11 February 2020
In this text Christopher Flensborg and Hans Beyer (SEB) highlight important insights concerning Transition financing, describing their observations and concerns from two different perspectives.
As calls for and commitments to a solid engagement by investors into supporting transformation towards a more resilient society increases, so do the requirements for information. From the investor side, this information is necessary to build an understanding for both headline (reputational) risk and financial risk. And, as a consequence, this will have a major impact on how financial advisors can contribute value-enhancing services both to the providers and the users of funds.
"Transition finance" is the new focal point of ESG and financial markets. Through Transition finance, the concept of Sustainability finance moves towards focusing on positive change rather than identifying green assets.
This widens the economic scope dramatically and provides the investment community with a plethora of new opportunities – and challenges. A lot of focus is on the Climate challenge and, related to that of course, Energy production.
But those two are "only" one aim of the current effort. What we at SEB believe is imperative to understand as well are the two mega trends within the financial industry that impact our ability to address those challenges: Transparency and Purpose.
Unless the financial markets are able to communicate how funds are allocated and for what purpose, the ability to amass the required investments will not be there.
These fundamental requirements in themselves require a lot of work. Transparency includes not only the name of a share or an issuer identity, but also information in relation to sustainable benchmarks and regulations in order for stakeholders to understand the effect of the investments.
Purpose includes not only direct impact of a certain investment but also that the investment is put into a societal context so that the embedded fiduciary mandate that comes through a financial investment is put into a wider context applicable to large-scale strategies.
In practice, this will require enhanced requirements on information provision. We believe the following five areas are among the most important ones where focus needs to be directed, no matter which role one has in tomorrow's financial system: In this text Christopher Flensborg and Hans Beyer (SEB) highlight important insights concerning Transition financing, describing their observations and concerns from two different perspectives •
- Fundamentally explaining the funding target's societal role
- Clearly communicating its transition strategy
- Giving clarity around the choice of Benchmark(s) used to illustrate ambition level
- Credibly describing the funding target's structure and internal governance to support the transition strategy, and
- Setting out the funding target's structure for stakeholder dialogue on performance assessment.
Re-pricing of assets
The financial implications of the above-mentioned trends and their implications should not be underestimated. We believe there is an inherited drift in asset prices due to the increased focus on Sustainability. But there are also important initiatives that both support and affect the informational issues involved and hence the potential re-pricing of assets. We believe the most notable to be:
- The Financial Stability Board's Taskforce on Climaterelated Financial Disclosures (TCFD), which has provided broad guidelines on the material impact of climate issues.
- The Central Banks and Supervisors' Network for greening the financial system (NGFS), which assesses regulators' roles on TCFD issues.
- The Principles for Responsible Investment, which has enforced TCFD disclosure among signatories (representing USD 85 trillion of assets).
- The European Banking Authority, which has addressed credit risk through enforced disclosure (June 2021 and June 2022) and systemic risk through proposing regulatory supporting factors (June 2015).
- The C40 Cities Climate Leadership Group, which drives collaboration and best practice-sharing on sustainable city development.
At SEB we are convinced that being able to master the transformation to a large degree comes down to how a company masters the communication in combination with the company's strategy. And this is the same no matter if you're an investor or a borrower.
However, we see that at this moment in time the borrowing community probably needs to catch up with the investing community (who started much earlier), and banks and other advisors are required to enhance their advisory capabilities in order for societies to avoid unnecessary disruptions related to asset re-pricing.
Implications for advisors
By providing a structure in which investors and borrowers can communicate in terms of economic and environmental values, existing instruments such as green bonds have successfully pointed the way forward in meeting these challenges. Provided the next generation of instruments created to support the transition follow the same path, we should be on the right track. The difference between many of the current instruments and the ones supporting the Transition is the complexity and width of the latter. The financing techniques will be much more heterogeneous and the scope enormous in comparison. SEB's role is to assist our clients, within all sectors, in understanding and navigating this transition. To achieve this, risking accusations of green washing and name washing, we believe there is only one plausible way; through full transparency in respect to goals, strategy and governance – and to have transition targets assessed by qualified reviewers before moving to any external communication.
On this journey we will see lots of successes, and likely some failures, as future standards are established. SEB as an institution has unique insights into what this journey will entail, having advised more issuers than any other bank in establishing their green frameworks. We have also facilitated the highest number of individual transactions within the green bond market.
This experience convinces us to approach the challenges ahead with humility and a realisation that advice regarding Transition will have to more bespoke than Green financing.
Introducing Transitional in the context of a bank
At SEB, we have constantly tried to maintain high standards of sustainable classification, realising the embedded conflict in a profitable investment banking practice versus the way profitability is expressed by analysts, auditors and regulators.
As we stated above, if Green financing can be considered a practice that is in a sense 'static', financing already-existing assets, Transitional financing is far more complex as it entails a movement measured against a baseline, with the movement and the baseline changing over time.
The balance sheets of medium-sized and large banks in the Western hemisphere reflect society as a whole. Assets could broadly be classified as already green (forestry), out of sync with a sustainable society (thermal coal); or potentially Transitional. And by Transitional we mean that the assets that today fund commercial activities which – with additional funding – can be transformed into having a more positive impact on society from a Sustainable perspective.
Finding the appropriate pre-set trajectory and the foreseeable future
The challenge for the individual financial intermediary is finding the appropriate pre-set trajectory. As referred to before, there is currently a multitude of differing knowledgeable bodies providing intelligence in this field.
When giving advice or proposing financing, a bank has to navigate between too stringent trajectories, excluding many truly climate enhancing activities, versus too lax judgements, where ‘solid polluters’ could become eligible for funding without enough of a contribution to a sustainable society.
Advanced lobbying initiatives combined with potential loss of short-term business potential adds to the complexity and further illustrate the complexity banks face.
There is no panacea to this issue and we do not expect this to be solved solely through regulation. Rather, we believe that the dramatically increased Sustainability focus in the investment community, combined with its rapidly increasing ability to assess how their investments contribute, is the real game changer going forward. This is very much in line with the purpose and transparency of the mega trends mentioned earlier.
In reality, this will materialise itself in transactions and public statements on who has been financing what and through this a standard will emerge. Banks can contribute through bringing the eligible borrowers to the market, as well as giving advice to those that are not eligible. Large asset managers (or asset owners), like AXA, have made clear statements of their preferences. These standards will hopefully drift towards Paris Agreement aligned targets, but most important is the everyday step taken towards a more resilient society. The pace of this movement will be controlled by the stakeholders of those large pools of capital amassed within the investment community.
The challenges ahead are true opportunities
So far, much of the focus regarding transition has been on the equity market. From an impact perspective, the development concerning the debt markets is probably more of a gamechanger. Most green financing has been itemised. Since transition financing is more centred on future investment decisions, communication and direction, it has thus far been focusing on the companies and how to assess them from an equity holding perspective. This is likely to be interesting from an IR perspective or maybe when issuing equity, but when the focus progresses into debt, it becomes a challenge for the corporations dependent on market-based funding. The importance of correctly assessing and labelling debt structures can not be exaggerated, and CFOs and Treasurers, together with their advisors, have to do the homework. For banks this will over time drive the development of their balance sheet.
We believe banks can find the right operational distance between business decisions and sustainability (including credit risk) assessments, in order to play the important role they should in the transformation of society’s economic activities. The tone should be set from owners and C-suite executives, or it will lead to a very incoherent implementation. In our experience, unless credit institutions are attuned to the pace of change they face a potential double whammy of increased weighted average cost of capital (WACC) and increased irrelevance as stakeholders, investors and customers move towards more Paris Agreement aligned requirements.
Strong indications of this are already apparent in certain parts of the world, and there is evidence of the replacement of banks for less transparent lenders – often based in jurisdictions where transparency requirements are low – or by weaker stakeholders with shorter horizons. It is our sincere hope that NGFS, TCFD and other great global initiatives, will help curb such short-termism.
Banks do play a pivotal part in society and can not just leave all of today’s funding commitments in preparation for a “possible tomorrow”. The transition towards a sustainable future is a fine balancing act where banks can play a conductor’s role if they succeed in balancing the mega trends with every day implementation. And when they do, the business opportunities are surely amazing.