Traditional trade finance, supply chain finance and ESG

(January 2022)

By Stephen Ptohopoulos ACIB, CCBI* 

Disclaimer: Views and opinions expressed are those of the author and are not necessarily those of his employer. 

The objective of this article is to summarise reading material (recently published) I came across about these topics and show the connection between the drive for digitisation of traditional trade finance and supply chain finance to objectives such as the migration to net zero emissions and sustainability in a broader sense.

The key features of traditional trade finance (TTF) are the intermediation roles performed by banks and manual processing of physical (‘hard copy’) i.e., paper documents.  When we talk about TTF products we are usually referring to bills for collection and documentary credits – the latter alternatively referred to as Letters of Credit (L/Cs).  Note that demand guarantees and standbys are used to support international trade transactions (can be thought as collaterals) as opposed to being payment instruments.

Supply Chain Finance (SCF) is defined by the Global Supply Chain Finance Forum (GSCFF) as “the use of financing and risk mitigation practices and techniques to optimise the management of the working capital and liquidity invested in supply chain processes and transactions.  SCF is typically applied to open account trade and is triggered by supply chain events.  Visibility of underlying trade flows by the finance provider(s) is a necessary component of such financing arrangements which can be enabled by a technology platform.”

The UN Sustainable Development Goals¹ (UN SDGs) comprise of a set of 17 objectives agreed by 193 countries in 2015 to address major environmental, social, and economic challenges of our time.  The goals include targets around sustainable communities, clean energy, responsible consumption and climate action (source: extract from COP26 Glossary of Terms, Chartered Banker Institute).

¹ https://sdgs.un.org/goals

Action to mitigate climate change and issues related to sustainability fall within the scope of ESG.  I have written about ESG in a previous article² which is a gentle introduction to this topic.

² My article titled: ESG 101 (January 2022)

ESG (Environmental, social and governance) is defined by the Chartered Banker Institute as “A way of judging a company based on factors other than financial performance, such as employee satisfaction or policies relating to the environment.”

Someone might what ask why should banks and non-bank financial institutions (NBFIs) be concerned about decarbonisation and sustainability.  After all, it is their clients’ economic activities that have an impact on the environment (including climate change) and therefore it should be their responsibility to address sustainability issues, taking steps such as moving towards zero emissions.

While clearly the business itself (i.e., the client of a bank or NBFI) has responsibilities because its activities impact the environment and climate change, three reasons spring immediately to my mind as to why their bank or NBFI is also expected to act.

Firstly, there is the outsized economic role and function that banks and NBFIs perform.  Many international trade transactions cannot be executed without financing.  Therefore, the policies and decisions of banks and NBFIs in terms of the allocation, availability and pricing of trade / supply chain finance can result in the channeling of credit to customers and activities that contribute to climate action and sustainability.  Even in cases in which a client’s supply chain partner finances the transaction or the use of a supply chain finance technique in which there is no bank or NBFI financing (e.g., Dynamic Discounting), banks and NBFIs are still typically involved in facilitating these transactions e.g., as payment agents.

Secondly, if not already, then certainly going forward, regulation with respect to ESG will be introduced, that go beyond disclosure and reporting requirements.  For example, regulators are likely to be considering introducing new requirements related to what are termed alignment with climate outcomes (ACOs).  This could take many forms, such as the imposition of capital charges for lending / assets that are incompatible with combating climate change or setting regulated entities ACO targets.

Thirdly, banks and NBFIs are facing increasing pressure and scrutiny from stakeholder groups, such as investors/shareholders, customers, local communities, and employees with respect to ESG issues.

There are many compelling reasons why the digitisation of trade is desirable: improving efficiency and productivity; reducing processing costs and faster throughput.  Less obvious is its potential to help trading parties and their finance providers meet their respective ESG obligations.  An obvious direct impact of digitisation will be to significantly reduce the use of paper. This will result in using fewer natural resources  (wood/pulp) and reduce carbon emissions (think of the energy consumed extracting raw materials, manufacturing, transporting, disposing, or re-cycling paper).  More significant are the indirect benefits of digitisation.  Utilising enabling technology such as the IoT, machine learning / AI, Big Data Analytics, etc., will result in the production of timely data.  This will make it possible to have the transparency required by trading parties and their finance providers in the context of discharging their ESG obligations.

A recent LIBF thought leadership article³ outlines the current state of play with respect to the digitisation of trade. Perhaps the biggest impediment are national laws that essentially still revolve around the use of paper documents, including negotiable instruments and documents of title typically used in international trade.  The United Nations Commission on International Trade Law (UNCITRAL) Model Law on Electronic Transferable Records (MLETR) can be thought as a kind of off the shelf ‘template’ which member states can use as the basis to draft legislation that caters for the use of digital records.  At a multilateral level, the Framework for G7 Collaboration on Electronic Transferable Records promotes the adoption by countries of legal frameworks that are compatible with MLETR.  In the UK the Law Commission has initiated the process of changing the law so that electronic records can have the same legal status as paper documents.

³ Digital supply chains can help reach net zero, by Ouida Taaffe (November 2021)

A market-based approach will be key to achieving net zero carbon emissions.  It is argued that the market price of ‘consuming’ CO₂ i.e., economic activities that result in carbon emissions must better reflect the indirect as well as direct costs involved, i.e., by also factoring in what are termed ‘externalities’.  Externalities is a term from the discipline of economics, referring to the side effects – which could be beneficial or negative – that arise from an economic activity that impacts the wider world i.e., beyond the economic actors directly involved.  To put this in some context, one (of the many) externalities of carbon emissions could be the costs to society from air pollution, e.g., costs of medical care for people with respiratory diseases like asthma; loss of economic output when workers take sick leave caused by such illnesses.   Therefore, carbon taxes and carbon trading schemes are advocated, to better address the problem of externalities and using the price mechanism to incentivize economic actors to reduce their carbon emissions.  To this end, in October 2021 the International Chamber of Commerce (ICC) published the ICC Carbon Pricing Principles.  It adopts a multi-stakeholder approach, acknowledging that there is no ‘one-size-fits-all’ solution and that it is unlikely that any time soon for there will be a global [carbon emissions] price.   Instead, it advocates policymakers to build on existing carbon pricing instruments e.g., those at the industry level and national regimes.

In my opinion the ICC Standards for Sustainable Trade and Sustainable Trade Finance (Positioning Paper – November 2021), written in collaboration with the Boston Consulting Group (BCG), can serve as the reference point and offer valuable guidance for industry.

The objectives of this positioning paper are enhancing understanding about sustainability in the context of trade and trade finance; providing impetus for discussion, ideas, exchange of information and know-how across industries in the private sector (which the ICC represents); collaborating with other multilateral organisations; adoption of common approaches in terms of how to assess and measure sustainability.  This will be made possible by developing agreed standards, definitions, and assessment methodology.

Measuring and assessing sustainability is not an end in itself.  Given the role and impact global trade has when looking at the bigger picture around sustainable economic development, the desired outcome is trade which is in accordance with the Paris Agreement⁴ and UN SDGs.  It should also bring about the ingraining of sustainability into supply chains.

⁴ A legally binding international treaty on climate change.  Its goal is to limit global warming to well below 2°C, preferably to 1.5°C, compared with pre-industrial levels (source: extract from COP26 Glossary of Terms, Chartered Banker Institute)

The paper represents a ‘work in progress’, an iterative process, setting out a roadmap from an initial state to a target state.  Trade in goods as well as services, processed with recognised trade finance transactions* fall within its remit.  It will cover the stages in the supply chain, excluding however the final, business-to-consumer (B2C) stage.

(*in this context referring to both traditional trade finance and supply chain finance)

Sustainable trade is defined in this positioning paper as “the import, export or trade of goods and services which actively support the achievement of one of more UN SDGs without infringing on the achievement of any other SDGs”

Building on above definition, sustainable trade finance is defined in this positioning paper as “the financing or facilitation of sustainable trade, using recognised trade finance instruments”

The management consultant Peter Drucker famously said, ‘You can’t manage what you don’t measure’.  This positioning paper establishes a framework to assess and measure the sustainability of a given trade transaction or trade finance portfolio.

For the purposes of the framework, sustainability, as set out in the 17 UN SDGs, is divided into three dimensions:

  • Economic
  • Human and social
  • Environmental

Proposed framework breaks down trade transactions into 5 components:

  1. Goods or services
  2. Seller
  3. Buyer
  4. Transition/transportation
  5. Purpose

Inputs, being data related to the 5 components as outlined above is processed by applying the prescribed framework methodology, producing the following outputs:

  • reporting infographic – which will show how sustainable a given transaction is with respect to each of the 3 dimensions and each of the 5 components
  • score/descriptor – which is a high-level summary of the transaction’s degree of sustainability

Each dimension and component of a transaction can be graded (a bit like the energy efficiency ratings of household appliances), indicating if it actively contributes to sustainability, meets recognised sustainability standards, does no significant harm from a sustainability viewpoint, does significant harm from a sustainability viewpoint or that there is insufficient data (in which case cannot be graded).

The framework should prove to be an invaluable analytical tool because it can be used to communicate and describe sustainability parameters, for reporting purposes, to profile transactions in terms of sustainability credentials, or be used to assess if a given transaction meets sustainability criteria.

Given recent changes in the political, economic, social, environmental and legal/regulatory environments, participants at the later stages of the supply chain and their finance providers are paying closer attention to ‘upstream’ activities, i.e., those performed by producers and suppliers.  Making supply chains ‘greener’ will contribute to combating climate change and making the transition to a zero-carbon economy.  Meeting ESG obligations has become a driver of the digitization of trade and trade finance.  Dialogue, initiatives, and action plans revolving around ESG and sustainability are being formulated at the enterprise and industry levels; by national and supranational governments and by multilateral organisations.

*Knowledge worker, analyst.  Associate member of the London Institute of Banking & Finance, holder of the Certificate in Bank Strategy, Operations and Technology (Certificated member) of the Chartered Banker Institute.

Other articles and further information about the author are available on LinkedIn.

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