How the ESG* analyst should think – Issues and dilemmas in the Nordic financial sector

We have released an ESG sector report for Nordic finance with 43 companies ESG risk researched. When conducting our ESG risk research in the sector we have met a few issues and dilemmas. How should we think as ESG risk analysts about this? (The link to the report can be found at the end of the article).

Issues and dilemmas on a general level

Dilemma – How to ESG risk research pure mortgage covered bond issuers?

Although AAA mortgage covered bonds (CB) are considered a low-risk investment, the ESG analyst will focus on the perimeter of the issuer and not the issued instrument. Many CB issuers also issue other types of bonds, therefore considering ESG research as irrelevant for pure CB issuers is a mistake.

With regards to the ESG risk of a pure CB issuer, it can only be complete when considering the whole value chain from the individual debtor all the way to the CB investor. This can only be done by integrating the origination process and client relationship management. If a pure CB issuer is owned by one single bank, we therefore think the ESG risk of the owner bank is appropriate for the CB issuer. On the other hand, if a CB issuer is owned by several banks this requires a separate ESG risk research.

Dilemma – When will Covered Bond collateral pool data include ESG risk assessments?

Today we see that ESG risk data is not included in many collateral pool reports, either not in the template or not filled in if the template is prepared for it. We find this surprising as Climate risk on the environmental side cannot be ignored especially for Mortgage CBs. Going forward, we would expect to see TCFD reports for the collateral pool in addition to other ESG risk relevant data like adverse impact data.

Lacking Scope 3 reporting

Banks are overall not good at reporting Scope 3 emissions for the financed activities. That said, it is improving, while the fine tuning of the approach will continue with more aggregation of debtor data versus today’s top-level estimation done by the banks.

An issue here is how to deal with consumer financing that finances consumer spending or collector companies with non-performing loans? They are also financing GHG emissions, but none of those we have ESG researched talk about this or have made any effort to estimate this.

Using too low intensity factors

When companies estimate their GHG emissions they sometime use very low emission factors for electricity, while knowing better as this is often in contradiction with the NVE (Norway) or equivalent guidelines. This leads to huge underestimation of the adverse impact as their financing has higher scope 3 emissions than it seems, and too weak measures are then being put in place to reduce these.  Some companies point to a choice made by their sustainability consultants or their sustainability data platform provider. Here we are wondering what value the sustainability consultants helping these companies putting together their reporting have, we are not impressed.

To make it even worse, we see companies with green loans insisting on market-based emission factors when they communicate the “Scope 4”, saved emissions. This is an awful practice by some of the banks covered in this report.

Disparate quality of reporting for legal requirements and voluntary initiatives

Norwegian Transparency Act, TCFD, UNEPFI and UN Global Compact are some examples of legal requirements and voluntary initiatives that require reporting. Many banks think the value is obtained once the adherence for the voluntary initiatives is signed and well communicated. Our experience is that the ambition and quality shown in these reports can be very different. We see examples of “empty shell” reports, mainly repeating the explanation texts from the standard and not containing relevant data for the specific company. Some of the companies should simply not have signed some of the voluntary initiatives if they do not have the real ambition or resources to follow up.

Issues and dilemmas for banks

KPIs quality and history

Since some years back the effort to publish more KPIs to strengthen the narratives relative to ESG risk mitigation has increased, improving the quality on some of the KPIs is now important to address. Improving the quality can be done by both changing to standard KPIs instead of own constructions and being precise of what perimeter is included (all subsidiaries for instance). Adding history is also valuable.

Own versus debtor risk mitigation

Some savings banks have guides and supports their clients to become more sustainable in their activity (mitigation of risk), but that does not mean they should not tell us about their ESG risks and how they integrate this in credit processes. It is paramount to start by assessing the current ESG risks to be able to choose the right action to mitigate the risk. Only supporting debtors may take focus away from the credit that they should no longer give when the ESG risk is too high.

Uneven TCFD reporting quality

Integration of climate risk in credit processes based on TCFD is increasing among the banks in our universe, but the quality of the reporting is very disparate, all from great level of details with maps showing environmental risk types and exposure to collateral assets to reports without any useful information not fulfilling the target of TCFD. For Nature risk (TNFD), all is still to be done, no company in our universe has started to work on this. There seems to be low understanding how Climate risk and Nature risk are interconnected, even among banks with large credit risk exposure in the agriculture sector.

Lacking transparency on External asset managers

We see too little transparent and clear information on sustainable finance like responsible investing, ESG risk integration and other sustainable finance relevant product claims. It is important that an issuer that offers savings products is transparent on these aspects as this is important for their client business. Just relying on the external asset manager to deal with this is not sufficient. Banks in alliances can benefit from stronger centralised suppliers in the field with more or less clear information, while those not having access to this easily come out weaker.

Local stronghold for savings banks

Savings banks have a special position in the local community with gifts and support as part of the company statues or as part of the owners’ statues, a stronghold compared to other national non-local banks. When adding the deep local knowledge and network this has a risk reducing effect in the relationship with clients and local communities (where the clients live and work). An analysis and consultancy company has previously carried out, commissioned by Eika Alliansen, a survey of the local banks’ effect on access to capital and growth in the local community. The main findings in the report show that local savings banks are crucial for small businesses in rural areas. The presence of local savings banks contributes to better access to capital. The local banks, with their proximity to the customers, have an informational advantage which they can exploit in their credit assessment process. The bank’s local presence and close relationship with customers enable the bank to be a value-creating partner for local business.

Employee loans

What is the process and what is acceptable size versus potential conflicts of interest for loans to employees and top management? Most savings banks’ executive management and board members seem to have loans within normal levels. But what if the loans to the executive management grow too big? Can they be independent in their judgements if they are operative in the same segment as clients? While this may not have been a problem so far, it may become one now as interest rates are at much higher levels and may stay there. A sector of activity to keep in mind here is real estate that will suffer both from higher financing costs and lower valuations. Too high loans to executive management for investments in this sector can quickly lead to conflicts of interest.

Dilemma – Green Bond issuers real impact

Is there a problem with lacking additionality for green bonds? Banks calculate GHG emission reduction in their green bond framework reporting, while there is no new reduction as for the most it is existing financing being transferred to Green Bond financing. There is zero real impact here and this should be addressed and be communicated honestly about.

Green Bonds – Who is really “contributing”? Another point here is that the banks are not the ones offering lower interest rate on “green” lending, it is the green bond investors that do (asset owners). Hence the “contribution” is limited unless the bank reduces margins for these loans. More transparency is required here, who takes the cost of lower revenue for the positive announced impact.

For GHG scope 3, only the debt part of the financing is relevant

When estimating the financed GHG emissions, many rely on a sector’s total GHG emissions, the sector’s total indebtness and the specific bank’s loan to the sector. They take responsibility for all the GHG emissions that way, forgetting other sources of financing, like equity and bond financing. They should as a proxy look at the split of the EV, more about this here: https://www.sustainax.com/index.php/2021/07/20/esg-reporting-how-to-split-the-responsibility-of-co2-emissions-for-those-financing-a-company-a-suggestion-for-the-banks-and-asset-managers/

Issues and dilemmas for specialist institutions (consumer credit, collection, etc.)

Dilemma – “Helping” the consumer?

There is an issue with the so called “helping” companies, specialist banks and collecting companies, offering refinancing for consumers with financial problems. This is often exemplified with some client testimonials. Is a new credit a solution when the client is already in financial dire?  Is it really better for the consumer? To make these claims credible, these companies should publish KPIs showing this. Some types of KPIs can be how the financial cost have gone down for the client if it did. The % going to collection and the increased cost for these clients. How much fees gained from payment reminders. How much fees gained from collection processes. To what extent non-performing loan portfolios are sold to specialists that will take care of the “dirty” work. The % going to seizure. It is time to prove it is really “helping”. There are business model risks here with collection fees being curbed by regulators and courts (example is the High Court in Spain that set a maximum interest level in 2020).

Issues and dilemmas for holding companies

Dilemma – Financial sector materiality?

Why financial sector materiality for some and not all holding companies? When holding companies are invested in several sectors and these sectors are different with regards to materiality, we consider the holding company as an investment fund and therefore we use finance sector materiality. When a holding company is specialised on a certain sector or with few holdings outside the main sector a specific sector materiality is applied, eventually with overlay adjustments.

Only reporting on holding structure

We see a tendency to do sustainability reporting only on the holding structure or headquarter and to not include the full consolidated group. This is clearly showing that the company is not considering the ESG risks in their investments and carry little value. We expect as a minimum here that the whole consolidated structure is included, but even other large significant holdings should be included in the sustainability reporting.

ESG risk integration transparency

ESG risk integration in investment decisions is both relevant for the company risk directly but also indirectly through the investors’ increasing scrutiny on this point. And here it is by far not sufficient to allude to some process where ESG risks are considered in investment decisions. We expect a clear description of a process reinforced with KPIs. The best also have a detailed policy and good governance information for this process.

Link to the ESG sector report for Nordic Financials.