ESG in Lending Decisions. What is in it for Banks?

[By Dhanush Thonaparthi]

The author is a student of NALSAR University of Law.

 

Introduction

Economic Social and Governance (ESG) policy is a concept of growing relevance among business houses, replacing the more traditional Corporate Social Responsibility (CSR) concept. It is reflected in the legislative and policy space of the government, with the most prominent example of this being the introduction of the Business Responsibility & Sustainability reporting mandated by The Securities and Exchange Board of India (SEBI), for India’s top 1000 listed companies by market capitalization. In this context, the article argues that banks should incorporate the ESG performance of a company alongside other factors when considering a lending decision, with persuasive reasons for the same and examples as to how ESG is already becoming a key factor in credit ratings and lending decisions.

What is ESG and how is it relevant for companies? 

ESG includes three components, its pillars, namely Environmental, Social and Governance. ESG refers to a set of standards regarding a company’s activities and behavior concerning the components of ESG. These factors, in the corporate context, are used to look at the long-term sustainability of a company. With an increased global push towards environmental consciousness, respecting social considerations, and better governance in companies, this framework becomes important in evaluating a company’s future performance and opportunities.

Achieving high ESG standards also becomes important for companies in the context of the stakeholder theory[1], which postulates that corporate success is not dependent only on shareholder and management satisfaction, but also on its relationships with its customers, the Government, creditors, and the public. The long-term survival and profitability of a company depend on it maintaining a good relationship with all its stakeholder groups. This is where ESG standards play an important role, considering that they address the environmental aspect, (which has been a major point of concern across countries and the public) the social aspect (mostly relating to the general public welfare, which is important for a company’s reputation and goodwill) and the governance aspect (better governance instills public and corporate confidence, meaning access to cheaper lending, more and better customers and more investment options).

How is ESG relevant to banks when making lending decisions 

Banks are financial institutions driven by profit motives and financial considerations. A major concern for banks is non-performing assets and delays in repayments by borrowers, reducing the profitability of the bank. This can lead to unrealized gains and/or unnecessary litigation for recovery, both of which any bank will want to avoid. Therefore, banks would want metrics that help determine whether a lending decision could translate into an unprofitable venture. A key factor that can be incorporated into such metrics is ESG.

A review of the literature on ESG as a factor in corporate lending has found that better ESG performance may correlate with lower credit risk, legal risk, and downside risk.[2] Additionally, a survey by Morningstar indicates that better sustainable performance leads to better risk mitigation.

We are currently undergoing the largest wealth transfer in history, with experts suggesting that nearly sixty eight trillion dollars of wealth will be transferred to the newer generations. We are in the middle of the largest wealth transfer in history. This is important for financial institutions as millennials fear climate change and would be willing to sacrifice financial benefits in favour of sustainability, and a company that is able to gain a leadership position in sustainability will be more preferred by millennials.

Before delving into more specific reasons as to why ESG is important for banks in their lending decisions, we have to, first consider the Environmental pillar of ESG. Companies that are compliant with existing laws and regulations are less likely to be penalized and fined for any potential violation. The future outlook regarding environmental legislation is that it will be more protective of the environment, leading to more restrictions for a company, which translates into more potential liabilities for companies that do not comply and additional costs for compliance.

For banks, this becomes important as a compliant company is less likely to incur these additional liabilities that add to the company’s costs. A company that goes beyond legally mandated environmental norms is more insulated from changes in regulation making it less susceptible to changes in legislation.

Secondly, the Social pillar of ESG is important for banks, as it helps determine the brand value of the company and to assess how much public goodwill the company enjoys. If companies do not value the rights of people, it leads to public resentment and outcry, which forces the governments to intervene, leading to unnecessary interference and even litigation and reparations. An example in this regard is the case of Facebook. Facebook had to pay nearly 725 million dollars to settle a class action lawsuit after it disclosed that information relating to 87 million users (about twice the population of California) was improperly shared with Cambridge Analytica.

Thirdly, Governance is an important pillar for banks to take cognizance of when lending, primarily because better governance means better company performance, a higher level of employee quality, and reliable company disclosures. If a company has bad governance practices, it can spell disaster for banks that choose to make lending decisions based on the company’s financials as disclosed by the company itself.

A good example of bad governance translating into unreliable disclosures is the well-known Satyam scandal. In this case, the company had falsified accounts, inflated the share price, and invested enormous amounts in property. Upon admission by the company’s chairman, the fraud became known, leading to a collapse of the market’s reputation and confidence in the company. This is a prime example, demonstrating how dishonest and inefficient governance practices can lead to the collapse of a company, putting lenders at immense risk of their loans turning into non-performing assets or defunct loans.

Fourthly, companies must be able to align themselves with the social values of the public and contribute towards the welfare of the society they operate in, because company perception plays a key role in the retention and expansion of a company’s customer base. If a company has a bad social reputation, then it is less likely that customers will opt for its products. Additionally, bad corporate social performance by a company can attract undue governmental attention to the company’s activities and lead to governmental interference, leading to a disadvantageous situation for the company. All of this would translate into potential defaults or delays in repayment of amounts lent.

We can round off our understanding by looking at two examples where ESG factors and principles have been incorporated into a comprehensive framework. The first example is how CRISIL has incorporated ESG principles into its framework to evaluate the credit ratings of companies. The second example is how the State Bank of India has developed a comprehensive ESG framework that will be incorporated into its lending decisions.

ESG and CRISIL 

In India, CRISIL is one of the most trusted credit rating agencies for companies. ESG is one of the components that CRISIL uses when determining the credit rating of a company.

A sample CRISIL rating report of Tata Motors Limited, published on 19th May 2023, shows how ESG is incorporated as one of the factors when determining the credit rating of Tata Motors Limited. In its detailed analysis, the report looked at whether Tata Motors’ ESG profile supported its risk profile. It also outlined a few key initiatives by Tata Motors to improve its ESG ratings and finally concluded that the company’s ESG profile and its commitment to ESG principles will enhance stakeholder confidence and improve its access to foreign and domestic capital markets.

CRISIL, in its report, has used ESG to look not only at the creditworthiness of Tata Motors for the current period based on past performance but also as to how its ESG commitments would enable it to access capital markets even in the near future, both at home and abroad. It has taken a holistic view of the company’s ESG performance and incorporated it into its credit rating.

Additionally, according to an analysis of CRISIL’s report, wherein it published the ESG scores of 225 companies, companies with the highest ESG scores have better credit ratings. This shows a positive correlation between ESG scores and credit ratings, meaning that better ESG performance by a company is likely to translate into better credit ratings, which is relevant to both banks when making lending decisions.

State Bank of India’s ESG framework 

State Bank of India (SBI) has adopted an ESG financing framework whose purpose is to evaluate which lending decision will create a positive social and environmental impact in the country and takes into account sixteen factors when making such a decision. These sixteen considerations include clean transportation, green buildings, renewable energy, and food security, among others.

Each of these considerations is looked at in more detail. For instance, to look at whether the borrower satisfies the requirement of clean transportation, the bank looks at the annual GHG emissions reduced or avoided, the number of clean vehicles deployed, and the estimated reduction in fuel consumption, among others.

This reflects how the bank makes an in-depth analysis when making lending decisions, ensuring that the ESG framework is implemented not only in letter but also in spirit. By incorporating sixteen factors that look into the three pillars of ESG comprehensively, SBI’s ESG framework is robust, transparent, and compliant with the core elements of the Sustainability bond guidelines, 2021, Social Loan principles, 2021, Social Bond principles, 2021, Green Bond principles, 2021 and Green loan principles, 2021 published by the International Capital Market Association, according to a second-party opinion by Sustainalytics.

Conclusion 

With an increased regulatory push by the government to ensure exacting standards of ESG in business houses, banks need to seize the importance of ESG and incorporate the same into their lending models. Each pillar is equally important from a moral and commercial perspective for both lenders and borrowers. We have also seen how SBI and CRISIL have already incorporated ESG principles into a comprehensive framework of their own, indicating that it is not only theoretical now but that there is a practical application of ESG principles when evaluating the credit rating of a company or when making lending decisions.

 

[1] Ankit Arora and Dr. Dipasha Sharma, Do Environmental, Social and Governance (esg) performance scores reduce the cost of debt? Evidence from Indian firms, Vol no. 16, AABFJ, 4, 9-10, 2022.

[2] Jiraporn, P., Jiraporn, N., Boesprasert, A. and Chang K., Does Corporate Social Responsibility (CSR) improve credit ratings? Evidence from geographic identification, FINANCIAL MANAGEMENT, 500, 505-531. 2014.

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