Will incentive issues stymie ESG ambitions for ECAs?
Is financing ESG-linked projects and exports going to be limited by what exporters and project financiers cannot do rather than what they can? How can (or should) incentives be improved and how can more deals that improve ESG outcomes be made bankable?
Read the headlines and it’s easy to think that the ‘greening’ of ECA finance is going gangbusters. A lot of the regulation to guide it is moving apace, major ECAs have formed E3F, an international coalition on export finance for the future to address the issues. But how are exporters, banks and export credit agencies able to respond to the challenges of Environment Social and Governance (ESG) without more comprehensive reform to the OECD Consensus? Are the incentives right and will the market continue to be driven only by what it cannot do, rather than what it can, to ensure better ESG outcomes? The question is, are you dealing with risk or good intentions?
Talk to the exporters in ‘green’ sectors such as the battery manufacturers, there still needs to be an (urgent) mind shift in how the energy transition in particular can be financed, and a need for more flexibility by ECAs in how they price and accept risk.
Gernot Bruch, head of export and project finance at Linde, observes that there is a lot of interest in green/sustainable deals on the part of potential financiers and banks, but ‘virtually no’ financing so far. “My perception is that in our sector this is not necessarily due to a lack of capacity, but rather to the (poor) bankability or economic viability of the deals. For example, in Central Europe, the production of green hydrogen is still three to four times more expensive than the production of grey hydrogen, but the willingness of potential customers to pay the green premium is still limited. Therefore, these deals usually only fly if they are substantially supported with public funding (allowances and grants).”
Let’s start with positive steps though. On 27 May, the Loan Market Association (LMA) issued updates to its guidance on Sustainability Linked Loan Principles and on 4 May it published its Social Loan Principles, which goes some way to help financiers address some of the social and governance issues potentially in tandem with the environment and sustainability. There has not yet been much market uptake of instruments issued using the LMA’s Social Loan Principles, but it is early days. The EU Taxonomy and Task Force on Climate-Related Financial Disclosures (TCFD) are also in place to help improve standardisation.
What’s my motivation?
According to one Nordic exporter: “Essentially the ECAs have not started from the green loan angle, they have more or less started from the opposite by focusing on what they are not supposed to do and what they have committed not to do and it’s almost as if what is left is supposed to be green.”
Starting from a negative is one approach. “I think that that's a fair representation of what we have today,” says one export finance head at a European bank. But is it possible for ECAs to incentivise the positive?
“As an exporter, or potential borrower, if something is supposed to be an incentive, there should be a price reduction component in it,” the Nordic exporter argues. “If you take any bond or any ECA facility or any commercial debt paper that's labelled green we're talking about a maximum of five basis points up or minus five basis points if you're not able to live up to the covenants or whatever is stated in the documentation. So there's not really any financial upside of being green because there's no framework around it.”
ECA hands still tied
Therein lies the rub. A lot of ECAs are unable to incentivise borrowers to any degree. In a world of targets of net zero by 2050 and climate mitigation, financing the energy transition is key. The challenge for banks is to ensure that ESG is not purely exclusive versus inclusive, and many want to help change companies’ activities. Many corporates are incentivised by reputational and affirmative actions and want to show that they're pushing forward an ESG agenda too. Some corporates want to be able to show stakeholders accountability and third parties assessing their ESG. Is it enough?
The banker points out that amendments to the OECD Arrangement on renewables were “done at a time when renewables meant the odd ‘windmill’ or solar farm in the middle of nowhere...things have moved on.” Fifteen to 20 years ago, there was some move to encourage renewables by allowing longer maturity tenors for such renewables, but the cables that connected those plants to the grid were not eligible for the same treatment. Such anomalies persist and the banker is not optimistic. “There is nothing in the Arrangement which would support the idea of moving to net zero, and even less to support social and governance elements in ESG.”
Getting consensus to change the Consensus does require full consensus (natch). With the smaller groups such as E3F, statements of intent remain broad, and export finance is not the exclusive realm of OECD countries. “The alliances are a step in the right direction, but not game changers. Price and tenor are the incentives that can move markets,” the banker says.
Says the head of export finance at another European bank. “There are no capacity issues for ESG deals that I am aware of. Bottlenecks maybe. I think ECAs are grappling with the issue. Some are much more advanced than others. Some benefit from the fact that most of their exporters are in green products whereas those that have an oil and gas footprint with no clear path forward find it more challenging.
If anything, everyone is trying to get credit and jump on the bandwagon to get the publicity that goes with it where they can. Until we come up with consistent and measurable criteria for the industry, it is going to be challenging.”
The green grammar with no shades of green
The green ‘grammar’ of the EU Taxonomy does not allow for shades of green. The binary approach does give a robust view of what is, or is not supportable in terms of sustainability. The taxonomy will particularly impact European banks (and European ECAs) who will need to comply – and that is a large percentage of the export finance market after all. Taxonomies for Asia are also in the process of being developed by the Green Finance Industry Taskforce GFIT out of Singapore (calls for contributions ended in early March).
Consistency in definition has been welcomed by many, particularly as there have been so many methodologies and definitions created in isolation. But critics argue that the EU’s effort is not helpful from the perspective of needing capacity in the energy transition.
“The EU Taxonomy is a nightmare from many perspectives,” warns the Nordic exporter. This, in particular, he argues is because of its treatment of the gas transition is too heavy handed, and he argues that European banks will be reluctant to finance energy transition when Europe still needs gas (although he concurs that coal and oil are ‘dead for our generation’).
That latter point was underlined at the end of May by a court in the Netherlands ordering Shell to cut carbon emissions at an accelerated rate. The International Energy Agency has also pushed for curbs on oil exploration projects from the end of this year. There are stark choices to be made, and as the European banker says, “some of those choices will be brutal.”
Monitoring transition may be better handled when, and if, the EU’s so called Brown Taxonomy emerges. While the EU still hasn’t fully decided about the treatment of nuclear and gas within its green taxonomy what a brown taxonomy will look like is still unknown.
In spite of the multiple guidance now in the market, the exporter argues there remains a wooliness and lack of definition. “There are instruments and there are these principles that the commercial banks have signed up to. But I think they're very flexible in a way that they interpret them and that's why you see a lot of things that have been done and they say that it's been green, it’s only the marketing that has been green.”
Green bonds evolution – can they help?
To rewind, there have typically been two types of incentive structures used in the capital markets in what’s been governing bank origination of ESG products. First has been the ‘green’ use of proceeds facilities – based on where the proceeds are going to be applied (renewables, manufacturing, etc) and the criteria gives it a ‘green’ badge.
Second has been sustainability-linked facilities. These are not restricted by use of proceeds and, can be for general corporate purposes – driving sustainable behaviours, aligned to corporates’ own goals and ambitions on their ESG trends – and in this, there may be a pricing benefit for corporate borrowers. To ensure accountability and transparency, these behaviours should be independently monitored to adhere to best practice.
Most ESG products started in capital markets, and green bonds have been around for a while but in the past 18 months have accelerated, as have sustainability-linked structures – in both term lending and revolving credit facilities (RCFs) – which are also moving into trade finance areas.
The market is moving from purely environmental and green type targets, to a broader ESG mix (although it remains early days for the social and governance elements). When looking at green use of proceeds facilities, these can also have a social or governance element added to it. This is what the new LMA guidance is trying to address too.
But what about the ECAs – green guarantees?
Swedish ECA EKN is at the vanguard of what ECAs are doing in terms of sustainability and its fossil-free ambitions are widely reported. It plans to be reporting under TCFD, starting with a preliminary project later this year. It has developed the first green (working capital/investment) guarantee for climate-friendly domestic projects in Sweden which will be launched imminently, says Victor Carstenius, analyst at EKN. Nonetheless, this remains domestic, and will cover up to 80% of bank risk. “The next step will be export credits, using the domestic green guarantee project as a template to have more favourable conditions for exporters.”
Carstenius agrees that up to now, ECAs have largely been focused on the negative – what they will no longer do (in terms of stopping financing fossil fuels, etc), but now he hopes that more incentives to promote green outcomes can come into play.
In terms of premiums or pricing incentives, there is less wriggle room. “It’s difficult to get past the OECD Arrangement and domestic Swedish laws which ensure the agency’s premium is in accordance with the credit risk taken, and legally cannot subsidise transactions for other reasons,” Carstenius points out. “We could look at cover ratios and national content requirements – and allow, for instance, higher foreign content for green transactions or higher cover ratios for them, but we haven’t decided on those yet.”
Many ECAs do want to more. And the banker says that, within the constraints of the Consensus, ECAs have been developing common lending points whereby they have become more lenient in terms of eligibility criteria for ESG. “The expectation from the banking industry is to see some kind of tangible preferential treatment in terms of price and tenor with projects with the right features.” The challenge in using green loans with a sustainability-linked label is, according to the banker, “it’s a learning curve that we’re all in the middle of, and some things that have been given a green label that is, at best, a bit of a stretch.”
Are other incentives possible to change beyond the confines of the total reform of the Consensus? Tools like CIRR are regulated by the Arrangement and in countries where it is deployed, it could in theory be tweaked. Pricing is more complicated and would require consensus. The banker points to technical reform to sector understandings on renewables and tenors. “They could look to expand on the renewables Sector Understanding to update it to today's challenges not the 2-3% of the grid which was the case when the current Sector Understanding was rolled out all those years ago. A technical change to an annex is easier than wholesale reform.”
Rewiring for green loans?
And in terms of ECAs supporting ESG-tied loans under, say, the new LMA guidance? “I’m keen to be promoting sustainable KPI features integrated into export credit facilities, but it’s not been done yet,” says the banker. The difficulty, he points out is that sustainability-linked facilities tend to be for general corporate purposes, while export finance by definition is mostly project related or tied export credits. “Nevertheless, it should be feasible to get export finance with sustainability-linked KPIs, and that is the sort of exercise we are trying to develop.”
The complication is that once bankers and corporate borrowers have agreed, the ECAs also need to be on board with the rationales and incentives, and that, the banker says, can be a challenge. “I can see them being onboard with the idea, but if the consequences of achieving the sustainability KPI is getting a rebate of a premium, or reducing the premium if not achieved, that is not easy. We will be having conversations with the ECAs, but I’m not wholly optimistic.”
Still all about the fundamentals
The Nordic exporter asked a direct hypothetical question about maritime financing to a banker. “Right now would you prefer to do Maersk or a Hapag-Lloyd commensurable financing for a vessel being run on LNG or oil? Or would you want to fund a ship owner who is basically bankrupt but has a very green idea and green finance attached?” He agrees that it’s a daft question and answer, but it shows that no matter how green you go, you won’t change the fundamentals, that the credit risk needs to be acceptable. “Credit risk is credit risk. And as a bank, you need to make a profit and you need to be sure and know what you're doing. Just because something is labelled green doesn't mean you can act in a daft way. The best way to approach this,” the Nordic exporter says is, “find a good project, make sure it's creditworthy, make sure it's bankable, and then add in ESG elements.”
Certainly accelerating the energy transition will demand more capital – in the battery industry alone, an estimated $40 billion in capital is needed, which will need to be supported by ECAs – and taking on more risk (and pricing and allocating it properly) will be key. It may well be a culture shock.