Integrating Sustainable Finance into Corporate Finance Processes: The New Norm

2020-10-21

The evolution from "nice to have" corporate social responsibility programs to the strategic embedding of sustainability into business models reflects the recognition given to the many ways in which sound Environmental, Social and Governance (ESG) performance can lead, and be tied to, sound financial performance. Thinking around ESG is no longer from the perspective of corporate communications and the defensive stance of risk mitigation, but about proactively seeking out new opportunities that allow business to innovate and find solutions which create additional value and revenue sources, whilst simultaneously adjusting to a more sustainable business model. This evolution, however, has not taken place uniformly with significant variations in awareness and action between geographic regions, industry sectors and individual companies.

A recurring theme during discussions with the subsidiaries of European companies in Japan is the gap in awareness and action between European business and their counterparts in Japan, who are commonly viewed as lagging regarding ESG. For the Japan operations of European companies, a key challenge is "how to localize the ESG related initiatives being established by corporate offices given the gap in awareness and action?". Addressing this is not just a challenge for Senior Executives, but as demonstrated by the actions of the European Commission in establishing the EU Taxonomy on sustainable finance, the corporate finance function has a clear role to play as an enabler through the corporate financing processes and decisions.


EU TAXONOMY:
The EU Taxonomy is a tool to help investors, companies, issuers and project promoters navigate the transition to a low-carbon, resilient and resource-efficient economy. The EU Taxonomy is one of the most significant developments in sustainable finance and will have wide ranging implications for investors and issuers working in the EU, and beyond.


So why are leading organizations shifting ESG responsibilities towards the corporate finance function? For European companies, the goals of the European Commission to promote sustainable finance, for example through re-orienting capital flows to sustainable investments, establishes a clear linkage between ESG and finance. Although not binding on non-EU companies, the EU Taxonomy is expected to have a ripple effect globally as the foreign subsidiaries of European companies respond to achieve the corporate ESG objectives in their local markets and its expected use by financial sector companies in launching new sustainable financial products.

From a financing perspective, there is a wide body of evidence indicating that CFOs recognize the impact of ESG performance on their cost of capital, clearly placing ESG in the remit of the corporate finance function. Recent analysis of the relationship between the cost of capital and ESG scores in the MSCI World and Emerging Market Indices reported the average cost of capital of the highest-ESG-scored quintile was 6.16%, compared to 6.55% for the lowest-ESG-scored quintile in the MSCI World Index, with a larger gap in the MSCI Emerging Markets index.

Changes in the financial services market, in particular the supply and demand for sustainable financial products, is providing additional impetus for this shift. Taking climate finance as an example of a demand driver, the European Commission has estimated that, at the European level, Euro180 billions of additional annual investment will be needed between 2021 and 2030 to finance climate adaptation. The financial sector is already responding, an example being the activities led by the International Capital Markets Association (ICMA) in establishing sustainable finance related principles and frameworks, including the Green Bond Principles and Sustainability Bond Guidelines. For companies raising capital in Japan, several of the leading Japanese banks have established new business units whose purpose is to introduce sustainable finance products to the market, backed by commitments by these same banks to achieve quantitative sustainable lending targets.

The movement by large Japanese lending institutions, commonly viewed as being conservative, to introduce sustainable financial products to the market sends a clear signal that sustainable finance is not something on the horizon but relevant to business today. For corporate finance functions in Japan where ESG awareness and expertise may not be well established, this raises the question of "How to respond?".

The corporate finance function has, in many cases, undergone a significant evolution from its roots as a function focused on funding activities. Research by PwC concludes that the corporate finance function will increasingly become a pivotal partner in driving forward-looking data insights to evaluate an organization’s performance against its purpose. The changes taking place require a skill set which typically does not exist within corporate finance teams and integrating ESG into the corporate functions impacts at multiple levels of the corporate finance team as shown in the table. To effectively respond to ESG issues such as sustainable finance, integrated reporting and ESG metrics, there is often a need for upskilling of the corporate finance team on ESG issues relevant to business operations.

Position

ESG Responsibility in the Corporate Finance Team

Chief Financial Officer (CFO)

Creating and presenting ESG related strategies to the CEO and Board that contribute to improving bottom line performance and delivering a sustainable business model

Financial Planner

Guiding integrating of ESG elements into strategic plans and investments and building ESG KPIs into company reporting dashboards

Controller

Integrating ESG KPIs and risks into financial reports and simplifying the ESG reporting process

Treasurer

Responsible for integrating sustainable finance into the business investment strategy

Addressing the question "How well aligned are existing financial processes with the evolving ESG environment?" has led to various innovations in corporate finance processes. One of the challenges is that, in many cases, the expected rate of return and time required to achieve it places ESG initiatives at a disadvantage compared to other investment opportunities. Establishing sustainable finance policies and frameworks, which provide clear guidance across the organization on the deployment of sustainable finance, is an example action being taken to promote ESG investment opportunities. In capital budgeting process, various “Green CAPEX” initiatives have been implemented which for example define different internal rate of return (IRR) requirements for ESG related investment and establishing dedicated funding programs for ESG investment opportunities.

As companies move to achieve corporate ESG objectives, the pressure to integrate ESG into the corporate finance function is expected to increase. The corporate finance team’s role is central to supporting the value creation process and delivering sustainable business models. Forward thinking corporate finance teams who respond to the new opportunities will be better positioned to benefit from the changing environment compared to those waiting for government led standards and regulations.

Point of Contact

Toshiya Banno

Senior Executive, PwC Japan LLC

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Yuki Isogai

Partner, PricewaterhouseCoopers Aarata LLC

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Philip Massey

Manager, PricewaterhouseCoopers Aarata LLC

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