Transitioning trade finance is ESG’s biggest challenge

When it comes to sustainability, trade finance has been relatively slow off the mark. While an ever-expanding range of products has captured the wallets and imaginations of bond buyers and corporate lenders, sustainable trade finance transactions have been few and far between.

As transaction bankers are quick to point out, that represents a big, missed opportunity.

“The urgent need in sustainable finance is to achieve scale,” says Viktor Ivanov, head of sustainability for transaction banking in Europe Middle East and Africa at BNP Paribas.

“Sustainable bonds and loans are growing steadily but remain a fraction of what is needed to meet the goals of the Paris agreement. We have to move towards a broader range of solutions, which includes trade finance.”

Pradeep Nair, head of structured solutions at Standard Chartered, puts it more bluntly.

“Global trade is equivalent to 60% of global GDP,” he says. “So, if you don’t address trade, then sustainability is a lost cause.”

This is not a new idea. Incorporating environmental, social and governance (ESG) metrics into trade finance has been under discussion for the best part of a decade, and the first pilot projects – including sustainable letters of credit, guarantees and supply chain finance programmes – emerged in the mid 2010s.

Yet by the end of 2020 widespread adoption of any of these products remained elusive. Sustainable documentary trade finance products still accounted for a tiny fraction of the total, while the number of sustainable supply chain finance programmes could be counted on the fingers of one hand.

Why has trade finance lagged so far behind corporate and investment banking? Bankers point to the very different characteristics of the markets.

“Most sustainable finance transactions to date have been in high-value, low-volume products, which makes them easier to analyze and deliver,” says Nair. “Trade finance is about smaller values and large volumes, so you need to have a process that ensures everything flows as efficiently as possible.

“Review of a transaction for sustainability takes time and costs money, so people have addressed the lowest-hanging fruits first.”

This view is echoed by Ebru Pakcan, global head of trade, treasury and trade solutions at Citi. “It is more difficult to put sustainability structures in place in trade finance than in corporate finance,” she says. “With corporate finance you’re dealing with one-time transactions, so it is easier to work out who the parties involved are and what are their sustainability standards and goals.

“In trade finance you’re dealing with companies with thousands of suppliers and millions of transactions, so you can’t do it on a transaction-by-transaction basis. You have to create processes and verification standards. That’s a lot more challenging from both the bank and corporate perspective.”

Others highlight the inherent complexities of trade finance.

“It is a long-established and very global business, which comprises a lot of different players and still involves a lot of paperwork,” says Annabel Ross of the University of Cambridge Institute for Sustainability Leadership (CISL). “This makes disruption very challenging.”

CISL made sustainable trade finance a core pillar of its Banking Environment Initiative as early as 2013, and has since piloted several projects in the area, including a sustainable shipment letter of credit, with leading global banks.

So far, none has been successfully scaled up.

Other stumbling blocks cited by market participants include the difficulties of sourcing reliable sustainability data and the lack of industry standards.

There are currently no trade finance equivalents to the guidelines for green, social and sustainability-linked bonds and loans produced by the International Capital Market Association (Icma), as well as by local regulators in markets from China to Brazil.

Andrew Wilson of the International Chamber of Commerce (ICC) sums up the problem succinctly.

“Putting together ESG and trade finance is the ultimate mess to wrap your head around,” he says. “The ESG market is all over the place, and trade finance is by its nature a bundle of contradictions and complexities. So, when you put the two together, you’ve got quite a messy picture.”

Nevertheless, there are signs that things are starting to move. As ESG has risen up the agenda over the last couple of years, and particularly since the start of the Covid crisis, banks have been scrambling to work out how to integrate sustainability into their trade finance offerings.

This has been partly driven by banks’ own sustainability commitments, including the outsize targets set for ESG financing by the likes of Deutsche Bank and Citi, which last year pledged to make €200 billion and $250 billion respectively available by 2025.

It is also a response to pressure from customers. Bankers report a jump in the number of trade finance requests for proposals (RFPs) featuring sustainability criteria over the last 12 months, led by large corporates in Europe and the US.

Marie-Laure Gastellu, deputy head of trade services at Societe Generale, says the range of companies looking at the sector has also expanded.

“The first players to engage with us on sustainable trade finance were those directly involved in the clean-energy sector, but we are now also seeing a lot of interest from firms in more traditional industries,” she says.

Ivanov notes that many corporates see trade finance and working capital as next in line in their sustainable finance journey after bonds and loans.

“Two years ago, most clients weren’t ready for this kind of conversation, but today a growing number are actively contemplating sustainable trade finance deals,” he adds.

To meet this demand, banks have been rushing to put together sustainable trade finance frameworks and expand their product offering. In many cases, this has involved adapting solutions developed in other areas to trade finance.

Products based on sustainable use of proceeds have taken inspiration from green bond markets, while an increasing number of banks are exploring the options for sustainability-linked trade finance products.

“We have the technical capabilities in place to integrate sustainability into all our existing trade finance solutions,” says Gerald Podobnik, chief financial officer of Deutsche Bank’s corporate bank. “Now we have to work with our clients to implement them, and then get from the ramp-up phase into a market-maturity phase.”

Possibly the biggest challenge in integrating sustainability into trade finance is working out who should foot the bill. Monitoring transactions for sustainability costs money, as does providing incentives for environmentally and socially compliant suppliers – and, as Ross at CISL notes, margins in trade finance are notoriously slim.

“There is not much room for meaningful incentives to flow from banks,” she says. “It is therefore a question of finding who in the value chain has both the commercial incentive and also the commitment to provide them.”

So far, that has mainly meant multinational companies that are happy to wear the cost in the interest of fulfilling, and in some cases publicizing, their sustainability commitments.

“Often it is down to how willing large corporates are to pursue and demonstrate transformation, especially if there is no clear pricing advantage of a specific sustainable product,” says Ivanov at BNP Paribas. “This is a central question in many conversations with clients.”

Indeed, far from being prepared to pay a premium for sustainable trade finance products, Nair says corporates often expect a discount.

“Many clients want to source sustainably, but they could do this without using a sustainable trade finance product,” he says. “The client currently takes on the activity of ensuring the required certifications are presented for validating sustainably sourced goods. So, if they do use one, some clients feel they should get some pricing reduction from it.”

In several pilot programmes some of the slack has been picked up by international financial institutions (IFIs) keen to support the sustainable trade finance agenda.

As well as Puma’s supply-chain finance programme, the IFC has also backed projects including the Banking Environment Initiative’s sustainable shipment letter of credit, as well as implementing a Climate Smart Trade programme covering goods relating to renewable energy production and energy efficiency.

A similar initiative by the European Bank for Reconstruction and Development, the Green Trade Facilitation Programme, had financed close to 1,000 transactions in green technology and materials for a total value of €675 million by the end of 2019.

Susan Starnes, head of strategy, trade and commodity finance for the IFC’s financial institutions group, says IFIs are well equipped to play a leading role in sustainable trade finance.

“We have several programmes that involve transactional trade-finance support and guarantees, so we know exactly what goods are moving across borders, where they’re going to and where they’re coming from,” she says.

“That means we are well-positioned to proactively support the trade and goods that ultimately help to reduce emissions or support climate abatement.”

While welcoming IFIs’ support, however, bankers say it will not be enough on its own to get the market moving.

As Nair notes: “It takes time to put these programmes together, and they are limited in scale.”

Most agree that the only way to generate real momentum in the market is through regulatory incentives.

“To make sustainable trade finance a reality there has to be a positive angle – and the most obvious is capital relief,” says Luca Corsini, global head of global transaction banking at UniCredit.

This is something banks have been calling for across the board, but the ICC’s Wilson says it is particularly relevant for trade finance.

“The attractiveness of the asset class over the last decade has been eroded pretty significantly by the implementation of first Basel II and then Basel III,” he says.

“Given that 80% to 90% of trade is financed in some way by financial institutions, if you really want to drive sustainable trade, there’s an absolute imperative to bake within the system some scaling or some reliefs for things that are deemed to be sustainable.”

As Wilson notes, however, persuading regulators to relax stringent criteria set in the wake of the financial crisis will be tough – particularly given the lack of agreement, globally or even at national level, on what constitutes sustainable trade finance.

“We believe definitional clarity is absolutely imperative,” he says.

This view is strongly supported by bankers.

Podobnik argues that the nature of trade finance makes standardization particularly important.

“Sustainable trade finance is a global phenomenon that will continue to develop globally, which is why we need global standards on definitions, disclosure and regulation,” he says.

Nair agrees.

“In sustainable trade- finance transactions, the different parties across different markets all need to speak the same language, which is where taxonomy becomes important,” he says. “This improves transparency and that will reorient capital towards sustainable trade flows and related developments.”

Fortunately, trade finance has one key advantage in this respect over other areas of banking in that it has a single global standards setter. The ICC is now looking to leverage that position to produce sustainability standards for the sector.

Following extensive consultation with bankers, regulators and other stakeholders, the organization is working on a framework for sustainable trade finance, the first draft of which is due to be published before the end of March.

It is expected to draw heavily on similar recent work by the European Commission – although unlike the EU taxonomy, which currently only covers climate change, it will cover social issues and transition finance.

Wilson says the initiative has been warmly welcomed by the banking industry.

“All the signals we have from major banks within our network on our standard-setting initiative are very, very positive,” he says. “People recognize the imperative and they also recognize the demand from consumers and customers.”

The ICC is not alone. Policymakers in jurisdictions including the EU, Hong Kong and Singapore are also looking at ways to introduce sustainability standards into both documentary trade finance and supply chain finance.

“Many regulators are working on this at the moment, so there will be a lot happening in the next two years,” says Nair. “We may not reach full alignment, but at least banks in each region will have their own standards for promoting growth in sustainable trade and that will be big leap forward.”

Gastellu agrees.

“If we want to have broad adoption of sustainable trade finance, particularly among smaller companies, and really scale up in this space, it would be helpful to have industry standards,” she says.

For Corsini, however, the main value of standards setting lies in its potential impact on regulation.

“We’re hopeful that once there is a sustainability framework for trade finance, the natural consequence will be capital relief for transactions which meet these standards,” he says.

Wilson also believes that “the really important piece” will come with financial regulation.

“Even if banks start to move more towards applying the common definitions we put out in the market, the ultimate decision factor in whether a transaction is approved or declined is going to be the capital weighting and capital allocation,” he says.

At the same time, he warns that the implementation of standards may not be enough to persuade regulators, who will also likely want hard evidence on the performance of sustainable assets.

“We need to be able to show empirically that a sustainable transaction actually is a better bet from a credit perspective than something that might sit outside that definition,” he says.

“Today, I think we’re all guilty to an extent of making bold claims about sustainability, without necessarily being able to put the rigour behind it to engender the trust that regulators would need to break free of the existing regulatory paradigm applied through Basel and Solvency.”

The ICC is exploring ways to provide this evidence using its Trade Register, which provides an annual measurement of risk in trade and export finance using data provided by 22 leading global banks.

“If we can begin to show in our case on trade finance the performance of sustainable transactions, then I think that’s an easier discussion to have with central banks and some regulators,” says Wilson.

Given the likely timeframe for regulatory change, however, some bankers stress the importance of looking for alternative ways to get things moving.

“Having regulatory support would obviously be a help in developing sustainable trade finance, but changes in regulation are long-term undertakings,” says Ivanov at BNP Paribas. “We must nevertheless progress in the meantime; there are many things that can be done in the current environment.”

Most of these involve working with traditional trade finance partners such as corporates, suppliers and IFIs. But some banks also see potential to develop the market by tapping into broader investor appetite for sustainability.

Nair says Standard Chartered is seeing a lot of demand from private investors, including mutual funds and sovereign wealth funds, for sustainable trade assets.

“They don’t prefer bonds because the end use is too remote,” he says. “They would like to invest more directly where the impact is immediate.

“With sustainable assets we will be able to get investor capital and then pass on the benefits of liquidity, diversified investors and costs to our clients. This should help in developing the market in the absence of regulatory relief on capital.”

Similarly, Wim Peeters of EcoVadis, a leading provider of ESG ratings for global supply chains, reports interest from mutual funds and private equity players in integrating sustainability into supply chain finance and dynamic discounting programmes.

“They want to see these invoices packaged in tiers of sustainability,” he says.

Proponents of sustainable trade finance also see reason for optimism in several trends outside the market, including the transfer of trade-finance transactions from paper to digital platforms – a long-awaited shift that has finally gained traction since the start of the pandemic – as well as a Covid-inspired review and restructuring of companies’ supply chains.

Wilson also points to potential tailwinds from trade policy.

“Our expectation coming out of the crisis is that there will likely be a growing focus on sustainable trade transactions,” he says.

He notes that the EU has already started embedding environmental and social protections into bilateral trade agreements and the administration of new president Joe Biden in the US has signalled that it will follow suit.

The World Trade Organization is also expected to turn its attention to the lack of sustainability in its rule book in the near future.

“We think there’s going to be a gradual ratcheting up of standards around the health, social and also the environmental dimensions of trade, which in turn obviously creates an imperative for the financial markets to respond,” says Wilson.

Combined with a broader societal focus on sustainability, bankers are confident that these trends will help to drive a big increase in sustainable trade finance over the next couple of years – even without regulatory support.

“Regulators could help to accelerate adoption and provide relief for all the players working in this direction by sending a strong signal that this is something that will be supported,” says Gastellu. “At the same time, I believe the market will gain traction because it is part of a broader societal trend.”

Ivanov agrees.

“The move towards sustainable trade finance has started,” he says. “I’m very confident that in the coming months we will see this trend accelerate, and trade finance and working capital solutions will soon become part of the mainstream of sustainable finance.”

Citi’s Pakcan also notes that, while the nature of trade finance may make incorporating sustainability more challenging, it also offers long-term benefits.

“The beauty of transaction banking is that, once things are set up, they very quickly become institutionalized,” she says. “In corporate finance, if you do one sustainable transaction, that doesn’t mean the next one will be sustainable. In trade finance, sustainability can quickly become the standard way of doing things, which means its impact and longevity will be more instrumental.”