European banks best positioned to be leaders in sustainable trade financeFinancial institutions with stronger ESG portfolios
experience lower risk costs which offset additional costs related to due diligence and reporting. This is from the point of view of lower loan loss provisions related to better creditworthiness of more sustainable borrowers. Nevertheless, adoption of ESG linked or Green Financing products in the field of trade finance has been lagging. One of the reasons for this is the overall complexity of trade finance, sometimes entailing a lack in the relationships either with the buyer or the seller or even the involvement of many parties. But more importantly, I posit, that the challenge is in the alignment of interests and incentivization. Given that Europe is the front-runner in this field constituting half of the global ESG Assets
and is the top trading partner for 80 countries
European banks are best positioned to lead the industry towards sustainable trade finance.
Trade finance assets being low volatility and low risk, are generally great candidates for securitization. Considering the stringent capital requirements and the evident investor interest in more sustainable investments, sustainable trade finance products are best positioned to be securitized contributing to the closure of the trade finance gap. Existing standards such as Sustainability Linked Loans or Green Bonds could be applied to trade finance products. There are already Financial Institutions doing these such as Standard Chartered
Supply Chains are, however, very complex, making traceability and transparency of sustainability data a challenge. Depending on the product, a missing relationship with one party may render the application of the standard non-viable. E.g. in case of a Guarantee Facility a missing relationship with the Importer
, or lack of disclosure requirements in the region complicate the initiative. So how could these issues be resolved.
A network with ESG-credits linked to value
In most trade finance transactions, you have a buyer, a seller and their respective banks facilitating a transaction. The financing costs connected to the transaction are oftentimes transferred indirectly to either the buyer or the seller. In case of forfaiting for example, the seller incorporates the discount that they need to accept from the forfeiter indirectly into the price. This transfer of value can serve as a tool for enforcing covenants pertaining to ESG criteria.
Imagine a network where the financing is contingent to ESG scores for both the buyer and the seller. The seller is required to report data about the origin of the materials, carbon footprint, employment practices etc. Whereas the buyer reports information on the carbon footprint of the distribution network, social practices etc. At the moment of signing a purchase agreement however, banks are already involved, offering each of the parties the possibility to collect ESG credits in case of adhering to predefined thresholds and reporting requirements.
Carbon footprint is relatively easy to quantify and link it to credits. Other criteria would require a deeper analysis and definition to be incorporated in the construct. ESG credits can be collected and converted to money for services provided by the financial institutions involved, be it for paying a premium for a guarantee or reducing a discount in case of forfeiting. Credits could also be transferred between the buyer and the seller incorporating an additional layer of pricing contingent to predefined thresholds.
To avoid the use of ESG credits on non ESG activities, incorporation of eligibility criteria would play a vital role. Checks such as use of child labor or manufacturing of arms can facilitate enforcement of eligibility criteria to the construct.
Such a network would not only align the incentives of the participants, but also bring transparency to the supply chains. In the case of CO2 footprint, companies would benefit from a better visibility on their supply chains overall instead of just their own activities. The financial institutions involved benefit not only from the reduced cost of risk but also from the larger interest of investors in the secondary markets subject to verifiable certification. The additional data collected would facilitate data driven decision making and upselling of services (e.g. pre-shipment financing).
Distributed Ledger Technology and Smart Contracts as a way for implementation
The distributed ledger technology has already gained a wide adoption across trade finance facilitating faster and more efficient trade finance transactions. Incorporating sustainability linked smart contracts into the process could make the network described above feasible. Transfer of value through ESG-credits among the parties in the chain directly creates an incentive for participation. Traceability reduces fraud risks. Enforcement of the covenants is automatically triggered letting no single party acting as an arbiter. Evaluation and scoring can be facilitated either by third-party certifiers or by AI based oracles. All this can foster trust and decrease the barriers for adoption.
Co-Creation as an opportunity for banks to deepen their customer relationships
There is a myriad of mechanisms that could be conceived for such products. Nevertheless, global companies are facing themselves the challenge of being more environmental and social, feeling the push from their investors. As banks have been nourishing long relationships with these firms and possess valuable knowledge on the nuances of their businesses, they are best positioned to support their corporate clients in their ESG endeavors. Co-creation will facilitate buy-in and adoption opening new opportunities for the banks. This will transform their roles from mere financiers to partners in shaping the corporate strategy.
To achieve this, banks should partner with industry players and their corporate clients to conceptualize sustainable trade finance products aligned to the corporate strategy of their clients. Partnering with consulting firms can prove to be an asset given the broader knowledge across industries and project-based nature of their business. Facilitating the execution of the ESG strategy in trade finance will position the banks as reliable partners for the next decades. Its time to act now while the window of opportunity is still open.Special thanks to Stephanie Paech and Golo Gröhnke for their contributions