Exploring the importance of ESG in Credit Management

Alexander Van Lil on integrating ESG Principles into Credit Management

At this year's Day of the Credit Manager, organized by the Flemish Instituut voor Kredietmanagement (IvKM), one of the key topics was ESG and its relevance to Credit Management. TriFinance ESG expert Alexander van Lil took the stage to discuss if ESG principles can be effectively applied to Credit Management.

Alexander brings a wealth of experience from his previous career as a Credit Manager. His background equips him with unique insights into evolving ESG regulations and best practices in credit management and credit insurance.

He introduced ESG regulations by focusing specifically on the Corporate Sustainability Reporting Directive (CSRD) which will be implemented in four waves from 2025 (reporting year 2024) onwards to 2029 (reporting year 2028). It will start with large companies (listed companies, companies with over 500 employees, and public interest companies) and gradually extend to smaller companies, culminating with non-EU parent companies of EU subsidiaries in the final wave.

Under the CSRD, companies are required to report on their environmental, social, and governance impacts, detailing their sustainability strategies, targets, and performance. Additionally, they must provide comprehensive information on their due diligence processes, risk management practices, and the effects of their activities on climate and human rights.

Alexander also elaborated on the Corporate Sustainability Due Diligence Directive (CSDDD) and the EU Taxonomy. The CSDDD mandates that companies identify, prevent, and mitigate adverse human rights and environmental impacts throughout their value chains, promoting responsible and ethical corporate practices. The EU Taxonomy, on the other hand, offers a classification system for environmentally sustainable economic activities, helping investors and companies identify projects that significantly contribute to climate and environmental goals.

ESG and its importance

According to Alexander Van Lil, there are four strategic reasons why ESG is crucial for Credit Managers. Companies that manage ESG effectively will have

1. improved risk management
2. sustainable growth and innovation
3. long-term efficiency
4. higher stakeholder satisfaction

These factors often result in improved long-term financial performance.

Additionally, ESG factors will significantly impact businesses, potentially surpassing the footprint of the Sarbanes-Oxley Act (SOX) of 2002. While SOX focuses on financial integrity and transparency, ESG aims to broaden corporate responsibility, extending its influence much further.

ESG and different speeds in the EU

Within the EU and its member states, we observe varying approaches in implementing ESG regulations. This is especially true for the CSRD and CSDDD. Some countries, like Belgium, adhere to CSRD regulations. Others, such as Germany and France, have taken additional steps with the CSDDD.

In Germany, the "Supply Chain Due Diligence Act" (effective since January 1, 2023), known as "Lieferkettensorgfaltspflichtengesetz" or LkSG, was inspired by the CSDDD. It mandates companies to uphold ESG standards across their supply chains. This requirement has significant implications for business processes like Source to Pay and Order to Cash, as ESG standards must be ensured throughout these processes end to end

In France, the "Corporate Duty of Vigilance Law," enacted in 2017, sets a robust framework for corporate responsibility, focusing on human rights and environmental impacts.

These laws pave the way for the broader EU directive on corporate sustainability due diligence. As the EU moves forward with its proposed directive, companies across all member states, including Belgium, should prepare for increased regulatory requirements to ensure sustainable and responsible business practices.

ESG’s impact will intensify

During the IVKM session, attendees noted that ESG and sustainability are currently hot topics in economic Bachelor's and Master's degree programs, capturing the interest of students who represent the next generation of managers.

Mario Matthys, TriFinance Expert Practice Leader ESG reporting, emphasized that "in the banking world, ESG analysts are being hired on a large scale to assess ESG performance. ESG ratings significantly impact capital markets and investor confidence in sustainable products. They provide critical information for investment strategies, risk management, and disclosure obligations, not only for investors but also for financial institutions."

Providers of credit insurance, specializing in receivables within the European Economic Area and export markets were also present at the IVKM Credit Manager Day. They noted that ESG and its scores have not yet been fully integrated into their current credit limit scoring models. However, when considering whether to extend credit limits beyond standard criteria, they also consider the ESG score of specific customers.

These indicators show that ESG is here to stay and will have an even greater impact on business in the future.

ESG and its impact on the credit appraisal process

Integrating ESG into your credit limit setting allows for a more holistic or comprehensive approach that goes beyond numerical data. This deeper understanding permits more exact credit evaluations, suited to each customer and their unique business situation.

As financial data providers integrate ESG scores into their portfolios, it is crucial to understand their methodologies and ensure transparency in how these scores are calculated and applied. This is especially important with the mandatory CSRD implementation planned from 2025 onwards. Providers often use their own methods, standards, and scales to compute these scores. They typically rely on data from company websites or proprietary econometric models based on financial statements or questionnaires. This diversity highlights the need for standardized practices to enhance reliability and comparability across ESG assessments.

For example, Standard & Poor’s calculated the ESG score for Danone. The company has an overall rating of 55 on a scale of hundred, but on the factor “Environmental” it has a score of 67, which is very good. However, Danone, one of the largest food producers in the world, has been charged in France (January 9, 2023) for the lack of having a serious plan of action to reduce its plastic footprint. The lawsuit was filed by three environmental groups: ClientEarth, Surfrider Foundation Europe, and Zero Waste France, under France's "Duty of Vigilance" law. The groups accuse Danone of insufficient efforts to reduce its plastic footprint and of failing to meet its legal obligations in managing environmental risks associated with plastic use. Currently under judicial review, the case has yet to reach a final decision. This situation raises questions about how the Environmental score of 67 aligns with these accusations, suggesting a potential discrepancy.

Given their diverse standards, scales, and methodologies, there is considerable doubt about the quality of current ESG scores from financial rating institutions. Greenwashing techniques - often used by companies for marketing benefits - may influence these scores.

Recognizing this risk, the European Commission conducted a study along with public consultations. These efforts highlighted numerous issues related to the functioning of the ESG ratings market, particularly concerning transparency and the integrity of ESG rating activities. In response, the EU took action. On February 5, 2024, the European Parliament and Council reached a provisional agreement on a regulation for environmental, social, and governance (ESG) rating activities.

This framework sets out the requirement for ESG rating providers to be authorized and supervised by the European Securities and Markets Authority (ESMA) to offer their services in the EU. These new rules aim to enhance the reliability and comparability of ESG ratings, fostering greater investor confidence in sustainable products.

Many major ESG rating providers operating in the EU are based outside the EU, so the regulation also establishes pathways for these non-EU providers to offer their services within the EU.

However, since this regulation is not yet mandatory, the ongoing quality issue with current ESG scores persists, posing a challenge for Credit Managers and Credit Insurers who seek to integrate these scores into their credit limit setting in a systematic manner.

How can we apply current ESG scores in Credit Management ?

‘The integration of ESG scores into credit limit scoring models is still in its early stages,’ says Benjamin Celis. ‘However, Credit Management should proactively prepare for a future where ESG considerations play a pivotal role. By raising awareness among senior management about the importance of ESG in Credit Management and its impact on internal scoring models, Credit managers can address upcoming challenges and navigate evolving regulatory landscapes more effectively. Including ESG performance in their credit policy will be crucial.”

Leveraging the ESG score to approve an increase in credit limit can already yield positive results, especially in uncertain cases where it’s not clear whether or not to grant the increase. Companies with strong ESG ratings often demonstrate better long-term prospects, providing a solid rationale for incorporating ESG criteria into credit decisions.

You can also integrate the EU Taxonomy into your credit limit scoring model. It provides a clear classification system for environmentally sustainable activities. First, evaluate how the customer's activities align with the taxonomy's sustainability criteria. This helps assess their long-term viability and risk profile. Then, use this sustainability assessment in your scoring model to determine the credit limit. The taxonomy’s clear classification system improves the reliability of your decision by addressing concerns about transparency, integrity, and quality.

Moving forward, it's crucial for Credit managers to stay abreast of emerging trends and regulatory developments in ESG. This proactive approach not only improves risk management practices but also aligns with broader corporate sustainability goals. Integrating ESG considerations into credit management frameworks can lead to better decision-making that supports sustainable growth and resilience amid changing market dynamics.

In summary, while the full integration of ESG into credit scoring models is still in its early stages, laying the groundwork now allows organizations to stay ahead of regulatory changes and seize opportunities for enhanced risk assessment and sustainable business practices.

Sources

CSDDD | Corporate Sustainability Due Diligence Directive

• All 2024 ESG and non-financial reporting regulations in the EU
• Linklaters, 'ESG Legal Outlook 2024'

CSRD | Corporate Sustainability Reporting Directive

Danone

• ESG Investor, 'ClientEarth takes Danone to Court Over Plastic Pollution'
• S&P Global, 'ESG Scores and Raw Data'
  
• Plastic Soup Foundation,'Danone hauled up before the French court for excessive use of plastic'

ESG Ratings Regulation

• ESG rating activities
  
• ESG rating activities: 'What the EU is doing and why?'