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A Look at the Engine for ESG: Finance

A Look at the Engine for ESG: Finance

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Between sustainability-linked loans and, more recently, green bonds, the finance world has been one of the early adopters and promoters of the ESG movement. We spoke with CMS Partners Ana Radnev, Cristina Reichmann, Ihor Olekhov, and Rafal Zakrzewski to check in on the status of ESG in this crucial sector.

Still Defining ESG

“The main question remains, still – what is ESG and how will the regulators adapt to it by creating a common language around it,” Radnev begins. She continues by saying that investors are “facing pressure, for example, from shareholders, financial institutions, or asset managers, to place a higher accent on ESG and disclose their policies.”

In terms of “the greatest promoters of the ESG push,” Radnev points to “how the approach of commercial and development banks and international corporates to create a dedicated ESG position is spilling over into other areas of the market. These roles, essentially, seek to develop the entire business operation of a company with sustainability in mind.” Zakrzewski chimes in noting that “development banks have had ESG-related aspects affixed to their activities for decades now.”

Radnev continues: “until recently, finance transactions, like loans or bond issues, placed a high accent on the environmental side of things, however these days, transactions are evolving in the direction of including ESG-related projects linked more broadly to other factors improving sustainability.” This, of course, further branches out to cover other corporate aspects, Radnev explains, including analyzing one’s overall environmental impact and reporting obligations.

Echoing the notion that “E” is the more focused on, as opposed to the “S” and the “G”– at least until recently – is Olekhov. “Since the war began in Ukraine, the focus has shifted somewhat, and both the sustainability and the governance elements have become more prominent,” he says. “Governance, in particular, has come to the forefront of ESG-conscious companies and financial institutions because of massive violations of international law rules by Russia and the related risks for companies and financial institutions to continue to work in Russia and with Russian counterparties,” Olekhov adds. “Most international companies left Russia and are completing the process of leaving Russia or of dealing with Russian counterparties, because of the risk to find themselves in breach of generally accepted governance rules and even ethical rules of conducting business.”

Moreover, Olekhov says that many businesses in Ukraine began assessing what their rebuilding efforts would entail and “seek to mold their operations to accommodate ESG.”

A critical element in ensuring that businesses are “appropriately positioned to evaluate the impact of ESG issues and to factor them into business decisions is the role that boards of directors play in the current and long-term stewardship of the companies they run,” Reichmann pitches in. “Elevating the ESG agenda to the boards is not a matter of choice; it is an integral part of directors’ fiduciary duties,” she says.

“This means that, as part of their fiduciary duties, directors have a responsibility to adopt an integrated, strategic approach for material ESG issues, to ensure these risks are identified and have been adequately addressed and that opportunities are maximized,” Reichmann continues. “Integrating ESG into business strategy and company planning is part of a sound risk management, and directors who fail to comprehensively and systematically consider ESG matters as part of their responsibility could well be deemed to be negligent in the performance of their fiduciary duties.”

Furthermore, Reichmann points out that, “with the growing focus on ESG of regulators, investors, consumers, and wider society, it could be considered that these developments reframe climate-related risks as financial risks, rather than just non-financial or reputational concerns, which may impact the balance sheet and profitability.”

The Taxonomy – A Solid Foundation To Build Upon

With the focus still very much on defining what ESG is and how ESG-related risks should be looked at, Radnev and Olekhov agree that the Taxonomy was a necessary stepping-stone for creating a unified approach and a common language for ESG. “The Taxonomy is the mere beginning; now comes the hard work of building on top of,” Radnev says. “There are technical standards being worked on, which are expected by the taxonomy. Overall, a more consistent and intensive regulatory work was spurred by it,” she says.

“The Taxonomy underlines which areas are open for further development,” Olekhov adds. “It provides the groundwork for behavior within certain industries, for instance – treating nuclear as green or not or the way of producing methanol.” Moreover, Olekhov believes that the Taxonomy has provided an excellent yardstick for the ESG projects and is aimed at protecting against greenwashing. “It will continue to evolve with time and with the advent of new technologies and processes in various areas. Before the Taxonomy, the rules were ambiguous for ESG requirements.”

The ESG Drive Riding Out the Storm

Between the war in Ukraine, the ongoing energy crisis, and high inflation rates, some argue that the ESG agenda is inevitably going to lose some of its momentum. Zakrzewski, for one, believes that “we are heading towards economic turbulence, with high inflation and energy price spikes, and that this might impact ESG, especially because the markets have become used to high liquidity and a lot of readily available funding.” He fears that ESG development efforts might be impacted if the situation changes adversely in that way.

Radnev, however, indicates that the focus will remain where it is and that the regulatory framework shouldn’t change in light of current developments: “ESG is here to stay. On the one hand, I believe that full compliance is still a couple of years away for most businesses. On the other hand, I don’t think that there will be any regulatory efforts that will have a slowdown effect on ESG developments, as a consequence,” she says. Radnev reports that “assessing the sustainability impact is now a necessary part of any new investment or restructuring of existing businesses, and having an ESG rating or being able to link growth to ESG KPIs as well will facilitate unlocking liquidity,” she believes.

Olekhov chimes in, sharing that, despite the ongoing war in Ukraine, the reconstruction and rebuilding process has already started. It will “involve many areas, including the infrastructure, energy, real estate, and construction industries. Importantly, the Ukrainian government understands that any reconstruction and rebuilding of Ukraine must embrace ESG principles, because the funding for these purposes would be provided by either public sources that have worked with ESG rules for a long time, or by private funds that focus on ESG rules now to a great extent.”

Looking at the region as a whole, Radnev believes that ESG will be an unavoidable metric when it comes to restructuring. “A strong accent is likely to be placed on ESG elements, especially concerning looking at supply chains. The way companies behave with their suppliers, how they predict consumer trends, how they commercially engage in certain areas – all will be affected,” she shares.

Olekhov adds that, in the context of Ukraine, “there is a high likelihood of seeing a large number of ESG-related innovation projects, focusing on new types of transport and energy storage solutions. Financing for all kinds of ESG projects is likely to come to fruition.” He feels that ESG is, as Radnev put it earlier, “here to stay for a very long time” and that “all of the market turbulences and volatilities in energy prices” are only more likely to “spur ESG projects to develop more than ever.”

Radnev does concede that there is one element that might lead to a slight drop when it comes to the volume of ESG-related transactions. “With the level of focus and scrutiny being applied to ESG claims, there might be a drop in terms of the number – for example, where there might have been ten, there will now be two – but these will be far more rigorously vetted,” she explains. “It will no longer be a matter of what you put into a loan agreement but also how you prepare transactions and monitor them.” The dedicated ESG roles she mentioned previously come into play here. “These professionals will be able to alert their employers about which KPIs are to be set, monitored, and reported on.”

Reichmann, again, turns to the boards and emphasizes that company boards should be “strategic in evaluating ESG issues, as part of their risk management duties, in line with international guidelines and regulations.” This way, they can ensure “the development of policies and strategies to address ESG matters, internal control, and auditing mechanisms.”

Hopeful Look Forward

In terms of what he’d point to as his one wish-list item for ESG in finance in CEE, Zakrzewski believes that consistency in approach would be the most important. “This would increase the investors’ familiarity with market products and promote cost-effective deal execution. If different institutions go in different directions, there is likely to be a lot of inefficiency,” he says. Still, he believes it “will more be a matter of the unification of market approaches than a top-down regulatory effort.”

Olekhov, on the other hand, says that “regulators would need to be more active in creating softer capital requirements for ESG-related loans, but that this has been lacking in many jurisdictions as of yet.” With the increasing numbers of ESG-related financial instruments, he feels the banks will “have more relaxed rules, but only if the regulators lead by their own example. As more market players realize the benefits of ESG, so too will there be more understanding from all parties involved.”

Reichmann pointed out that in some sectors, “mainly for credit and financial institutions, listed companies, and carbon-intense sectors, regulators have already imposed mandatory requirements with respect to ESG risks, as part of the risk management and risk appetite framework.” She believes that irrespective of the sector, “directors must be mindful of the interplay between ESG factors and the discharge of their fiduciary duties and therefore ESG issues should be a key part of board agendas.” To fulfill their duties, Reichmann says that boards “need to be fully aware of the implications of climate change” as well as to have the skills to assess their company’s current ESG posture and “develop strategies, policies, and internal controls for producing consistent, transparent, and measurable sustainability performance data.”

Agreeing with Reichmann, Radnev concludes that, ultimately, the markets must continue educating themselves about the crux of what ESG is, instead of just riding the zeitgeist wave: “While you do not need every loan to be green, you do have to understand the core values of ESG as a concept. Only in this way can progress be achieved.”

This Article was originally published in Issue 9.7 of the CEE Legal Matters Magazine. If you would like to receive a hard copy of the magazine, you can subscribe here.