By Bill Noel, Chief Product Officer, Solifi
Introduction
Sustainability, corporate responsibility, net-zero. These are all buzzwords that circle the asset finance industry. Some may consider these to be trends, but the reality is that sustainability is increasingly becoming a priority for businesses, not just in the finance industry but across the board. Regulations are evolving, and the expectation to build a strategy around the environment and society is no longer just a marketing point; it is becoming a legal duty.
ESG is at the forefront of sustainability discussions in the European Union, and it will not be long before the principles are adopted globally. It is important that lenders adapt their strategies to accommodate ESG requirements as the assets they lend change over the upcoming decades. The Corporate Sustainability Reporting Directive (CSRD) was announced in January 2023, and, as part of this, many businesses in the European Union will be required to report on sustainability.
Consumers, especially the younger generations, are becoming much more conscious of the brands they are buying from. A report by the Capgemini Research Institute found that 53% of consumers have switched to lesser-known brands due to their commitment to sustainability. This number is even higher at 57% for 18-24-year-olds. This demonstrates that there is a growing demand for products that meet ESG goals, and the asset finance industry is presented with an opportunity to support this trend.
This article will examine the role of ESG in the asset finance industry and how lenders can centre their business strategy around it.
The Evolution of ESG
To fully appreciate the role of ESG as a central component in the business strategy of secured finance organisations, it is crucial to understand what it entails. As discussed in the World Leasing Yearbook 2023, financial institutions have become increasingly aware of the importance of ESG to their business and have been building ESG considerations into their growth plans and risk assessments.
The concept of ESG is not new. The phrase goes back two decades to a report by the UN titled “Who Cares Wins”. The report, initially overseen by eighteen financial institutions, provided recommendations to integrate ESG into analysis, asset management, and securities brokerage. While ESG is now discussed across many industries, its roots grew in finance.
ESG in the asset finance industry not only means financing products that are environmentally friendly but also making decisions based on the practices of manufacturers. For example, supporting an organization that creates a lot of waste products and, in turn has a negative impact on local communities through pollution would contravene ESG principles.
Changing legislation is proof that ESG principles are here to stay, starting with Europe. The European Green Deal is an ambitious initiative that aims for Europe to become the first climate-neutral continent by 2050. It also aspires to improve the well-being of society, with skills training to support the transition and the creation of jobs. The Paris Agreement, which addresses sustainability goals on a global level, is a treaty aimed at tackling climate change that was signed by 196 parties at the UN Climate Change Conference in 2015. These initiatives make it clear that corporate responsibility is no longer simply a tick-box exercise, and ESG forms the core beliefs needed to reach these ambitious targets.
Whilst Europe seems to be leading the charge, efforts are being made globally to address ESG compliance. Many international manufacturers have signed The Climate Pledge, which agrees to regular reporting, decarbonization strategies through innovation and to reach net-zero annual carbon emissions by 2040. These manufacturers will need finance options that support them and their customers in meeting this progressive target. According to Drive, the technology in electric cars is up to 40% more expensive than their ICE (Internal Combustion Engine) equivalents. This higher cost of manufacturing will be passed through to the customer therefore, reliable finance options are required to ensure consumers can still access these products.
Analysis by Bloomberg expects global ESG assets, such as electric vehicles, to exceed $53 trillion by 2025, over a third of all total assets under management. Although this is an impressive number that reinforces the significance of ESG, a study by NAVEX found that, whilst the majority of businesses surveyed had a formal ESG program in place, only 50% believed that their company performed effectively against environmental metrics, and only 39% felt they successfully addressed governance and social issues. It is critical for lenders to not only seek out ESG assets but also have the processes in place to accurately consider and measure the impact such assets may have across the ESG principles.
There is a lack of a clear definition of an ESG asset. Often, it is assumed to be all socially responsible asset investments, such as electric vehicles and their charging infrastructure, or green initiatives, such as wind turbines or waste management systems. However, there is no officially recognized agreement on what assets could come under the term. The EU taxonomy provides some guidance at the activity level but not at the asset level. Currently, various industry bodies, alongside governments, are working to further develop the frameworks used.
Quantifying the Unseen: Scope 3 Emissions
The environmental angle is a prominent element in ESG strategy discussions, and this is why Scopes 1, 2, and 3 emissions play an influential role in decision-making considerations. In particular, secured finance lenders will focus on the implications related to Scope 3 reporting, which encompasses indirect upstream and downstream emissions within an organization. A study by Deutsche Bank found that Scope 3 emissions have 10 times greater impact on the environment than the combined Scope 1 and 2 emissions, demonstrating the necessity to address the contribution that lenders make to climate change. Within Scope 3, there are multiple categories, with category 15 “Investments” being the most pertinent to lenders. The “Investments” category covers not only its title but also lending and advisory services. Lenders need to be aware of the environmental responsibility they have on the assets they choose to finance, deliberately managing support for projects that impact negatively on climate change.
There are many ways that secured finance lenders can address their Scope 3 emissions. Leasing is becoming an increasingly preferred method to “go green.” It offers businesses the ability to finance the equipment they require to make positive changes rather than investing capital to buy equipment outright. Assets like solar panels and electric vehicles are often too costly and not a capital investment priority for many businesses. Suitable finance options may open up opportunities for businesses to make greener and more sustainable choices.
Asset finance lenders are in an advantageous position to support projects that address climate change. A report by Grand View Research found that the global renewable energy market is expected to grow at a compound annual growth rate (CAGR) of 16.9% from 2023 to 2030, establishing an emerging opportunity for equipment such as wind turbines, solar panels, biomass systems, and heat pumps, to be financed.
Alongside green energy, the electric vehicle market is also starting to boom. According to Fortune Business Insights, the global market is expected to grow at a CAGR of 17.8% between 2023 and 2030. Supporting this figure is research by Centrica, which found that 62% of the businesses they surveyed expect to operate a 100% electric fleet by 2026. Whilst EVs for personal use will need finance options, businesses requiring company cars or vehicle fleets will also present a good opportunity for lenders to embrace ESG strategy.
It goes further than personal and business use, however. Many local councils and governments are exploring opportunities to deliver greener public transportation. For example, Transport for London operates its buses at 100% low or zero emission. This presents a unique prospect for asset finance lenders to hit all the factors of ESG, as zero-emission buses help the environment and improve air quality, and good-quality public transportation helps the local communities.
The Supporting Role: Other Approaches to Sustainability
Organizations can take advantage of different methodologies to help them implement sustainable practices within their strategies. One example is the Triple Bottom Line, which measures social and environmental impact, with a particular focus on how businesses can bring value to customers, staff, and communities.
According to Harvard Business School, the 3 Ps – Profit, People, and the Planet – which forms the Triple Bottom Line – help secured finance businesses align their sustainability strategies by analyzing the impact their practices have across these three categories. Advocates of the Triple Bottom Line methodology dispute the notion that incorporating sustainability into strategy is unrealistically optimistic. Core to the principle is profit, and it has been proven that corporate social responsibility can, in fact, drive success, with a survey by Markstein and Certus finding that 46% of consumers pay close attention to the effort a business makes towards social responsibility when supporting the brand.
The European Union has been striving to address the social and environmental challenges across all industries with new initiatives. In December 2019, the EU Commission introduced the Green Deal, which is based on the principles detailed in the circular economy, where the life cycle of products is extended through recycling, reusing, leasing, etc. In an effort to reduce the 2.2 billion tons of waste the EU produces each year, businesses are expected to limit waste as much as possible and, as a result, release increased value from the products we make by reusing and repurposing individual part components.
A recent example in the automotive industry is leading automotive manufacturer Renault, who have been implementing the principles of the circular economy for over a decade by designing their vehicles with longevity in mind. The manufacturer is a shareholder of The Future is Neutral, a business that supports the drive to make the automotive industry carbon-neutral through a closed-loop economy, which entails the recovery and reuse of materials from existing cars, such as batteries, into new vehicles.
The circular economy brings some promising opportunities beyond tackling climate change. It is suggested that it could increase the EU’s GDP by 0.5% and create more than 700,000 jobs in the region by 2030. Sustainability Linked Loans (SLLs) are an effective way to support a circular economy framework, which links interest rates to agreed sustainability criteria. This model incentivizes borrowers to focus more closely on sustainability and, in turn, meet ESG goals.
A constraint that creates a barrier to the circular economy that is in the secured lending industry’s interest to solve is the lack of external finance for SMEs. 30% of SMEs engaging in circular innovation rely on debt. The answer to this is obvious; secured lenders need to offer finance options suitable for SMEs to meet their sustainability and ESG goals.
Teething Problems: Challenges of ESG
Whilst ESG has been a topic of conversation in the industry for almost two decades, it is still being defined and there is some apprehension from both secured lenders and OEMs in committing to a long-term strategy, whether that is because of reduced profits or the fear that it is seen as a marketing strategy rather than conscious change. Greenwashing, the act of misleading customers regarding the level of positive environmental business impact, is a significant concern. Greenwashing is an easy way to take advantage of the buzz around ESG, but it will have a negative brand impact if consumers feel that it is merely a marketing tactic rather than a genuine change.
One of the largest challenges as ESG grows in prominence is reporting. According to Reuters, critics feel that the current methodologies are too complex and are not rewarding those effectively managing ESG risks in a fair way. There are areas which are being debated and where more definition is required, such as green investment, for which there are currently no universally-agreed standards. Often investments claimed to be green are in fact not particularly sustainable. Combining this issue with constantly changing regulations and legislation highlights the difficulty for companies to stay abreast of accurately tracking their investments.
Furthermore, companies that provide ESG ratings are unregulated, resulting in benchmarking challenges across the industry. New EU legislation has been proposed with the aim of preventing firms that sell ESG ratings from providing consulting services to investors. Failure to comply could result in fines of up to 10% of their net turnover.
Servitisation (or pay-per-use) is one of the prominent topics of discussion as it is considered a viable option to achieve the goals of the circular economy. Items can be leased for when the customers need them, which is great for the customer. However, this can be challenging for lenders, as they will need to find multiple customers to use the asset until the end of its lifecycle, and pricing will need to change based on age, condition, and so on. This type of lending requires more involvement for a longer period of time, and it may be an impractical and costly approach for companies managing a large portfolio. These challenges can, of course, be overcome in some situations with the right technology, which can enable lenders to manage the complexities related to managing large portfolios, such as pricing, service, and maintenance, in an efficient and effective way.
However, legacy and not-fit-for-purpose technology can be a major roadblock if it is incapable of supporting scalability and growth. Many asset finance firms simply lack flexible technology that can adapt to the changing landscape. Managing new contracts tailored to these new opportunities will be onerous without the right technology that can automate processes and scale with the business as additional contracts are secured.
What Does The Future Hold?
The future trends are likely to show continued and increased focus on ESG. As more legislation related to OEMs comes into effect, manufacturers require financial support to enable them to switch to sustainable products and practices. Now is the time for lenders to get ahead of the curve and capitalize on the opportunities new legislation may bring.
Focussing on implementing an ESG strategy is not just about profit or impact on wider society: it will also have a positive impact within secured finance organisations. A study by Marsh and McLennan Company found that companies with the highest employee satisfaction have 14% higher ESG scores than the global average. This is due to Gen-Z and Millennials believing in ESG principles much more strongly than their predecessors, and with 72% of the workforce expected to be within these demographics by 2029, lenders need to acknowledge the role of ESG inside their organization in order to attract and retain talent. When employees feel valued and are happy, they tend to be more productive, stay in post longer, and overall the quality of their output will be higher. It is crucial to note that well-planned ESG strategies deliver wider benefits beyond protecting the environment, as they can positively impact companies’ opportunities for scalability and success.
Technology is allowing lenders to analyse the data that we have in a more meaningful way. Consumers are interested in buying from brands that are sustainable, presenting an opportunity for secured lenders to support these brands with financing options. Lenders need to ensure that they are investing in the right technology that can support the evolving requirements of the industry.
Ultimately, with changing consumer behaviors, new legislation, and increased expectations, ESG principles are here to stay. It is imperative that the lending industry pivots to suit the needs of the market.
This article is an excerpt from the 2024 edition of the World Leasing Yearbook
