ESG Initiatives Take Hold in Banking Sector

Introduction

In recent years, environmental, social and governance (“ESG”) initiatives have become a driving force in many industries, and the banking sector is no different. Since green bonds first emerged in the European market in 2007,¹ sustainable finance has steadily gained momentum, with the most significant progress seen in the last five years. Global annual sustainable debt issuance more than doubled from US$769.1 billion in 2020 to US$1.689 trillion in 2021, with no signs of slowing down in 2023.²

The global push for ESG initiatives is largely driven by consumer demand. A recent study found that 83 per cent of consumers think that companies should be actively shaping ESG best practices and more than 50 per cent believe that companies should be doing more to advance ESG issues.³ Financial institutions are responding to this call to action with more than 300 banks, representing almost half of banking assets worldwide, adopting the UN Principles for Responsible Banking (a framework for sustainable banking designed to be integrated into banks’ strategies and across their portfolios).⁴ Further, more than 40 per cent of the world’s banking assets have committed to the UN-convened Net Zero Banking Alliance (“NZBA”).⁵ The Canadian banking sector has experienced this shift in priorities as well. The Canadian Bankers Association reports that Canadian banks recognize that the financial sector is central to addressing climate change⁶ and eight Canadian banks and credit unions have joined the NZBA.⁷

Sustainable finance encompasses a broad range of banking practices and tools, through which financial institutions incentivize borrowers to reach ESG-related targets. Sustainable performance targets can centre around renewable energy, water consumption, sustainable sourcing, affordable housing, among countless others. Rewards for achieving key performance indicators vary and are often incorporated into credit and loan agreements through mechanisms for decreasing interest rates and fees.

Innovation in Financing Tools

Green bonds, which offer financing for projects intended to achieve environmental benefits, continue to dominate the sustainable finance market with more than US$600 million worth of green bonds issued in 2021.⁸ However, in the last five years, the financial sector has seen tremendous innovation in the debt instruments offered to borrowers. In 2017, the first sustainability-linked loan (“SLL”) emerged in which interest rates on a syndicated loan were linked to an ESG rating assessed by an independent third party. Since then, SLLs have become the second-largest and fastest-growing segment of ESG debt instruments, largely due to the flexibility of the loan.⁹ SLLs are attractive to borrowers as they can be used for general corporate purposes, as opposed to green bonds and loans which must be allocated to sustainable projects. Large Canadian companies have begun converting billions of dollars of their debt to SLLs, since they were first introduced in Canada in 2019. SLLs have garnered global interest. In 2019, the Loan Market Association, the Loan Syndications and Trading Association, and the Asia Pacific Loan Market Association jointly published the Sustainability-Linked Loan Principles for guidance on SLLs in global markets (their most recent version was published in March 2022).¹⁰

Not only has the market seen innovation in the debt instruments offered, but also in partnerships between governments and financial institutions. The Government of Canada has committed to achieving net-zero emissions by 2050 and is actively engaging the banking sector in reaching this goal.¹¹ Government agencies have recently begun partnering with financial institutions to guarantee loans for borrowers transitioning to more sustainable business operations, showing that all players in the Canadian banking and finance industry continue to develop creative solutions to pushing out more ESG-focused funding.

The ‘S’ in ESG

As evidenced by the popularity of green bonds, environmental interests have long since occupied the majority of the sustainable finance market. The quantifiable nature of many green projects lends itself well to sustainable finance where measurement is a critical factor. However, in the wake of the COVID-19 pandemic and increased social unrest, social initiatives have been on the rise. The North American debt market has seen financial institutions launch a billion-dollar bond to promote the advancement of women in executive positions and issue bonds with targets linked to increased access to resources in low- and middle-income countries. SLLs are proving to be an effective vehicle for social priorities as initiatives can span industries and borders. Social initiatives can include human rights; health and safety; employee engagement and satisfaction; Indigenous peoples and communities; diversity, equity, and inclusion; ethics and security; among others. We have also seen “S”-focused performance indicators make their way into loan agreements whereby borrowers may see reductions in interest rates and fees payable if they can demonstrate that a certain percentage of those working on their development projects are members of defined equity-seeking groups.

International Progress

Financial institutions in Europe and Asia have been active participants in the sustainable finance market as well. Europe accounts for half of all global ESG assets and European lawmakers are actively working on ways to regulate the green bond market.¹² Billions of dollars of green bonds have been issued in Hong Kong, with no signs of a slowdown in that market.

Canadian financial institutions operating internationally and international financial institutions operating in Canada may face additional regulatory hurdles and consumer pressure in the coming years to ensure the terms of their lending around the world adhere to local and global ESG principles.

Looking Forward

In 2023, we expect more growth and innovation in sustainable finance in Canada. With growth and innovation also come regulatory scrutiny and calls for evidence-based reporting on sustainable finance goals and targets. We have seen, both in Canada and globally, regulators crack down on cases of “greenwashing” and courts demand action from some of the world’s largest companies in upholding their ESG-related promises.

The Canadian government has announced requirements for federally regulated financial institutions to begin reporting on climate-related financial risks, with the goal of phasing in reporting requirements by 2024.¹³ As such, throughout 2023, we expect financial institutions to begin setting up and rolling out this reporting framework and see it make its way into reporting requirements passed down to borrowers. In accordance with the Task Force on Climate-related Financial Disclosures framework,¹⁴ banks will be expected to collect information on climate risks and emissions from their clients, which means this requirement will be passed down to borrowers, who will be required to make climate-related financial disclosures to access funding.¹⁵

Final guidelines have been published by the Office of the Superintendent of Financial Institutions (“OSFI”) following development of OSFI’s expectations for disclosures and management of environmental risks by federal banks in Canada. OSFI has three expected outcomes for banks to achieve pursuant to proposed Guideline B-15: (a) that the bank understands and mitigates against potential impacts of climate-related risks to its business model and strategy; (b) it has appropriate governance and risk management practices to manage identified climate-related risks; (c) and it remains financially resilient through severe, yet plausible, climate risk scenarios, and operationally resilient through disruption due to climate-related disasters.¹⁶

Conclusion

Globally, we are seeing a strong push to not only increase ESG visibility, but also to incorporate ESG initiatives into strategic planning across all sectors. The changing regulatory landscape exemplifies the permanence of ESG initiatives – they are not just a fleeting trend, but a mainstay in the banking sector which demands compliance and co-operation. Financial institutions have a unique opportunity to drive innovation within the sustainable finance sector and the economy at large through their borrowers.

If you require assistance with any matter or question related to ESG in banking, please reach out to a member of our Financial Services Group.