ESG need not be a blocker to sound export finance

Export credit agencies and other lenders need to take a more holistic approach to ensuring ESG standards are reflected in finance documentation for projects instead of sticking rigidly to standardised wording that has been developed, which may impose unnecessarily burdensome requirements on engineering, procurement, and construction (EPC) contractors tasked with delivering vital projects that serve to improve economic, social and health outcomes around the world.

The need for the export financing market to change its approach to managing environmental, social and governance (ESG) risk in projects was discussed in a panel session I chaired recently at the TXF Global conference in Athens, which Pinsent Masons sponsored.

Sustainability in export financing

The idea that finance should be a driver of positive social and environmental outcomes is not new.

The OECD has long been involved in setting standards relating to export credit and last year agreed to adapt terms and conditions that many export credit agencies apply globally, to better support the transition to a green economy.

The Equator Principles – a voluntary set of standards for determining, assessing, and managing social and environmental risk in project finance – were first launched in 2003. Development of the principles, which have subsequently been revised, reflected the desire of many institutions to meet external calls to place ethical considerations towards the forefront of financing decisions – by channelling loans and other forms of finance to projects that could demonstrate their compliance to minimum social or environmental standards.

This ethical agenda has evolved in the years since, with new frameworks emerging to seek to encourage sustainable finance in response to today’s climate emergency and broader concerns about the impact of business operations and financing arrangements on people and the environment.

One of the frameworks now commonly used was developed by the Loan Market Association (LMA) in the UK, in partnership with other trade bodies around the world. They have developed ‘green loan’ principles and supplementary standards, designed to reflect the wider policy and regulatory agenda on ESG that continues to evolve internationally – as well as the increasing demand on the finance industry in respect of sustainability from shareholders, customers, and activists.

As the ESG agenda has developed, an entirely new industry has emerged. There is now a proliferation of ESG consultants that support export financiers in assessing ESG risk attached with prospective financing of projects. Those consultants typically provide detailed environmental and social due diligence (ESDD) reports, while large financial institutions themselves commonly operate with ESG teams that shape internal decision making on ESG issues and help steer those institutions’ adoption of relevant ESG standards, like those developed by the LMA.

The product of this activity is the setting of ESG-related contractual obligations in project contracts, which EPC contractors and borrowers are tasked with meeting.

The current problem

At the moment, ESG standards are often lifted and dropped from model provisions the likes of the LMA have prepared into export finance contracts for projects. The thinking behind this is that it provides institutions with comfort that they are according to industry standards on ESG. However, this is a rigid approach that can effectively ‘gold-plate’ ESG risk management requirements and may go beyond what is appropriate for individual projects.

Shaping the approach is the global clampdown on so-called ‘greenwashing’ by regulators. In the context of the introduction of more stringent regulation – like the Financial Conduct Authority’s new anti-greenwashing rule that took effect in UK financial services on 31 May this year – and enforcement, institutions are naturally tending to take a cautious approach to the way they manage ESG risks and the resultant claims they make about the sustainability of the projects they finance. The fact institutions are also at increased risk of litigation or potentially damaging public relations campaigning from shareholders and activists, where they perceive greenwashing, also plays into this. It is in this context that some institutions have been electing not to overtly publicise their support for, or make claims about, ‘green’ projects they invest in – a trend that has been colloquially referred to as ‘greenhushing’.

Another factor in the approach we see being taken is that stakeholders on occasion lack a detailed understanding of ESG standards. This can result in the over-scoping in the commissioning of consultants’ ESDD reports – adding complexity, delay and ultimately cost to due diligence exercises – and it can mean that a commercial view on the risks flagged in those reports and in how they should be mitigated by ESG professionals internally is disproportionately skewed towards ESG issues. The picture can be further complicated with added delay and cost where more than just the leading bank in a syndicated loan arrangement decides to undertake its own ESDD.

Managing ESG risk is important, but there are other important considerations to factor when determining whether to finance a project and what contractual requirements to push for. In the developing world especially, there is a pressing need for new transport, health and sanitation projects – potentially life-changing infrastructure. Adding delay to, and pushing up the cost of, delivering such projects by imposing overly burdensome ESG requirements in contracts is hard to justify on a human and commercial level. Export financiers need to have a stronger voice in articulating why the socio-economic benefits of projects are worth the risks.

A rigid application of the LMA principles and standards is not envisaged by the LMA itself. They are designed to be applied flexibly, giving financiers scope to apply some pragmatism and commercial sense when subjecting EPC contractors and borrowers to ESG requirements. To do so will require upskilling and a more holistic and collaborative approach to ESG risk management.

Some may see utility in the development of a robust, certified new ESG labelling system, as it could offer institutions a simpler way of satisfying themselves as to the ESG risks in a project while being cross-cutting of the different standards in operation. Labelling could especially help unlock capital in the context of so-called transition finance, where there is an urgent need to accelerate investment in clean energy and other carbon-reduction projects to meet international climate targets.

More broadly, however, export financiers need to be willing to work in partnership with EPC contractors to recognise the fact that projects are run differently in developing or emerging markets relative to the developed world. There is a greater need to share risks and understand that not all ESG risk can be accounted for in advance and that these will need to be addressed collaboratively during the execution phase.

In return for being more efficient in putting ESG requirements into contracts, export financiers can legitimately expect EPC contractors and other professional advisers to improve their own understanding of ESG standards so that they can identify and address related issues arising in project delivery. At the same time, robust reporting and monitoring of delivery of ESG requirements is needed beyond just the construction phase to mitigate risks of any mis-labelling and greenwashing.

Co-written by Camilla Ash of Pinsent Masons.