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How environment and social governance can change your business

The way businesses are managed is always changing, however, more than ever before, the expectations about the results and in particular, how they are achieved, are dramatically changing. There is a new paradigm that has arrived to stay.

by Juan Ramón Miguélez

EMEA Regional Director Environment, Society and Geomatics

13 September 2018
calculating bankability
Introduction

When oil prices were high, top companies in the Oil and Gas sector dedicated funds and efforts to managing sustainability and Environment and Social Governance (ESG). Then, all of a sudden, oil prices decreased and so, too, did this focused effort and funding across the sector. Now that oil prices are incrementally escalating and the pressure on clean energy sources is increasing, there are companies that have traversed the desert of low oil prices with their funds dried up. Does anyone want to allot funds to a poorly-managed ESG company? Will investment funds go to the poorly-managed or the appropriately-managed company? Where do you think the money will go?

This paper is not about ticking the ESG box to get funds at a lower cost. Instead, it is intended as a guide, nudging the reader to honestly assess your company’s ability to translate your ESG policy, and to think about changing the way you do business in order to deliver promise and value to your stockholders.

Background

How can you be sure that a project is managed according to ESG standards? The simplest answer to this question is making sure that your project is bankable, which ensures alignment with ESG standards. Here’s why: investors are often convinced to place their funds in lenders’ accounts because lenders say they will invest in activities that protect or benefit society and its environment.  

So how or when is a project considered bankable? A project is considered bankable if lenders are willing to finance it.  This is the clear position of the European Investment Bank. Yet, before we arrive at bankability, we have to understand the context from which some of the direct benefits will be extracted by the companies taking this approach, which may also affect the lenders’ criteria to finance a project. 

Project Financing

In the current context, large and small-scale projects face a range of challenges including government regulations, construction schedule and budget, and profitability during operation. Obtaining project financing is almost always the greatest challenge for the developer. 

It’s not a new one. Long ago, Roman and Greek merchants used project financing techniques to share the risks inherent to maritime trading. A loan would be advanced to a shipping merchant on the agreement that such loan would be repaid only through the sale of cargo brought back by the voyage. Sound familiar?  In modern finance terminology, this means that project financing would be repaid by the internally generated cash flow of the project. This technique was widely adopted during the 1970s in the development of the North Sea oil fields, and in the US power market following the 1978 Public Utility Regulatory Policy Act (PURPA) (Gardner&Wright). 

The increasing tendency for companies to use project finance mechanisms has necessitated the involvement of lenders, usually in a syndicated manner, to distribute the risk of project development. Additionally, there are three main motivators for sponsors to seek project finance:

1. Limited Recourse. In case of investment failure, a Lender’s only recourse may be the assets of the Project Company.
2. High leverage. It is not uncommon for projects to be 90% debt financed, which carries additional benefits:

Lower initial equity injection requirements, decreasing the  project investment risk;
Enhanced shareholder equity returns; and
Deductible debt finance interest from profit before tax (PBT), reducing the (post-tax) weighted average cost of capital of the Project Company.

3. Balance Sheet Treatment. This allows the shareholders to book debt off  from the balance sheet. Having established the current context and trends related to project development financing, we can return to the original, definitive question: “Is this project Bankable?” To answer this question, we must review the criteria that drive a lenders decision to financially support a project.

Essentially, there are four key drivers:

1. Economic sustainability, which encompasses cash flow to support repayment of the loan under different stress scenarios, assessed through technical reviews of the operability and reliability of the project as well as the product or service market;
2. Loan Interest Rate, which should be balanced against the risks;
3. Policy Compliance, particularly those that are public such as Equator Principles and IFC Standards and Guidelines; and
4. Operational Risk, which can be translated into risks affecting the Repayment of the loan and/or the bank/lender reputation.

For the purposes of this paper, we are going to focus on Policy Compliance and Operational Risk.

Most banks or lenders have embraced the Equator Principles as part of their policies. When conducting bankability assessments, lenders look for compliance with Equator Principles and IFC Standards and Guidelines, as well as Good International Industry Practices (GIIP). Consultants are usually engaged to prepare the documents from the developer side, whereas the lenders engage with other consultants to review the business structure against those standards. Time, effort and potential changes to the initial design are involved in assessing compliance with these standards, which are also related to operational risk, which is perhaps the most crucial element of the bankability assessment.

As mentioned previously, the lender takes on risks related to repayment and reputation. The due diligence of a project identifies existing or potential liabilities that may disrupt the cash flow or the project balance sheet, and policy compliance (against Equator Principles, IFC Standards, and GIIP) is an effective and expedient way to identify them. If the developer fails in the cash flow forecast due to improperly addressed risks, the likelihood of repaying the loan decreases. Furthermore, if any of these risks have links to social or environmental mismanagement, the lender’s reputation will likely be affected, which is particularly detrimental to those who sell a social, environmental, and ethical portfolio (Green Funds or Socially Responsible Investors).

Risk Assessment and Project Bankability

According to the World Bank , the following key risks need to be allocated and managed to ensure successful financing of a project:

  • Construction and Completion Risk
  • Operating Risks
  • Demand Risk
  • Force Majeure
  • Political and Regulatory Risk and Expropriation and Nationalization Risk
  • Environmental Risk
  • Social Risk
  • Tenor and Refinancing Risk
  • Currency Exchange Risk
  • Interest Rate Risk

The perception that risk has changed in the last 10 years has affected the context of project bankability. Based on analysis by the World Economic Forum (WEF), risks between 2007 and 2010 were primarily geopolitical, economic, and social (health). Since 2011, environmental and societal issues have been in the top five . The WEF's Global Risk Landscape 2017 shows the impact and likelihood of global risks.

The Risk Radar update from the CRO Forum, a group of professional, insurance industry risk managers that focus on developing and promoting industry best practices, identified environmental and societal-related issues as risks likely to result in a claim in the next 10 years. 

Additionally, according to Goldman Sachs (2010), Non-Technical Risks account for up to 70-75% of cost and schedule failures in projects in the form of schedule delays and cost overruns, local deal opportunities, and a host of stakeholder-related issues.  An example of this might be a company in the extractive industry that suffers $6.5bil value erosion over 24 months due to non-technical risks, including community opposition and delays in regulatory approval - exactly the situation that lenders try to avoid.

Until relatively recently, compliance with local regulations was almost the only requirement for a project to proceed. Environmental and social issues were seldom included in the project conceptualization, visualization, or design. However, in recent years, there has been a dramatic shift in both risk perception and lender requirements to provide financing.

Companies with good ESG increase the bankability of any of their projects by properly managing environmental and social risks, and, from a financial scope, they usually outperform others because they demonstrate better governance in every aspect.

Applying ESG Principles to Minimize Risk

When a project is assessed for financial feasibility, the project is purely conceptual, with no tangible performance that can be assessed. Parallel to the business case, only policies, procedures, and targets related to environmental and social performance can be assessed. These are all summarised under ESG. 

Actual performance is a solid indicator that predicts future behaviours with more confidence. In the case of large companies, actual performance can be shown in other areas (such as human resources or project execution) in addition to their policies, procedures, and targets (ESG), enabling project financing. 

In the case of new ventures where no track record exists on environmental and social performance, only the ESG setting in terms of documents and the team leading the project can be used as an estimator of future performance. A differentiator that reduces the risks for lenders, as discussed previously, is if the new venture adheres to Equator Principles, IFC Performance Standards, and GIIP. Adherence to these principles and standards is a way to avoid, mitigate, or compensate potential environmental, social, and governance risks through proper ESG setting. This perspective is not based on belief, but on time-honored reality that has been proven over the last 40 years. 

ESG and Portfolio Optimisation

Even for companies that have a bad ESG track record, the confidence of lenders can be regained if they establish a new venture that integrates solid ESG.  As discussed above, bankability and application of sound ESG practices can reduce the risks associated with projects, thereby increasing the chances of success. The application of these concepts is not limited to a single project- they can be applied to an entire portfolio. Therefore, as noted at the beginning of this paper, a project can be used to resolve the difficulties of a complicated portfolio. 

Since the early 70s, around 2,250 academic studies have been published on the link between ESG and Corporate Financial Performance (CFP), 70% of which were published during the last 15 years (Friede 2015).  Deutsche Asset & Wealth Management (DAWM), jointly with the University of Hamburg, conducted a review of these studies, finding that roughly 90% of them relayed a non-negative ESG–CFP relationship. More importantly, a majority of them reported positive findings: 47.9% in vote-count studies; and 62.6% in meta-studies.

More recent studies  reinforce these finding with the following results:

Theoretically, an increase in the number of UN PRI signatories and an increase in ESG awareness within investment strategies would result in a decreasing ESG alpha (shrinking correlations over time) due to learning effects in capital markets (Friede 2015).  In essence, as more and more companies adopt ESG practices, the correlation between ESG and CFP should decrease as there will be no difference between companies with regard to CFP that can be attributed to ESG. In other words, a diminishing learning curve across all the companies would eventually eliminate the difference. Interestingly, this outperformance from the financial point of view continues to exist. The difference between companies with good ESG performance (thus better CFP) and those that do not have good ESG indicators continues to grow.

An example of the above is presented in Figure 2, comparing the Morgan Stanley Capital International KLD 400 Social Index and the S&P 500 Performance. 

 

 

Figure 1: Morgan Stanley Capital International KLD 400 Social Index v. S&P 500 Performance

As seen in Figure 1, MSCI KLD 400 stocks have outpaced S&P 500 for many years. As of 2015, MSCI was outperforming S&P 500 by $100 indexed value.

These facts support the concept that companies with better corporate governance are unlikely to suffer from environmental, social, or business disasters that consume resources and cause short-term falls in the share price, therefore freeing up cash to pay shareholders or improve the business.  This in turn makes those companies and the projects they sponsor more bankable than others.

CONCLUSION

ESG is a smart way to do business- not just a tick in the box. It is important to remember the following when assessing the bankability of a project:

  • A good starting point is to understand whether a company is ready to implement or currently implementing ESG practices properly, which are key to reducing project risks;
  • High (unmanaged) risk, including low chance of loan repayment at the agreed interest rate, deters lenders from providing financing;
  • Environmental and social issues are increasingly becoming sources of risk, reflected in the recent reports from the World Economic Forum;
  • Aligning procedures and behaviours with Equator Principles, IFC Standards and Guidelines as well as Good International Industry Practices is a way to avoid, mitigate, or compensate those risks in an acceptable way for lenders, as this demonstrates better governance of environmental and social issues and is linked to better financial performance.

In summary, companies with good ESG increase the bankability of any of their projects, by properly managing environmental and social risks, and, from a financial scope, they usually outperform others because they demonstrate better governance in every aspect. The better the Environmental, Social, and Governance setting, the easier the access to the credit market. If ESG practices are applied across the board, companies benefit from lower cost of capital, better operational and financial performance, and improvement in their overall enterprise value.

Learn more about how Advisian can help you understand and manage your interfaces with the natural, physical, social, cultural, regulatory and built environments - wherever you choose to operate.


References
  1. https://www.hsbcnet.com/gbm/attachments/products-services/financing/project-finance.pdf accessed on 05/06/2017
  2. http://www.eib.org/epec/g2g/i-project-identification/12/123/index accessed on 29/05/2017
  3. https://ppp.worldbank.org/public-private-partnership/financing/risk-allocation-mitigation visited on the 31/05/2017
  4. http://reports.weforum.org/global-risks-2017/the-matrix-of-top-5-risks-from-2007-to-2017/ accessed on 29/05/2017
  5. https://www.thecroforum.org/wp-content/uploads/2016/12/ERI-Radar-October-2016.pdf accessed on 02/06/2017
  6. Goldman Sachs. 280 projects to change the world. January 15, 2010
  7. Ruggie, John (2011): Managing human rights impact in a world of converging expectation
  8. Gunnar Friede, Timo Busch & Alexander Bassen (2015) ESG and financial performance: aggregated evidence from more than 2000 empirical studies, Journal of Sustainable Finance & Investment, 5:4, 210-233, DOI: 10.1080/20430795.2015.1118917
  9. Oxford University, Goldman Sachs, Arabesque partners, Insead 200 studies are related to business case for sustainability, sustainability & cost of capital, and ESG & Corporate Operational Performance, and Corporate Financial Performance.  Studies were issued by multiple organizations (e.g. Harvard Business School, Harvard Business Review, Deutsche Bank, University of Oxford, MSCI. Columbia University and other high caliber institutions   
  10. Op cit
  11. https://www.fundstrategy.co.uk/socially-conscious-funds-dont-suffer-performance-penalty-analysis/ accessed on 30/05/2017
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