ESG in the banking industry - Ep2 (Part 1)

Transcript

Kyla: Welcome back to another episode of the Engaging ESG podcast series. I am your host, Kyla Visser, and in this session we are going to cover a few of the topical matters relating to ESG in the banking industry specifically pertaining to financial reporting.

Joining me today is Dipthi Govind, a technical accounting senior manager specialising in the banking industry in the PwC South African practice.

Welcome Dipthi.

Dipthi: Thank you, Kyla. I am thrilled to be here today.

Kyla: Dipthi, we have briefly introduced the 3 pillars of ESG in the previous podcast. E being the environmental impact, S being the social impact and G being the governance angle, and it is evident that ESG is becoming a hot topic in all industries.  (excuse the pun, laughs) 

Dipthi: Well, there is an overall focus on Banks to incorporate ESG into their risk management frameworks which has driven a need for Banks to be more conscious of how the funding they provide is being used. 

What we have been seeing lately are social bonds and sustainability-linked bonds alternatively known as green bonds/green loans being issued by entities in our local market with corporates being counterparties for these products.

The International Finance Corporation has provided a green loan to ABSA. Standard Bank has also issued sustainability-linked bonds and most recently listed two social bonds on the JSE to provide funding for affordable housing.

Social bonds are sources of funding provided for initiatives to obtain positive social outcomes and are being provided to aid in the ‘S’ aspect of ESG given the high level of unemployment in South Africa. Both DBSA and Nedbank have also issued similar instruments.

Therefore, as you can see Kyla, we are seeing an increase in our local market on the different ESG related instruments that are being issued.

Kyla: You’ve mentioned the ‘S’ aspect of ESG through the social bonds, which is becoming increasingly relevant in the local market. Can you unpack the ‘E’ and ‘G’ aspects?

Dipthi: Yes, sure. From an environmental perspective, we see that banking institutions are providing ‘green’ loans to entities, which we will elaborate on a little bit further.

From a governance perspective, the banking industry is one that is highly regulated and this expands to matters such as data privacy, consumer protection and ethical behaviour just to name a few issues that would fall under the governance pillar.

Kyla: Thank you for that Dipthi. Before getting into the details of the accounting considerations, can you perhaps take a step back and explain the big picture impact on the balance sheet as it relates to the ESG impacts?

Dipthi: Like I mentioned earlier, we are seeing an increase in the volume of green loans issued in the local market. These loans vary in terms and conditions but are often significant in amount and are denominated in foreign currencies. 

These green loans have accounting implications from both the borrowers and lenders perspective.

Kyla: Dipthi, before we go into that, would you mind explaining to our listeners what a green loan is?

Dipthi: Well, a green loan is a loan whose contractual terms provide for the cash flows to vary depending on borrower-specific ESG metrics or other environmental measures, or collectively known as ‘green measures’. Examples of these include measures relating to compliance with emissions and waste regulation standards, energy efficiency metrics, CO2 emissions standards and energy consumption standards relating to the asset being financed. These loans can also be referred to as ‘Sustainability Linked Loans’. Another term that is often used is “green variability” which also collectively defines the variation in cash flows as a result of these green measures.

Kyla: Great - thank you for elaborating on that! Going back to your points on the ‘big picture’, what are the major impacts that ESG can have on the balance sheet Dipthi?

Dipthi: This can be quite tricky Kyla and requires careful consideration and analysis of the loans you are dealing with. 

What makes these loans particularly tricky is we need to use existing guidance in the International Financial Reporting Standards to determine the accounting; however when these standards were written, green loans were few and far between and not really considered. So to just touch on a few considerations from the lender’s perspective which is generally the asset side of the balance sheet. 

The first key consideration is how to classify these loans on the balance sheet as this will impact recognition and measurement. When I speak about classification it's essentially whether the loan should be measured at amortised cost, fair value through other comprehensive income or fair value through profit or loss. This is driven by both the Bank’s business model and an analysis of the contractual cash flows and whether the cash flows represent solely payments of principal and interest criteria commonly referred to as the ‘SPPI test which is quite complex for green loans. 

The next is the calculation of expected credit losses where these loans and other receivables are measured at amortised cost or fair value through other comprehensive income particularly for customers in industries adversely impacted by ESG. And lastly fair value measurements and how to derive observable and unobservable inputs which are impacted by ESG. 

On the liabilities side of the balance sheet being from the borrowers’ perspective a key consideration would be to determine whether the variability in the cash flows gives rise to an embedded derivative, and again fair value considerations.

Kyla: I can already pre-empt some estimates and judgements being involved in this as well, am I right in making that assumption, Dipthi?

Dipthi: Spot on, Kyla!

Kyla: So what are some considerations in thinking about whether the loan meets the SPPI test?

Dipthi: Well, to your point, judgement will be involved and this is an area that continues to evolve in terms of where the line will be drawn between SPPI and non-SPPI features. In order to determine whether such loans satisfy the SPPI test, the contractual terms that determine variability in cash flows as a result of the green measures should be carefully assessed.  

One consideration when applying the SPPI test is whether the link to the green measures is reflective of changes in credit risk.  When assessing whether a contractual variation of cash flows based on green measures reflects a change in credit risk of the instrument, the nature of the asset, the nature of the borrower and the specificity of the green measure are a few factors that are relevant to consider. 

In making the assessment as to whether or not the variation in interest rate reflects a change in credit risk, it will be important to understand the commercial rationale for including green variability in the loan, and to consider the cause and effect relationship in changes to the contractual cash flows  driven by green variability. 

I would like to emphasise that if the impact of a cash flow characteristic can only ever be de minimis i.e. have a minimal impact on the cash flows or is not genuine, the feature should be disregarded when assessing SPPI. However, it is important that the economic rationale for including the clause in the first place is carefully considered as well as considering consistency with how such clauses are portrayed in other aspects of the entity’s reporting.

Kyla: That is very interesting, Dipthi. Examples always work well, would you mind taking our listeners through an example in order to demonstrate the SPPI assessment?

Dipthi: You’re already one step ahead of me, Kyla. 

Let’s consider the following example: A loan is advanced to an investor to fund a building refurbishment designed to increase the energy efficiency of the building, with the loan also being collateralised by way of a security interest in the building. The building generates rental income and the refurbishment plan includes a series of performance measures which, if met, will ensure that the refurbishment is on track to deliver the intended reduction in energy consumption at completion.

The interest rate on the loan will increase if the project is not delivered in accordance with the agreed performance measures.

Failure to meet the performance measures and deliver the intended reduction in energy consumption will very likely reduce the value of the building and hence adversely impact the ‘probability of default’ and the ‘loss given default’ of the loan.

Therefore, as you can see, because a failure to meet the performance measures reflects an increase in the credit risk of the loan, subject to consideration of all other relevant factors, the loan might pass SPPI, provided that it can be demonstrated that the magnitude of the change in interest rate is commensurate with the change in credit risk.

So Kyla you were correct on how important the judgements are.

Kyla: That is a very useful example, thank you Dipthi! You did highlight that ESG is becoming prevalent for lenders and borrowers. To our listeners, please join us in part 2 of this episode where we will continue on the accounting considerations as it relates to the borrowers.

Kyla: "This podcast is brought to you by PwC. All rights reserved. PwC refers to the South African member firm or one of its subsidiaries or affiliates, and may sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details. This podcast is for general information purposes only, and should not be used as a substitute for consultation with professional advisors."