Financing the Future: An Interview on High ESG Risk Industries and Opportunities for Banks

Financing the Future: Conversations in Sustainable Finance is a Q&A series where we sit down with featured environmental, social, and governance (ESG) experts from Sustainalytics, sharing their insights on how businesses are using finance to meet the challenges of our transition to a sustainable future.

In this instalment, we talk to Mayur Mukati, Sustainalytics' Corporate Solutions Associate Director, about how banks are working with clients in high ESG risk industries to set and meet targets for material improvements on ESG risk factors.

Sustainalytics: Thank you, Mayur, for joining us for another instalment of Financing the Future! I’m looking forward to your thoughts on how banks can finance climate initiatives and help companies in high-risk industries reduce their negative impacts.

Mayur Mukati: Thank you very much! It’s my pleasure.

SUST: Let’s get to it. Looking at industries with high environmental, social, and governance (ESG) impact and risk exposure, such as oil and gas, mining, and steel, what role can banks and financing play in helping companies in those sectors reduce their greenhouse gas (GHG) impact?

MM: Banks have a critical role to play in the climate transition of hard-to-abate sectors by financing companies’ efforts to achieve robust, science-based targets to reduce greenhouse gas emissions within this decade or so. Linked instruments, like sustainability-linked loans (SLLs) and bonds (SLBs), are a strategic component of these companies’ efforts.

Through such financing, banks can help clients with the important task of setting targets that encompass a material portion of the issuer’s or borrower’s overall emissions, especially relevant Scope 3 emissions. There is existing public guidance from recognized investor initiatives, such as the Climate Action 100+ Net Zero Company Benchmark, on the parts of the Scope 3 categories that are relevant for such emissions-intensive sectors.

SUST: Can banks support clients in high ESG risk industries to develop their climate transition strategies?

MM: Working with clients in high-risk industries to build their climate transition strategy and improve the quality and credibility of their sustainable finance transactions is another important way banks can help companies to reduce their impact. Active investors in the sustainable finance market often discuss the importance of backing up such client transactions with credible, entity-level transition strategies and commitments. Supporting transactions with a strong overarching strategy displays climate leadership and enhances investors’ confidence.

SUST: We’re seeing an increasing number of companies from industries with high ESG risk accessing sustainable finance through sustainability-linked bonds and loans. What meaningful key performance indicators and targets should banks be looking for when structuring these instruments for issuers?

MM: This is a very timely question looking at the current sustainable finance market. Our recommendation from a methodology perspective is that companies should look to recognized sources, such as the Sustainability Accounting Standards Board’s Materiality Map or ESG ratings, to identify which issues are material to them and their subindustry. Then they should set their KPI(s) based on addressing such issues. Taking this approach also means the KPI will have high applicability, i.e., it is expected to cover a significant portion of the intended impact. This depends on whether the client has included most of their business facilities and operations or sites in the performance calculation of the selected KPI(s). Ideally, these indicators should be externally benchmarked against recognized standards, for example the GHG Protocol Corporate Standard and Corporate Value Chain Standard for structuring a KPI on Scope 1, 2, and 3 GHG emissions.  

SUST: What about setting targets for the S and G aspects of ESG?

MM: Setting sustainability targets for social or governance factors is a more difficult task. Clients in many subindustries can leverage recognized carbon performance guidance (and underlying decarbonization trajectories) such as the Transition Pathway Initiative and Science-Based Targets Initiative, but there is limited guidance on social and governance topics. Imagine a mining company setting targets on the industry-specific material issue of occupational health and safety. It’s not only difficult to benchmark for companies with different sizes and locations, but also, these targets are heavily dependent on robust implementation of comprehensive policies, processes, and monitoring systems, rather than investments in physical assets, like low-carbon technologies.

SUST: What can banks and their clients do to make sure their social and governance-focused targets are credible and ambitious?

MM: Until wide-ranging standards for social and governance targets and measurement are developed and adopted, the most effective method is going to remain working with independent third-party verifiers like Sustainalytics. Verifiers have a critical responsibility to assess material issues based on their own judgment and understanding of ongoing market developments.

In principle, we look at clients’ proposed Sustainability Performance Targets (SPTs) in terms of material improvements in performance over a business-as-usual scenario. To determine whether a target is ambitious, we examine a company’s past performance on an issue, along with performance of its subindustry peers, and look ahead to assess whether the company will materially improve over historical data or in line with leading peers to achieve its target by the observation date.

Last but not least, the expanded details on the capital allocation plan and projects that are expected to result in such material improvements enhance investor confidence regarding clients’ intentions beyond what they communicate on the structure of the SLL or SLB.

SUST: It is said that finance is one of the best tools to support environmental and social impact and to contribute to the COP26 goals and various other international sustainability targets. How can banks play a role and where do you believe the growth possibilities are in sustainable finance?

MM: This is an important question, and the answer is evolving. At a fundamental level, banks are facilitating the flow of capital to companies that are aiming to improve their performance on sustainability, as well as to dedicated sustainable assets and projects. They are also engaging with companies in their portfolios to help them manage their material ESG issues, and they are setting an example by working to reduce their own ESG-related risks, especially physical and transition climate risks.

I expect banks will continue to play significant role in innovation. For example, on the capital and money market fronts, banks are integrating ESG in new financial instruments, such as green and sustainable deposits, equipment finance, trade finance like guarantees and letters of credit, and repurchase agreement transactions (green/sustainable repo). They are also advancing emerging ESG themes such as biodiversity conservation or gender equality through use of proceeds or sustainability-linked instruments.

[Editor’s note: We discussed this topic in greater detail in January.]

SUST: Now ESG is having a growing impact on mergers and acquisitions too. How are banks helping clients in that area?

MM: Banks’ ESG advisory divisions are helping clients integrate ESG due diligence processes within M&A transactions, often for clients in hard-to-abate sectors. Material ESG issues related to buyer or target have the potential to negatively (or positively) impact the deal structure and valuation during and after the merger or acquisition, so it’s important to understand and assess the existing and potential ESG risks and opportunities. This may mean using internal and third-party ESG data, ratings, and other related assessments.

SUST: Let’s finish off with some incredible numbers. 2021 was another great year for sustainable finance. Environmental Finance’s Sustainable Bonds Insights report indicated that green, social, and sustainability-linked bond issuance reached USD 1.03 trillion in 2021, which was a 69% increase over 2020. In your opinion, what economic factors supported this growth?

MM: I see multiple, interrelated drivers for the growth in sustainable debt issuances.

First, there is a connection to regional and global events that started before 2021. There has been continued interest in social bonds since we saw the surge in issuances as a response to broad social issues, such as racial inequity in the United States and the COVID-19 pandemic.

There also seems to be increasing awareness and genuine enthusiasm from the global investment community about the role of financial markets in meeting the Paris climate accord. We are seeing significant action supporting a green economic recovery from COVID-19. I expect that in response to ongoing geopolitical events, market participants will continue to take part in more discussions around investments with regards to the nexus of energy security and the clean energy transition.

SUST: Thank you Mayur for providing your insights on banks and high-risk industries! We’re looking forward to our next discussion.

Whether or not your company is highly exposed to ESG risk factors, managing the material ESG issues that affect your business can contribute to superior long-term enterprise value. Download our new ebook, Understanding Materiality: Lessons From Industries With High ESG Risk to learn more.