From coal, to real estate, to small business lending, environmental, social, and governance underwriting criteria are a critical tool for banks to reduce risk and enhance profitability for themselves and their business partners.
In Part II of our green banking series, we examined the growing opportunities for banks to profit through financing a more environmentally sustainable future. This installment looks at the importance and benefits of managing risk through environmental, social, and governance underwriting criteria.
As the underwriters of projects and entities across industries and geographies, financial services providers have a distinct need to understand how changing environmental conditions and expectations will affect their investments. As noted in an earlier installment of this series, climate change is estimated to cause $1 trillion in annual damage by 2040 – potentially a very expensive prospect for banks and other financial institutions whose projects and assets are damaged.
Consider how BP’s market capitalization plummeted by more than 50% while its credit rating fell from AA to BBB after the disastrous Deepwater Horizon oil spill in 2010. Such a massive blow to a company’s financial standing is certainly something that entities holding debt (not to mention equity) wish to avoid.
Environmental underwriting criteria are a means for banks to apply the precautionary principle in engaging clients to understand and improve their environmental performance.
Investment underwriting criteria that consider environmental, social, and governance (ESG) issues are also tools to identify more profitable opportunities. The United Nations Environmental Program Finance Initiative (UNEP FI) explains this in a report entitled “Show Me the Money: Linking Environmental Social and Governance Issues to Company Value.” The UN body states that “Seeking good investments under [this] lamp post, as well as looking at more familiar factors, can often give excellent insight into a company’s quality of management and corporate governance. Clues are often seen to large unpleasant surprises [sic]…as well as undervalued opportunities in day-to-day management of environmental, social, and governance factors.”
It is possible to quantify the effect that strong environmental management has on how credit risk is viewed. A 2010 study by Drs. Rob Bauer and Daniel Hann of Maastrich University found that, across industries, a record of strong environmental management helped borrowers reduce their borrowing rates by up to 64 basis points.
Banks are becoming acutely aware of the relationship between ESG factors and credit risk, and have moved to develop ESG underwriting criteria. Citi, for example, adopted its Environmental and Social Risk Management Policy in 2003, and has since provided training to over 4,000 of its loan officers on managing such risks. The bank was instrumental in the creation of the Equator Principles and the Carbon Principles, two widely referenced credit risk management frameworks for determining, assessing and managing environmental and social risk in project finance transactions.
How do ESG criteria affect lending? Consider coal power, which accounts for over 50% of electricity generation in the United States. Coal is the most carbon intensive fossil fuel and, correspondingly, is an energy source facing increasing regulatory challenges related to its greenhouse gas emissions and other environmental issues. Leading banks such as Citi, Bank of America, Wells Fargo, JP Morgan Chase, and Credit Suisse understood that this increased regulatory risk represents a tangible risk to project finance in coal powered electricity generation. In response, each of these banks adopted the Carbon Principles, which is an enhanced due diligence process aimed at providing a consistent approach for banks and their US power clients to evaluate and address carbon risks in the financing of electric utility projects.
Such enhanced diligence does not prevent doing business in any given sector, but rather helps both financiers and their borrowers to better qualify and mitigate risks. This leads to greater profitability for both parties in the long run, which is why utilities like American Electric Power, NRG Energy, and Sempra Energy have endorsed the Carbon Principles.
From coal to real estate to small business lending, environmental, social, and governance underwriting criteria are vital tools for banks to reduce risk and enhance profitability for themselves and their business partners.
Andrew Malk is the Founder and Managing Partner of Malk Sustainability Partners (MSP), a specialty management consultancy, which guides businesses in developing profitable corporate environmental sustainability programs. MSP has particular expertise in developing green banking strategies. This article was written in collaboration with MSP Partner Zach Goldman. If you have enjoyed this series so far, we invite you to download a complimentary Malk Sustainability Partners white paper outlining our case for green banking. It is available online here.