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Trade finance is one of the most fascinating business areas in the financial sector. Millions of small transactions make global trade possible every day. Consequently, there is also a very direct link to our society at large. First and foremost, trade finance is an important enabler of economic growth, and therefore a key contributor to global prosperity. But might it, in some instances, also be an enabler of controversial businesses — businesses that cause detrimental environmental and social impacts?
Let’s start by answering the question, What is trade finance? and looking at how can it expose banks and insurers to environmental and social risks.1
Trade finance is an important cog in the global economy. The World Trade Organization (WTO) estimates that 80–90% of world trade relies on trade finance. Trade finance is conducted primarily by commercial banks and insurers, which support importers and exporters, as well as traders, in a number of ways: by issuing letters of credit or other guarantees such as performance bonds, and through short-term lending to cover transaction costs, such as when commodities are being shipped from sellers to buyers. Depending on the type of trade finance transaction, reputational risks and (less likely, but not impossible) liability risks exist at several levels. These levels include the good itself (e.g., asbestos fibers, which are banned in many countries), the conditions under which the good has been produced (e.g., palm oil from non-certified sources), the means of transport (e.g., crude oil spills that result from ship, rail or truck accidents during shipping), and the purpose for which the good is to be used (e.g., equipment used in controversial projects). Even when there is no good involved, risk may still be present — for example, with a performance bond related to the construction of a controversial project.
Because of the significance of this business for both buyers and sellers, banks and insurers can be seen as important enablers of global trade. Although most major financial institutions are making tremendous progress in identifying and assessing the environmental and social risks of their business transactions, for the majority, trade finance remains a gap in their environmental and social risk management systems.
This gap has a critical impact: Trade finance is closely interwoven with practically all sectors’ value chains, and particularly with trade in commodities from the extractive and agricultural sectors, for example.
Given its significance, why does the environmental and social risk governance gap continue in trade finance? The most important reason is the sheer volume of the business, and the limited size of individual transactions. Margins are often low, so little time or money can be spent on due diligence.
Second, in many cases little information is available on how and where goods have been produced and on their intended use, particularly if the commodities in question are fungible. The lack of information and the length of value chains pose significant challenges. However, there is a trend towards more transparency in this area, which is being driven in part by demands for improved traceability.
Third, the business case is not as obvious as it might be in other business areas. Many of these transactions are not public; in comparison to other transactions, they are rather small, and they often involve companies that are not typically on the radar of activist groups. Nor does the media care about them. “These issues need to be balanced in developing a proportionate approach to screening,” says Simon Connell from Standard Chartered’s environmental and social risk management unit. Joseph Stark, a managing director in the bank’s Transaction Banking division adds, “Our bank is committed to leading the way for the banking sector to screen trade finance transactions for possible environmental and social risks. It is part of our brand promise to be ‘Here for good’.”
There are good reasons to close this gap. At least two arguments can be made from the regulatory perspective alone:
- Back in 2011, unnoticed by many executives, the European Commission put forward a new definition of corporate social responsibility as “the responsibility of enterprises for their impacts on society.” This definition has nothing to do with previous views of CSR as philanthropy or the like. Such a definition has implications, in terms of both public and regulatory expectations of private-sector companies. In the same document, the Commission also wrote that “to fully meet their corporate social responsibility, enterprises should have in place a process to integrate social, environmental, ethical, human rights, and consumer concerns into their business operations (…)”
- It is now much simpler to establish a connection between a financial institution and a client’s adverse “impact on society.” The UN Guiding Principles on Business and Human Rights brought about a significant change in paradigm: a company is seen as responsible not only for harm that it caused or contributed to, but also for harm that is linked to its operations, products, or services through a business relationship. The argument that a financial institution is, by its very nature, only indirectly linked to harm caused by clients, and therefore has no responsibility to address that harm, is an outmoded defense. In a letter to the Organisation for Economic Co-operation and Development (OECD), the Office of the High Commissioner for Human Rights made it clear that there is no such thing as an indirect link: “There is either a (direct) link between the products, services, or operations of a business enterprise and an adverse impact through a business relationship, or there is no link.” Companies may also be held accountable for potential violations of the OECD Guidelines for Multinational Enterprises.
Furthermore, reputational risk cannot be ruled out. Examples include transactions in which the name of the institution features on a performance bond.
All of this is why trade finance presents a huge opportunity from a sustainable finance perspective. Owing to their important role in the agricultural sector, a small number of large financial institutions are able to influence significant sections of global value chains. Stark also believes that “adding in simple environmental and social risk filters could have a significant impact on the success of sustainability initiatives in the global trade arena.”
It is therefore no surprise that there have been several attempts to close these gaps in recent years. In addition to commodity-specific initiatives, the Banking Environment Initiative has launched the Soft Commodities Compact, and the International Finance Corporation is currently working on the GMAP tool. Still, many of these initiatives remain difficult to implement in the day-to-day business of trade finance units, particularly because they require exhaustive due-diligence processes. ECOFACT is currently working on a web-based tool to help financial institutions to screen smaller trade finance transactions. The objective is to support business units in making quick and consistent decisions, and to close the gap identified above.
1. Note that this article discusses the trade finance business related to the global trade in services and the physical delivery of goods, and does not cover trading in commodities on financial markets and the corresponding controversies.