG in their decision-making processes. However,there is a scarcity of seasoned ESG professionals. Even though demand hasskyrocketed, investment firms have found it hard to recruit professionals withboth ESG knowledge and investment experience.
Itis evident that sustainable banking practices and ESG considerations in tradefinance are being largely driven by the European banks, such as StandardChartered Bank, Rabobank, ABN Amro and ING.
Mismatchedskill sets between ESG and investment professionals
Thetypical separation of ESG responsibilities and investment analysis within manyAsset Managers can affect the integration of ESG issues into the investmentprocess. The knowledge gap hampers the collaborative environment typicallyrequired.
Historically, the focus of ESG roles has been on governance, engagement and voting. ESG professionals did not historically need an investment qualification or background. (11) According to recent reports published by the CFA Institute and the PRI, the main challenge of ESG integration is a limited understanding of ESG issues.
Thelack of an ESG orientated company culture is also a major barrier.
However,we are in the middle of a transition. Ten years from now people won’t be havingconversations about ESG as a separate discipline.
ESG will be part of how one does business in the investment world. (12) Whilst we make this transition, training of professionals is of paramount importance.
Whilst some training sessions and exams are slowly starting to emerge in the ESG space, these sessions and exams target the investment world primarily and not the banking world.
(12) Jane Ambachtsheer, Mercer Investments
Figure 2: ESGintegration survey
Themyth that ESG investment is a drag on returns
Typicalinvestors’ lack of knowledge of ESG has also slowed its implementation.Compared to five years ago, 83% of advanced investors in Hong Kong saidsustainable investing has become more important.
64%of them have increased their investments in sustainable investment funds as aresult. In contrast, only 77% of less advanced investors had the same view with53% of them increasing their sustainable investments.
This suggests that experienced investors better understand the benefit of integrating sustainability into their investment portfolio.
However,dispelling a key myth regarding ESG will support its validation by allinvestors. Some investors and investment managers still view ESG investmentwith deep scepticism.
Thatview follows the narrative that ESG incorporation will limit the universe ofinvestments and therefore the potential performance opportunities.
Onceagain, better transparency and reporting would help close the investorknowledge gap around ESG and create a virtuous circle encouraging investors tointegrate sustainability into their investment portfolio.
Historically,ESG investing has mostly focused on managing portfolio risks. One delegate at aUNPRI workshop stated that ESG professionals and investors alike tend to speakonly about risk, and not opportunities. Changing this focus to ESG as a sourceof sustainable competitive advantage which can stimulate market outperformanceis gaining momentum with investors.
TheEccles et al (2012) study “The Impact of Corporate Sustainability on OrganizationalProcesses” identified companies that had long-standing good practice in termsof sustainability (closely relevant to ESG).
It underlined that, “High sustainability companies significantly outperform their counterparts over the long-term, both in terms of stock market as well as accounting performance”. (13)
The graph below shows how stocks of sustainable companies tend to significantly outperform their less sustainable counterparts. It shows the evolution of $1 invested in the stock market in value-weighted portfolios. There are numerous studies documenting(14).
‘’ There is still a bigpart of the investment community concerned that ESG will jeopardise returns.That concern is based on old information.’’
Jane Ambachtsheer, Global Head ofSustainability BNP
There is however, criticism that ESG data does not go far back enough to provide complete historic and conclusive evidence. Therefore investors want further proof that ESG leads to opportunity rather than merely mitigating risks.
(13) https://www.nber.org/papers/w17950
(14) Shedding Light on Responsible Investment: Approaches, Returns and Impacts,” Mercer, November 2009.
Viewof the future – trade finance to widen adoption and the positive impact of ESG
Thesteady growth of ESG investing began accelerating around 2013 and 2014, whenthe first studies were published showing that good corporate sustainabilityperformance, and especially sound corporate governance, is associated withsolid financial results.
Theidea that investors who integrate corporate ESG risks can improve returns isnow spreading across capital markets on all continents. This has extended tosome providers of trade finance and to trade finance funds. With the increasingevidence that ESG principles have a positive impact on long-term risk adjustedreturns, investors welcome the addition of new asset classes and strategies.However some of the restraining factors already identified need to be betteraddressed.
Thedevelopment of ESG indices and better reporting
Asnoted, the lack of indices measuring trade finance transactions causes aparticular challenge for the trade finance asset class. The creation of tradefinance indices will require some lateral thinking but is not insurmountable.
Betterreporting, transparency, and the development of indices, will lead to improvedaccess to information, meaning investor attitudes, values and beliefs willchange.
Furtherspurred on by market pressures, investors will be able to take a betterlong-term view, strengthening their approaches to ESG investing, and helpingsolve the dilemma between the short-term and long-term benefits referencedabove.
Therapid development of tradetech and fintech solutions will make reporting of ESGfactors a lot easier for the trade finance industry.
Therole of technology
Technologicaladvances can also drive the standardisation of data and common standards acrossthe trade finance industry.
Thereis huge potential for blockchain technology to provide industry solutions toimprove trade efficiencies, reduce cost, reduce fraud and reduce compliancerisks.
Asalready seen in the Australian speciality beef industry serving Chineseconsumers, blockchain can also solve the problem of traceability and enablecustomers to trace the origins of products and the sustainability of the supplychain.
TheHalotrade project, allowed Sainsbury’s and Unilever to trace which farmer theirtea had come from in Malawi. Unilever then took this a step further, andprinted the story of the farmer for specific tea on the bags sent out forconsumer use.
Bridgingthe knowledge gap
Sometrade finance practitioners have started to hold ESG conferences or sessionswhere they share their knowledge or approach. Transparency is key to overcomingthis challenge. Sessions like this will really help the trade finance industryovercome the knowledge gap surrounding ESG. Smaller Trade Finance funds alsohave a part to play.
Theyengage with SME’s on a day-to-day basis through their work stream, allowing thesharing of ESG knowledge across continents and throughout companies – againhelping to close that knowledge gap. In this way, smaller borrowers can beencouraged to improve their governance, improve gender equality or develop theskills of their workforce.
BlendingESG with trade finance – a force for better returns and a better world
Thereis huge potential for the trade finance industry to play a large role indelivering the UN SDG’s with active engagement and on-going monitoring
Findinga harmonious way for ESG investing and trade finance to function together facesseveral challenges. These challenges are surmountable and their resolutionopens a huge opportunity and potential for the trade finance industry tocontribute to the UN SDGs.
Thegrowth potential of the asset class may accelerate as banks securitise pools oftrade finance assets to provide a more liquid debt instrument to institutionalinvestors. Within this context and the growing consideration of ESG factors forasset owners, there is an avenue for them to demand the incorporation of ESGconsiderations or clearly defined ESG outcomes into those securities.
Sustainabilityis relevant to all companies as it helps to ensure their long-term viability.It establishes a triple bottom line that seeks to improve social andenvironmental value along with financial return. We believe that sustainabilitydoes not inhibit—in fact, it improves— a company’s ability to create value.
Byactively engaging with counterparties and other companies that make up thesupply chain, trade finance participants can encourage many environmental,social and governance changes throughout the industries that they fund.
AsESG gains momentum in trade finance, sector and country indices will bedeveloped, allowing benchmarks to be created. ESG in trade finance will thenbecome more transparent, with participants reporting more. These advances willchange the attitude, values and beliefs of smaller investors when consideringESG linked trade finance. They will be encouraged to take a long term approachwith commensurate benefits to the ESG investment industry and corporatebehaviour.
Thereis a clear business case for sustainability and superior ESG practices. Theylead to superior operational performance and lower cost of capital. Investingin ESG products is not enough. Participants need to engage and work together tohelp create sustainable markets for all. The trade finance sector is very wellpositioned to create a virtuous circle between the adoption of ESG principlesby companies, their short term financing and the provision of longer terminvestment capital to drive attractive, sustainable growth.
GIBAM’s approach to incorporating ESG into trade finance investments – a casestudy
AtGIB AM, sustainable investment forms part of our philosophy. We began bymerging the Saudi Vision 2030 and the UN SDGs to develop the pillars that weremost important to us.
Thepillars of our framework are as follows:
Thisframework is then filtered down across the different asset classes. The TradeFinance team adopts a double-tiered approach.
Firstwe look at our Counterparties, and ask them to fill out our CounterpartySustainability Questionnaire.
Thequestionnaire provides non-exhaustive questions, based on the pillars of ouroverarching framework that are used to assess how a counterparty incorporatesESG and conducts its business in a sustainable and responsible manner.
Secondly,we look at each transaction and obligor. As we do not lend directly, we areoften undisclosed to the obligors and so onsite visits of obligors is oftendifficult. We therefore encourage counterparties to assess ESG factors duringtheir due diligence onsite visits. We also request that counterparties fill outour Transaction Sustainability Questionnaire, on behalf of the obligors.
Thequestions in the Transaction Sustainability Questionnaire are also based uponthe pillars in our overarching framework.
Whilstmany trade finance transactions are short-term, we aim to build long-termrelationships with our counterparties.
Thisenables us to continue our engagement with the counterparties over a medium tolong-term basis. We look to engage actively with our counterparties to supportthem throughout our relationship, encouraging them to conduct business in amore sustainable manner.
Throughengagement with our counterparties, we hope for a ripple effect further intothe supply chain. With our encouragement, counterparties work closer on theground with obligors, especially the smaller enterprises, in developingcountries to help develop and guide those obligors to conduct their business ina sustainable manner.
