Driven by client demand and the fear of being left out in the cold, the financial sector is being compelled to do more to back sustainably produced commodities. Financial motivation is key to banks’ role in incentivising this practice, writes Shannon Manders.
When Japanese conglomerate Mitsubishi Corporation (MC) bought a strategic stake in Singapore-listed Olam International in August last year, the move was ostensibly driven not only by a desire to lift the firm’s profile as a global player in the food industry, but also by the draw of Olam’s approach to managing sustainability.
Such was the allure of Olam’s sustainable and traceable sourcing of agricultural products that MC ended up paying a 29.3% premium above the average share price for the previous 12 months.
“The partners will be working together to expand their global network for procurement of food products with the aim of responding adequately to growing customer concerns about sustainability, specifically as it relates to a wide range of confectioneries and raw materials,” reads a statement issued by MC, which became the commodities trader’s second-largest shareholder.
At the time, the group CEO of MC’s Living Essentials group, Takehiko Kakiuchi, said: “Combining our processing, manufacturing and downstream business experience with Olam’s extensive sustainable raw material supply platforms, we will transform the business into a globally sustainable model, both in qualitative and quantitative terms, while we build a value chain that is closely connected to the needs of customers.”
Fast-forward six months, and the two have established a Japanese joint venture (JV), MC Agri Alliance (MCAA), which plans to import and distribute a range of commodities in the Japanese market, with a focus on sustainable agriculture.
“Consumers around the world are increasingly placing a premium on sustainable food products,” reads a statement issued by Olam (which owns 30% of the new JV). “The establishment of MCAA enables MC and Olam to expand their network for responsibly sourced raw materials and improves their system of distributing agricultural and food products in Japan and around the world,” it continues.
Although the developed world has long been engaged in sustainability efforts to various degrees, the deal highlights the competitive advantages – and financial costs and returns – of actively pursuing, and investing in, sustainability.
Changing the conversation
Significant commitments to sustainability have been happening thick and fast in the corporate domain. A major signal of intent came a few years back when the Consumer Goods Forum (comprised of several hundred consumer goods manufacturers and retailers with approximately US$2.5tn-worth of combined procurement power), pledged to achieve zero net deforestation by 2020.
But it’s not only the commercial arena that is dedicating itself to the cause: there are also some meaningful promises being made at a higher level.
In January this year, the newly launched G20 Green Finance Study Group held its inaugural meeting in Beijing. Its task is to identify institutional and market barriers to green finance and, based on country experiences and best practices, analyse how the financial system can mobilise private green investment and transform the global economy. In doing so, the group is working with central banks and ministries of finance from around the world to understand the role that such institutions should play in this agenda.
The initiative is being mirrored by a Financial Stability Board (FSB)-backed task force on climate-related financial disclosures, established at the end of last year, to make recommendations for consistent company disclosures that will help financial market participants understand their climate-related risks. It is hoped that this will help to accelerate global investments in technological innovation and clean energy by increasing transparency.
According to Michael Bloomberg, chair of the task force, managing climate-related risk is “increasingly critical to financial stability, but it can’t be done without effective disclosure”. “The recommendations from the task force will increase transparency and help to make markets more efficient, and economies more stable and resilient,” he says.
Issues relating to sustainability are also resonating with national legislators: Southeast Asia’s infamous transboundary haze caused by the annual burning of land for the production of pulp, paper and palm oil on the Indonesian islands of Sumatra and Kalimantan has led to legal action from Singapore against Indonesian firms that could result in massive fines.
In the financial world, the Banking Environment Initiative (BEI) was set up six years ago by the chief executives of some of the world’s biggest banks to lead the industry in collectively directing capital towards environmentally and socially sustainable economic development.
The work of the BEI thus far has included the development of the Soft Commodities Compact, which aims to align the banking industry with the CGF’s zero net deforestation resolution, and the establishment of the Sustainable Trade Finance Council, a group of trade finance bankers, traders, importers and industry bodies, convened by the University of Cambridge Institute for Sustainability Leadership (CISL). A key focus of the council to date has been to understand how to scale up the role that banks can play in supporting the shift towards sustainable soft commodity supply chains.
In April this year the BEI published a discussion paper called Incentivising the trade of sustainably produced commodities (see the executive summary elsewhere in this feature), to set out the group’s initial ideas and trigger wider debate throughout the industry. The paper was launched at a roundtable co-hosted by CISL and GTR and attended by commercial and multilateral bankers, commodity traders, agricultural supply chain groups and NGOs.
Why banks should care
It is widely understood that the non-sustainable production of four commodities (palm oil, soy, beef and timber products) causes around 50% (although some say it could be as high as 80%) of tropical deforestation.
For the simple reason that trade finance is a primary facilitator in enabling the production, trade, shipment and processing of all commodities, there is no denying the systemic impact that all industry players have on these processes.
“What we’re starting to see is that this is an issue registering on the agenda of credit committees, slowly but surely,” says Andrew Voysey, director of finance sector platforms at CISL. “Whether it’s because of the legal liability risks or simply the fact that supplier/buyer preferences are shifting, there is a transition to be acknowledged, and the risks of being left on the wrong side of that transition exist at some level,” he explains.
The BEI’s discussion paper suggests that there are three key roles that banks can play in supporting the production of sustainable commodities: firstly, it emphasises banks’ influence in the innovation of trade finance solutions to enable sustainability information to be traced and identified in the first place. For example, the BEI suggests in its paper that distributed ledger electronic bills of lading could be used to record the presence of sustainability certification in a structured format. But as one commodity trader told GTR recently: “We can trace easily to a co-op, but all the way to the farm, honestly, you’re asking too much.”
The paper goes on to suggest that banks can “amplify the demand signal” already set by certain importers, by committing to only finance sustainably produced commodities and phasing out non-sustainable financing progressively over time.
Finally, it highlights the effect of the price differential between sustainably produced commodities and their unsustainable counterparts on market share and suggests that banks have a role to play in finding ways to incentivise sustainably produced commodities to reduce this discrepancy.
Carrot and stick approach
Until now, banks’ approaches to sustainability have largely been voluntary. This is changing due to strategic drivers, which the BEI identifies as: managing risk; generating or seizing commercial opportunity; developing a better understanding of evolving client needs; increasing shareholder value and deepening the positive contribution to society.
The paper asks a fundamental question: “To what extent can the entrepreneurial and innovative instincts of individual banks be relied upon to deliver industry-level change without changes to the underlying ‘rules of the game’?” It goes on to argue that “without further appropriate action to co-ordinate efforts at an industry level and correct system-wide market failures, progress may well be hindered by shorter-term profit concerns and competitive pressures”.
Speaking on condition of anonymity at the GTR/CISL co-hosted roundtable in London in April, a spokesperson for an international agribusiness company told the room that for banks and producers alike, there needs to be a “carrot and stick approach to change”.
“We’re working with 4 million stakeholders – encouraging them to reforest and change their systems. But, quite frankly, nobody’s going to do something unless they’re paid to do it,” he mused.
In addition to the need for meaningful incentivisation for both those that finance commodities and those that produce them, the majority of participants called for additional regulation to create standardisation in the industry and level the playing field.
“As banks, we all hate the amount of regulation that is around at the moment, and what I’m about to suggest will potentially lead to more,” proposed a banker from a global institution, speaking at the roundtable. She suggested working with the Basel Committee, for example, and asking if there was something they could do around regulatory capital and how banks can account for the risk-weighted assets (RWAs). “If it’s sustainable trade they [the Basel Committee] may allow you to lower the RWAs. Or they could go in the other direction and if it’s unsustainable trade and it’s known to be environmentally damaging, there could be higher RWAs.”
A spokesperson from an international NGO that promotes the sustainable use of resources told the room that given the influence that the finance sector has on politics and policy, banks could in fact be doing more to engage with policymakers and politicians and influence the regulatory framework. He called for organisations such as those represented in the discussion to: “Go to Brussels and talk to policymakers and say: ‘We want to have a conversation, we’ve got some ideas, we’re not afraid of this kind of thing. We are leaders, we want this to be a level playing field.’”
Turning their attention to the use of financial instruments, roundtable participants were in agreement that the trade finance market is unlikely to develop new products to meet sustainable financing needs, but rather to continue using existing products in a slightly different way, such as with the development of green bonds and the sustainable shipment letter of credit (SSLC).
The SSLC is a financial solution developed by the BEI that opens up the opportunity for banks to incentivise the trade of sustainable palm oil. It is backed by the International Finance Corporation (IFC), which offers preferential terms for this type of shipment to its partner banks in the form of potential reductions in the cost of capital, which banks can choose to share with their customers (see executive summary).
But while providing some relief to banks, cheaper financing is no longer a quintessential requirement: with many banks having to downsize post-financial crisis, they’re now far less likely – and able – to reach the smaller producers that demand it. “As far as we’re concerned, our client base – big producers, big traders, medium-sized traders, maybe, but certainly no more medium-sized producers – they don’t need cheaper financing,” argued an international banker.
And when cheaper financing is sought after, it is frequently very hard to come by, as one representative from a multilateral financial institution told the group: “The issue for us is that we borrow in the capital markets, and if you are borrowing or issuing a bond, the bondholder is not going to give cheaper financing because you’re lending cheaply to some of their customers.”
Other suggestions for financial motivation came in the form of balance sheet management, with the caveat that multilateral institutions and commercial banks work more closely together to co-finance the requisite deals. “Maybe there could be some form of incentive for banks to work in a compulsory way by saying: ‘No matter whether you like it or not, you’re going to have to put US$500mn a year of lending towards working with development institutions [in supporting sustainable trade].’ That could make a difference,” was one proposal.
In addition to a purely financial approach, the BEI’s discussion paper suggests that the compliance processes for banks could be enhanced to achieve best practices in sustainability, and proposes that the know your customer (KYC) process, in particular, could be expanded to include sustainability criteria.
It acknowledges that not all soft commodities have an internationally recognised sustainability certification scheme in existence, and suggests that an alternative, or additional, solution may be to include sustainable risk screening in customer due diligence processes.
“The objective would be to create a simple and effective post-transaction monitoring mechanism at the client level, providing an opportunity to engage with clients to understand how they are managing the risks they are exposed to via traded commodities,” the paper outlines, adding that such tools, including the IFC’s Environmental & Social Performance Standards, already exist.
“I think you can go a hell of a long way in solving this problem by just making sure that law is enforced,” an NGO spokesperson said at the roundtable, noting that the battle is not only against bad environmental practice, but that the industry is often faced with the contravention of national law.
The point was contested by a banker who was adamant that banks “can’t police everything” and that this responsibility falls to other players in the industry.
A certain element of defensiveness and resistance bubbled beneath the surface of the entire roundtable discussion: bemoaning investor and shareholder pressure and the need for a commercial business case or lamenting the demise of conventional banking (for which sustainability schemes could be more of a reality), some of the banks in attendance struggled with grasping the true nature of their responsibility in sustainable trade.
“It’s very easy during a conversation like this for any one of us to feel defensive about the role that we might be expected to play, either individually or institutionally. And that’s not the point, actually,” said the BEI’s Voysey during the roundtable.
Whether individually or through an institutional leadership approach, the fact that banks can do more to drive the conversation is undeniable. The BEI’s discussion paper itself states that in the specific context of trade finance, there is “arguably unrealised potential for banks” to get involved in incentivising sustainable trade. Whether this is through offering preferential pricing and/or integrating environmental and social risks into their reputational and credit risk management policies, they can influence access to capital today.
Nevertheless, scalability remains a key challenge, and the discussion paper concedes that there are limitations to how scalable an approach might be if only undertaken by a few individual banks, particularly in terms of preferential pricing. “The biggest issue I have following this conversation is there’s going to be a huge problem of scaling this,” declared a commodity trader. “Sustainability is about mainstreaming. I’m not interested in niche certification schemes.” For its part, the BEI does not intend for its discussion paper to “just sit on a shelf”, said Voysey. The group is in the process of actively developing its next round of thinking about what more can be done at the collective level to turn some of these thoughts into practice, to mobilise more resources to be able to do that and to make this thinking more widely known. “So watch this space,” he concluded.
Executive summary: Incentivising the trade of sustainably produced commodities
The Banking Environment Initiative’s (BEI) Sustainable Trade Finance Council of banks, importers, traders and industry bodies was convened by CISL in early 2015. Its aim is to leverage banks’ role as facilitators of international trade and thereby accelerate the transition to a world where importing sustainably produced commodities, at scale, is a new market norm. The Council has been building on the work of the BEI, including the Soft Commodities Compact and the Sustainable Shipment Letter of Credit, to help achieve this aim. A key focus of the Council to date has been to understand how to scale up the role that banks can play in supporting the shift towards sustainable soft commodity supply chains. This question is relatively new to the trade finance industry and, while momentum is visibly growing, many issues remain to be worked through. The Council has therefore developed this discussion paper to set out the group’s initial ideas and trigger wider debate throughout the industry.
Why is this work important?
Agricultural expansion is widely acknowledged as one of the greatest causes of tropical deforestation. Shifting to sustainable forms of production is known to offer developmental, economic and environmental benefits and companies, governments and civil society actors around the world are focused on achieving this transition. Trade finance is a primary driver in enabling the production, trade, shipping and processing of most commodities, and typically those linked with deforestation
such as soy, palm oil, timber and beef. Responding to client needs, which differ depending on how deep into the transition they are, banks therefore have a unique role in working across commodity supply chains to support this journey. Banks’ own motivation should go beyond innovating to align with client needs and enhancing their social value and also recognise the risks they may be exposed to if their business is behind the curve of this transition.
Expanding the product solutions for sustainable trade
The BEI, in conjunction with the Consumer Goods Forum, developed the concept for the Sustainable Shipment Letter of Credit (SSLC) – an approach that, with the support of the International Finance Corporation (IFC), enables banks to reduce the cost of exporting certified sustainable palm oil to other emerging markets. This concept addresses a pivotal issue in the palm oil supply chain which is that major emerging market importers are not favouring sustainable methods of production, often because of the premium prices expected, leaving producers with mixed demand signals. The approach has been verified as practical and commercially attractive.
The Sustainable Trade Finance Council has been exploring how the SSLC approach can be expanded beyond palm oil to other forest-sensitive commodities and beyond the letter of credit to other trade finance instruments. Expanding the approach to other soft commodities would require a credible, internationally recognised sustainability certification that can be evidenced in the trade finance documents already handled by banks. Relevant schemes in the soy and timber supply chains do not appear to offer easy solutions today, so would require persuasion to evolve their systems modestly. Further opportunities for expanding the SSLC to additional documentary trade finance solutions are already within reach, however expanding the approach to trade finance under open account terms may require multi-stakeholder innovation.
Incentivising sustainable trade at scale
Opportunities for individual trade finance banks to identify and incentivise sustainably produced commodities through trade finance processes already exist, but because this is a new area for them, a key question is how banks across the industry can be encouraged to focus on this important agenda. The Council has therefore also been exploring different drivers for industry-level engagement, including: 1) cost of funding in the market, 2) regulatory cost of capital, 3) compliance/’know your customer’, and 4) enhanced risk management. Building sustainability drivers into the determinants of the cost of funding in the market for trade finance banks was identified as the most viable and practical consideration to energise this agenda in the short term. Supporting a more systematic consideration of sustainability in credit risk analysis should also be pursued over the medium term, and there are already signs of individual bank leadership on this front.
The Council has made the following recommendations based on the findings of the discussion paper:
- Market testing to ascertain what level of demand there is for the SSLC in its current form, prioritising those banks and clients who are best placed to benefit.
- Co-ordinate and develop efforts with multilateral development banks and export credit agencies to identify ways in which the cost of funding for sustainably produced commodities can be reduced.
- Integrate sustainability into mainstream education of credit risk officers.
- Maintain a ‘watching brief’ on – and be ready to engage with – further interest shown by regulators.
The Sustainable Trade Finance Council is now seeking feedback from the broader industry on these key findings and recommendations and would welcome hearing from interested parties via CISL.
Source: University of Cambridge Institute for Sustainability Leadership. The discussion paper can be accessed on the CISL website: www.cisl.cam.ac.uk