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What does ESG mean for banks?
Sustainable business is becoming increasingly important for companies. ESG criteria are mentioned again and again in this context: the abbreviation ESG stands for Environmental, Social and Governance. This means that companies must increasingly account for whether they and their suppliers comply with certain environmental and social standards. From 2024, more and more companies will be required to prepare an ESG report.
But it is not just the ESG issue that is gaining importance for companies. Banks are also increasingly paying attention to ESG criteria and taking them into account when granting loans, for example. An EU directive requires banks to check whether borrowers meet sustainability criteria. The result: companies with a poor ESG rating sometimes have to expect higher credit costs or, in the worst case, have difficulty obtaining a loan at all.
How do banks assess a company’s creditworthiness?
Banks assess the creditworthiness of companies based on four factors, explains Carl-Dietrich Sander, a management consultant and financing expert from Kaarst near Düsseldorf. These factors are traditional: the company’s rating, the calculation of debt servicing capacity and the available collateral. A fourth point has now been added to the classic credit check: ESG. Banks use ESG criteria to better assess and minimize the risk of investments.
The fact that ESG plays a role in banks at all is due to an EU directive on the regulation of the financial market. The implementation of this Sustainable Finance Disclosure Regulation (SFDR) is the responsibility of the national banking supervisory authorities. In Germany, Bafin in particular is driving the consideration of ESG criteria by banks. “Bafin’s rules were completely revised in 2023 and now the topic of ESG is slowly but steadily gaining importance for banks,” says Sander.
What role does sustainability play in banking?
“In the future, banks will have to classify the loans they grant according to ESG criteria,” says Sander. On the one hand, this involves the question of how sustainably the companies to which banks lend money operate. For example, what is a company’s carbon footprint? How does the company ensure that standards are adhered to in the supply chain? What are those responsible doing to promote diversity and prevent discrimination?
Risk management when granting loans is particularly important to banking regulators. “Especially with long-term loans, companies must remain able to service their capital over a long period of time,” explains Sander, who is also a member of the financing and rating specialist group in the federal association “Die SME-Berater”. “And that is only possible, so the assumption goes, if companies operate sustainably and therefore have a future-proof business model.”
Banks must therefore also assess the viability of a business model, says Sander. “The question here is: How sustainable is a company?” In other words: What transition risks exist in the respective industry on the way to greater sustainability? And: Where does the company stand compared to others? The banks’ ESG assessment also takes into account environmental risks associated with the location – such as the risk of natural disasters.
In addition, the topic of sustainable banking is becoming increasingly important: many banks have committed themselves to making their portfolios more sustainable – ESG criteria are thus increasingly becoming a prerequisite for access to cheap financing.
Which ESG criteria do banks pay attention to?
Banks pay attention to a variety of ESG criteria. In the environmental area, these include CO2 emissions, waste management, water consumption and the use of renewable energies. ESG criteria of banks in the social area include health and safety in the workplace, responsibility in the supply chain and inclusion. Corporate governance refers to compliance with compliance guidelines, transparency and the quality of risk management.
However, financial institutions do not currently assess each company individually based on these ESG criteria; banks instead work with a scoring system. Banks assess the ESG risk of companies on a scale from A to E, with A standing for low and E for high sustainability risks. “The classification is still mostly relatively general,” explains Sander. But the trend is towards increasingly detailed questionnaires, from which a detailed ESG risk score is then derived.
The large banking associations – savings banks, cooperative banks and private banks – have already developed corresponding scoring models, although they are not yet in widespread use, says Sander. The ESG indicators and sample questions of the Association of German Banks are even public and can be used by the Association website can be downloaded.
How important is location for the ESG assessment?
“Currently, banks assign companies to a risk class based on their ESG risk scores, which depends primarily on the industry and location,” explains financing expert Carl-Dietrich Sander. The decisive factor for the classification is therefore not the company’s efforts to operate sustainably, but often simply the postcode area of the company’s headquarters.
If, for example, the company’s location is often affected by flooding, the score automatically deteriorates. The specific circumstances are not taken into account: the poor score remains even if the company has taken safety precautions or the production sites are possibly located somewhere completely different to the company headquarters. “It is worthwhile for companies to actively point out that the risks are distributed differently at the actual location,” advises Sander.
How important is industry affiliation?
The second important criterion besides the location is the industry. Some industries naturally have higher environmental risks, such as the chemical industry or fossil energy production.
“From a sustainability perspective, it obviously makes a difference whether I am a tax advisor or a fuel trader,” says Sander. Banks would classify members of the latter professional group – based solely on their industry affiliation – in the ESG risk class “E”. The business model of a tax advisor, on the other hand, entails only low sustainability risks – members of this profession are therefore classified in the ESG risk group “A”.
The industry classification is not always comprehensible: In the ESG risk scoring of the savings banks, companies in the construction industry are given risk class “B”, manufacturing “C” and agricultural companies are given a blanket “D”. Anyone who is not satisfied with their ESG rating should actively work to have it changed, advises Sander. Farmers could, for example, ask: “Was the fact that I have converted my farm to organic farming already taken into account in the classification?”
What are the consequences of a poor ESG score?
“A poor ESG rating by the bank can, for example, lead to the terms of a loan deteriorating,” warns Sander. “In the worst case, the company will no longer receive a loan at all.” The financing expert therefore advises actively asking how the bank carries out the ESG rating. Only then can entrepreneurs prepare for it and, for example, submit the relevant documents or take measures to work towards a better scoring.
“As a rule, banks will keep their reasons secret and will not mention the scoring in the background,” says Sander. However, banks are obliged to provide information about why a loan was rejected. The financing expert advises owners to work towards improving the scoring: “Entrepreneurs should highlight the special features of their business model that make them stand out above the standard.”
How can companies improve their ESG scoring?
Sander recommends first of all to highlight what is already happening in the company in terms of sustainability. “Just collect what you are already doing or ask your employees, they often have completely different ideas.” Most companies are already doing a lot in the areas of environment, social issues and corporate governance, but have never systematically compiled these activities.
“Many companies don’t even know what is relevant,” says Sander. One criterion in the social area is equal or unequal pay for men and women. The owner of a craft business with 15 employees may not even know that he has to deal with this gender pay gap. To determine differences in salary, banks usually use industry data – regardless of the actual pay in the company. “Anyone who already pays their team equally should therefore actively highlight this in their sustainability report.”
What else can companies do in the area of ESG?
After taking stock, the next step could be to set goals in the various areas – environmental, social and corporate governance. For example, companies could develop sustainability strategies and, for example, use more renewable energy or avoid packaging waste. In the social area, companies can increase employee participation or get involved in social projects. The introduction of ethical guidelines and transparency have an impact on the area of corporate governance.
“Entrepreneurs could, for example, determine their carbon footprint,” suggests Sander. The relevant tools and instructions can be found free of charge on the Internet (for example here: www.ecocockpit.de). With this help, companies can create a carbon footprint and update it regularly. “This gives you an initial sustainability report that you can give to banks so that your lenders can see that you are dealing with the issue.” A few pages would be completely sufficient for this purpose.
In addition to improving internal processes, companies can also seek ESG certification or have themselves assessed by specialized agencies. This can also have a positive impact on the bank’s ESG scoring.
Why is ESG still important for companies?
The topic of sustainability is not only relevant for working with banks: “Other stakeholders will also ask you about it – customers, suppliers, employees and applicants,” says Sander. “Large companies – such as supermarket chains – regularly pass on their reporting obligations to suppliers.” In many industries, young people also choose their employer based on how the company deals with sustainability aspects.
Companies that do not meet ESG criteria risk financial disadvantages and reputational damage. A solid ESG strategy, on the other hand, helps companies not only to minimize risks, but also to seize opportunities by positioning themselves as responsible and future-oriented market participants. Sustainability can thus become a decisive factor for long-term success.
“You shouldn’t just look into ESG with banks because of financing,” recommends Sander. “Ultimately, it’s about the future viability of your own business model.” Entrepreneurs could therefore also use ESG criteria to strategically develop their company.
The expert
Carl-Dietrich Sander is a management consultant from Kaarst near Düsseldorf. He has been advising owners of medium-sized and small companies on financing issues for more than 25 years. Before that, Sander worked in senior positions in the banking sector. The author of the book “Negotiate with lenders on an equal footing” is a member of the Financing and Rating Specialist Group in the Federal Association of SME Consultants.
