Contribution of ESG to Corporate Credit Appraisal Process (2024)

With the ongoing discourse on climate change and the growing imperative to take action, banks and other financial institutions are under mounting pressure to incorporate Environmental, Social, and (Corporate) Governance (ESG) considerations into credit appraisal processes. The evolving regulatory landscape surrounding this issue underscores the need for banks to establish a framework that enables the integration of ESG factors within their risk assessment methodologies.

Traditional credit appraisal process

The credit appraisal process evaluates creditworthiness based on financial and non-financial assessments. The financial analysis examines historical and projected financial data, while non-financial analysis evaluates business operations and relevant factors. By considering both aspects, lenders make informed lending decisions.

Evolution of ESG in the credit appraisal process.

The credit appraisal process has evolved to incorporate ESG factors due to global social and environmental consciousness. Climate-related risks, workforce inclusion, and human capital are now considered, driven by regulatory advocacy and globally accepted accounting standards. The availability of relevant data helps integrate the ESG perspective into risk assessment frameworks, facilitating the evaluation of downside risk in credit investments.

ESG overlay on credit appraisal

Integrating ESG into credit appraisal overlays ESG factors onto the traditional assessment framework, enhancing the evaluation of a borrower's creditworthiness. The financial analysis focuses on key metrics, while the non-financial analysis assesses ESG factors. This approach enables informed lending decisions, considering both financial metrics and sustainability performance. The ESG overlay recognizes the material impact of ESG factors on cash flows, default risk, and long-term viability, managing ESG-related risks in portfolios.

Conclusion

The integration of ESG factors into credit analysis enhances a financial institution's capacity to evaluate the potential downside risk of credit investments in the face of climate change-related transition and physical risks. Implementing an overlay approach to ESG assessments, such as a scorecard, allows for scalability and adaptability to each bank’s specific requirements while considering the regulatory framework of the jurisdiction in which they operate. Financial institutions can make more informed lending decisions by adopting such measures and contributing to sustainable and resilient economies.