This article first appeared in the October 2021 issue of Butterworths Journal of International Banking and Financial Law.

Background

The need for a just transition to a green and sustainable future is at the core of policy and initiatives such as the EU Green Deal and the Net Zero Carbon Benchmark. A just transition takes into account actual and potential negative impacts of the changes required, addresses inequalities and improves the lives of all, levelling up across communities and countries – a transition that leaves no-one behind.¹ SMEs have a crucial role in achieving international sustainability goals particularly in recovering from the pandemic which has deepened existing inequalities. Often referred to as the backbone of economies (representing about 90 per cent of businesses and more than 50 per cent of employment worldwide), SMEs are drivers of sustainable and inclusive growth - taking skills and income to underserved communities, promoting social cohesion and addressing inequalities. The diversity and flexibility of SMEs also foster and encourage innovation which many larger companies cannot (or will not) exploit. In the EU, almost a quarter of SMEs already enable the transition by offering green products or services and SMEs represent more than 90 per cent of clean tech enterprises in the UK.² However, SMEs, in aggregate, are also high polluters estimated by the OECD as contributing 60-70 per cent of industrial pollution in Europe.

Whilst it is clear that the “sustainability ripple effect” of SMEs must be mobilized to achieve international sustainability goals, in reality, despite extensive support programs, their access to finance remains a key challenge.

There is no clear definition of ‘SME’, with legal and technical definitions varying by country and region and complicated by the fact that these businesses represent a very broad range of enterprises, strategies and sectors with diversity at each level. This makes it difficult to estimate the actual financing gap being experienced by SMEs. However, the International Finance Corporation estimates a financing gap of over USD 5 trillion for micro, small and medium enterprises, with women-owned businesses accounting for 32 per cent of that financing gap and, despite substantial support programs at EU and national level, EU SMEs still face a financing gap of EUR 20-35 billion.³   

Key challenges in accessing finance

SMEs have historically faced a range of internal and external barriers affecting their ability to access finance both directly and indirectly. On the demand side, SMEs themselves may be limited by a lack of resources and experienced staff to enable them to provide lenders and other investors with relevant financial and non-financial information of sufficient quality. These limitations can ultimately lead to information mismatches between finance providers and SMEs resulting in shorter repayment periods, higher cost of capital and greater risk for creditors. These challenges in accessing finance can often be more pronounced for innovative sectors and for enterprises led by under-represented groups including women, seniors, youths and immigrants.

Is Sustainable Finance the answer?

Historically, SMEs have been reliant on banks as a source of funding. However, more diversified funding for SMEs has long been seen as essential for the creation of tailor-made solutions which are better equipped to serve the diversity of SMEs.

As the volumes of sustainable finance have continued to grow (with the OECD estimating over USD 30 trillion of global assets incorporating ESG factors in 2020), the good news is that the diversity of sustainable finance products and SME-focused initiatives, policies and strategies have also grown.

As well as increasing volumes of impact financing and blended finance structures, the private sector has developed mainstream finance products including green, social and sustainability linked loans (SLLs).

At the same time SMEs have also been afforded improved accessibility to the debt capital markets through listing and regulatory requirements tailored to SMEs, the issuance of green bonds which aggregate SME loans, mini-bonds and SME loan securitization structures.

In addition, in light of the economic impact of the pandemic, governments and regional institutions have stepped up their pre-existing efforts to improve and diversify SME funding, with an extensive EU support program including the European Commission’s SME Strategy for a Sustainable and Digital Europe, Horizon 2020 and the EU Commission’s new CMU Action Plan which aims, amongst other things to increase the supply of finance for SMEs.

To what extent are SMEs able to access appropriate mainstream sustainable finance and what barriers remain? 

However, despite the above developments, the sustainable finance sector has not, for the most part, specifically addressed or integrated the needs, strengths of, or historical challenges faced by SMEs. This has the unintended consequence of amplifying existing market failures and historic barriers and new ones have emerged.

Growth in the sustainable finance sector has been accompanied by a proliferation of law and regulation, voluntary codes, principles and declarations, trade association principles, reports and guidance on every aspect of sustainable finance and related issues. This momentum has contributed to the growing need for transparency and disclosure of ESG-related data (both qualitative and quantitative). This is crucial, firstly, to ensure the credibility and integrity of sustainable finance products, to enable market participants to assess and reduce risk and monitor sustainability performance and secondly, because sustainable finance and investment decisions are based on data and disclosure.⁴  

The overarching challenge in this context, for all organizations, is to decide what to prioritize and what is mandatory, useful, relevant and affordable. For SMEs, however, this challenge is more pronounced because the burden of being aware of, understanding and complying with complex, fragmented and overlapping regulations, standards, labels and administrative formalities is proportionally more significant and costly than for larger businesses. On top of basic financial literacy, SMEs must now also understand sustainability risks and opportunities, be able to identify relevant data and information, create sustainable business models and implement relevant internal processes.

From a regulatory perspective, for example, these businesses must understand not only what is directly mandatory but also what may affect them indirectly (such as multiple laws relating to diligence of supply chains⁵). 

The cumulative impact of all of this regulation is recognized as a major problem which is hindering rather than helping SMEs to access sustainable finance and investment. This is because most regulators and policy makers may not specifically or adequately consider the indirect impact of the proliferation of these regulations and policies on SMEs. There is concern for example, that the long-term impact of proposals relating to climate change stress testing and the EBA’s “Report on management and supervision of ESG risks for credit institutions and investment firms” may result in a tightening of lending conditions applied to SMEs.  

Similarly, regulation such as the regime that is emerging around the EU Taxonomy Regulation (which could potentially provide SMEs with a useful framework for disclosure concerning the sustainability of their activities on a voluntary basis to investors) does not yet take into account SME challenges. The EU Taxonomy is not aligned with those international or national certificates and labels for environmental purposes most often used by SMEs. As a result banks (still the main source of finance for SMEs) are grappling with the lack of relevant SME data necessary to determine alignment of SME activities with the EU Taxonomy. In effect, this means that using the new EU classification system for SMEs is likely to be inefficient and costly for both SMEs and banks.

Helpfully, trade associations such as the ICMA, APLMA, LTSA and LMA are developing product-related principles and guidance designed to increase standardization as well as to reduce the risk of “sustainability washing". However, such principles and guidance do not, as yet, include an analysis of the direct or indirect effects on access to such financing for SMEs. To the extent that any such impact is taken into account, given the heterogeneity of SMEs at all levels, no detailed recommendations are suggested.

This is adversely affecting the ability of SMEs to access this form of finance. SLLs for example, whilst offering benefits for SMEs (including flexibility of use of proceeds, improving sustainability performance through pricing incentives and developing or improving ESG-related data and information processes) have developed in a way that have increased transaction costs, complexity and management time. Lenders are likely, for instance, to require that an SME obtains a pre-signing second party opinion and that it have in place an enterprise-wide sustainability policy or strategy on which to base key performance indicators and sustainability performance targets. 

Taken together, these developments have all amplified rather than addressed the existing challenges SMEs have always faced when it comes to sourcing and providing relevant detailed data for potential investors. Financial institutions are creating internal frameworks and guidance and credit processes based on law and regulation, guidance and principles which have not taken into account SME challenges around data, information, processes and resources.

SMEs are often involved in break-through green or clean innovation, yet the challenges faced by those businesses requiring early-stage capital also seem to be more pronounced for those creating clean technologies and sustainability-related goods and services. These types of SMEs can be perceived as high risk, capital intensive, lacking collateral and track record. These challenges can be addressed by shifting perceptions and enhancing credit risk processes through the integration of mechanisms such as risk transfer tools, and catalytical demonstration capital (such as credit guarantee schemes and catalytic first loss blended finance structures). Digital solutions are also offering new credit information sharing mechanisms to streamline credit application procedures for SMEs, with recent UK initiatives including the open data platform proposed by the Bank of England and the FCA’s proposal for a Digital Sandbox).

Creating an effective SME eco-system – the need for collaboration

An efficient SME sustainable finance eco-system is required and this requires collaboration and partnerships across the financial system driven at multiple levels in order to understand and implement necessary supply- and demand-side changes.

SMEs need finance but they also require tailored advice, technical assistance and education which empowers them to access sustainable finance and digital solutions, to improve their awareness of the commercial importance of sustainability opportunities and eligibility criteria for different funding options. They also need to appreciate the negative consequences of their not considering and implementing sustainability practices.

Market participants and their advisers should develop and incorporate strategies for SMEs in the context of risk management frameworks and create sustainability roadmaps that apply those strategies to specific sustainable-finance products. Such strategies and roadmaps should aim to ensure coherence and alignment at all levels of the organization. This requires deliberate and intentional consideration of SME financing needs and the challenges and limitations of SMEs at different stages of their life-cycle as well as effective collaboration. 

Key Points

• Financial institutions are creating internal frameworks - and guidance and credit processes - based on law and regulation, guidance and principles which have not taken into account SME challenges around data, information, processes and resources.
• Market participants and their advisers should develop strategies and roadmaps with deliberate and intentional consideration of SME financing needs.
• This includes consideration of challenges and limitations of SMEs at different stages of their life-cycle.

References

1.https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal/finance-and-green-deal/just-transition-mechanism_en 
2. OECD, 2017
3. https://www.smefinanceforum.org/data-sites/msme-finance-gap
4. https://www.weforum.org/agenda/2020/01/sustainable-finance-starts-with-data/
5. E.g. the “EU Directive on Mandatory Human Rights, Environmental and Good Governance Due Diligence”. This has resulted in support programs such as a the “Think Small First”, “once only” and “digital by default” principles.

Authored by Sukhvir Basran.