Riding the ESG Wave, after the Crest

Marc Naidoo is a sustainable finance partner in international law firm, McGuireWoods’ London office.

As 2022 draws to a close, participants in the global financial market may look back at less than satisfactory results in their ESG portfolios, both in terms of value and volume. Whilst the year-on-year exponential growth of these deals would always equalize at some point, some would be left scratching their heads on how quickly financiers recoiled at larger transactions. The question that then arises is whether the ESG wave has crested already, and what is the market outlook for 2023 and beyond?

The majority of market participants spent the last three years formulating expansive ESG policies that would keep them of the right side of the shift in the market. We saw massive changes in strategies as fossil fuels were divested from, credit decisions were relaxed and risk management structures were repurposed to further ESG investments. The market was awash with buzz terms, statistics and seminars, which created the impression that the financial market was at a stage of: ESG or bust. The forerunning deals made sense, and addressed major issues in need of funding. However, these deals needed private capital and financiers needed to deploy funds into ESG investments in order to appease stakeholder pressure. As with all needs, these deals proved to be low hanging fruit. The market became more competitive, but also more saturated. Financiers began to ‘out-ESG’ each other and drive the market to the point of ESG or bust.

Marc Naidoo

As this continued, the narrative became more robust which, like with all things, attracted more scrutiny from stakeholders and activists who challenged the narrative. We’ve seen protests, explosive reports and blatant contradictions on private sector ESG credentials as financiers struggle to make the leap from low hanging fruit to deals where there are some grey areas. The result has been financiers recoiling from larger spotlight inducing transactions, especially where greenwashing has ironically become low hanging fruit for regulators.

This however, may be the point at which the ESG wave cresting can actually lead to a more sustainable marketplace. As interest rates and inflation go up, the financial market will have to keep moving deals in volume in order to stave off the effects of a recession. In this regard there needs to be a shift from pure play ESG transactions in order to increase volume and scalability of financial transactions. The market will need to revert to a time where financiers were taking ESG requirements into account, before they were scrutinised to do so, a time where commercials overrode narrative.

To move back to that time, a prediction can be made that we see more investments going back into non-ESG assets, but with a view to including ESG components. This would increase the volume of transactions, but also give financiers a bit more leeway under accusations of greenwashing and paying lip service to what stakeholders demand. By no means is the suggestion to conduct deals with no accountability, but accountability can be effected through hybrid instruments that focus on a larger cross section of ESG requirements. Pure ESG assets can limit the freedom of commerce, so a focus on “old and new” would be welcomed. For instance, a deal involving fossil fuels can be mitigated by including; i) environmental restoration covenants as well as restrictions relating to how an asset is built or extracted; ii) social upliftment covenants to ensure that there is a benefit to the communities around the project in question; and iii) governance maintenance covenants to ensure that diversity in corporates is correctly implemented. These are but a few examples of how the ESG spectrum can be incorporated into conventional transactions.

The above also ensures that large corporates are kept onside with the market. The power of change lies with large multinational companies: they are the market participants that need to be held accountable for their actions. Pure ESG transactions tend to have the effect of these large companies divesting from large non-ESG assets to smaller less accountable private sector participants. There is no ESG upside if that happens. A hybrid approach allows the market a bit more flexibility, but ironically more accountability. The same applies to financiers, who will not have to constantly look over their shoulders as their, sometimes outlandish, claims and goals draw the ire from stakeholders.

The wave for ESG has crested. The influx of media attention, rules, regulations and publicity has meant that the easy win deals are few and far between. Market participants are now grappling with the weight of expectation and scrutiny which has resulted in a slow down of ESG deals, but with the backdrop of the unrealistic narrative that they have created. At this junction, 2023 will see the return of conventional financing, albeit with hybrid elements to ensure that there is still accountability in the market, which is why ESG was important in the first place. The wave has crested, but we now need to ensure that it does not crash, rather we should enjoy some stability and try to ride it out comfortably in what is shaping up to be a challenging 2023.

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