Companies and banks in need of (debt) finance are facing ever more arduous challenges. These are no longer confined to simple questions of debt servicing capacity, the level of collateral to be provided, or the adequacy of equity investment. Increasingly, financing decisions tend to focus on sustainability and ESG criteria as well.
As national and European climate targets have been established, a profusion of new legal requirements and regulations has emerged. One of the key aims of these new regulations is to create transparency around corporate business models. More and more, companies are required to identify and quantify their sustainability and ESG (E = Environment, S = Social, G = Governance) “aspects” so that ultimately, the latter can be measured and compared. For companies with business models that do not (or no longer) meet these requirements, there is a risk that banks will no longer be willing to provide them with finance or, at the very least, that credit terms may become significantly less favourable.
Large corporations are not the only enterprises to be affected by the increasingly stringent regulations in question. They also impact small and medium-sized enterprises, which represent the lion’s share of companies in Germany. Even though many SMEs are not directly affected by legislation such as the German Supply Chain Due Diligence Act (Lieferkettensorgfaltspflichtengesetz – LkSG) due to come into force on 1 January 2023, they have no choice but to grapple immediately with the issues concerned wherever the latter impact supply chains in which they are involved. Furthermore, the decision to extend these laws and regulations to smaller companies has already been taken – not just in Germany, but across Europe as a whole.
The social and environmental responsibility of companies and banks has acquired a whole new dynamic. “Social responsibility” and the way it is assessed when making lending or financing decisions has now become – alongside the analysis of a company’s annual financial statements – another key element in the credit rating process. Increasingly, rating systems no longer rely exclusively on “hard and soft facts”, but also take ESG factors into account.
Of course enterprises large and small are already very aware of sustainability. However, structured sustainability reports that are easy for third parties such as banks or business partners to interpret are often still lacking. The Corporate Sustainability Reporting Directive (CSRD) agreed this year at European level – subject only to the European Parliament’s formal approval – is expected to come into force on 1 January 2024. And additional, even more stringent conditions are already on the cards. It is not enough, however, for companies to tackle these regulations only once they come into force; companies must ensure that they make extensive, structured preparations in advance. This is the only way to ensure that their sustainability reporting complies with the law. The CSRD not only makes it more important for companies to report on the impact of their business operations on people and the environment; it also requires companies to report on specific sustainability aspects such as carbon emissions.
In addition, just like financial reports, future sustainability reports will also have to be subjected to external audits carried out by independent auditors (depending on the level of auditing required). They will also become a necessary part of the management report.
The new requirements do not just pose challenges for companies; they also affect the members of staff responsible for making lending decisions in banks and savings banks (as well as other credit and financial services institutions), who must familiarise themselves with the complex issues involved. Corporate balance sheets and P&L accounts can only be meaningfully analysed and interpreted if one is familiar with their structure, content and scope of discretion. Similarly, the relevance of sustainability reports to financing decisions can only be assessed in a structured and meaningful way if one is familiar with the subject matter and the most important legal and regulatory requirements. To assess sustainability targets and ESG aspects, one may usefully draw upon various criteria, including KPIs (key performance indicators). Just as when analysing traditional financial statements, the major advantage of KPIs is that they can be directly correlated, tracked and compared over time, and analysed in direct comparison with the KPIs of other companies, as well as with industry benchmarks. This provides a full picture of the company being assessed and encourages rating agencies to embed a “sustainability credit rating” in the company’s financial credit rating. Clearly it will be essential for companies and financial services providers to ensure that staff are fully trained in these increasingly complex areas.