Dr. Rebecca Harding, Independent trade economist
Sustainability and trade – the problem
Trade and supply chain finance is uniquely placed to make trade more sustainable.
Trade finance and insurance constitutes around 80% of the value of world trade and banks finance around 40% of global trade according to McKinsey.[i] In 2022 World Trade was estimated to be some US $32 trillion.[ii] This is some $25.6 trillion in total finance, and $12.8 trillion of Bank Intermediate Trade finance that could help move the world’s supply chains to more sustainable business models over time. At present it is estimated that just $1 in every $5 of trade finance contributes positively to sustainable development goals[iii] – this is an opportunity for trade finance to make a real difference to the sustainability agenda.
The regulatory paradox defined
However, trade and supply chain finance providers are currently struggling with the burden of increasingy punitive sustainability reporting requirements. These urgently need to be standardised so that a common, comparable and consistent audit standard across the world. Unless this happens soon, the scale and frequency of reporting requirements within the trade finance function will lead inevitably towards a prohibitive “KYC 2.0” nightmare.
Recent research suggests that there are in any case limitations of regulation as a means of managing the transition to more sustainable trade and supply chain models.[iv] This research suggests that the current regulatory approach to sustainability reporting for financial institutions restricts the capacity of banks, and their clients, to invest in longer-term projects that prioritise a transition to more sustainable business models. More than this, there is an increased the likelihood of “greenhushing”, or under-reporting, to avoid accusations of greenwashing.
This is a regulatory paradox. In other words, the longer-term interests of global society and the planet are being disincentivised by a regulatory structure that is focused on both the past and the financial risks associated with lending now.
Yet the reasons why it is happening is intrinsic to the way capital market regulation works.
Almost by definition, regulation is there to avoid financial crises in the future using the lessons of the past. Even in something as future-oriented as energy transition or decent work for everyone on the planet, the approach is, and always will be, backward-looking and risk-based; similarly capital treatment will be treated equally for all lending, whether short or long term and, more importantly whether enabling transition or not.
What does this mean for trade and supply chain finance?
For trade and supply chain finance the results are profound. Any trade finance is complex, high frequency and multinational; it is very short term and has lower risks of default.[v] However, there is no differential capital treatment for trade finance generally and export, project or supply chain finance directed towards transition projects specifically. This means that practitioners can only prioritise “transition” funding if the costs of funding these projects are borne by the financial institution itself.
So the regulatory paradox in action produces raft of unforeseen consequences, quite apart from “greenhushing” which are existential for trade and supply chains across the world.
For example, the “Global North’s” regulations are focused on a narrow definition of sustainability that prioritises the “E”, or environmental aspects of ESG. However, the requirements of economic development in the “Global South” and particular the African continent, mean that the S, or social, aspects of Environment, Social and Governance reporting are more important. A coal mine may raise flags for an organisation in the global North, but in the Global South, that mine is a source of employment, income and social cohesion.
The challenge for international trade and the rules-based order
Defining the impact of world trade on sustainability is at best a challenge and at worst impossible. On one level, between 20% and 30% of global CO2 emissions are associated with international trade making it a major contributor to the environmental challenges the world faces.[vi]
On another level, almost by definition, international trade enables goods and services to move around the world that contribution positively to climate transition – for example, exports of environmental goods represented some 8.1% of all exports globally in 2021 according to the IMF,[vii] while its role in creating better jobs and economic growth is a mantra of the World Bank,[viii] the World Trade Organisation[ix] and the International Chamber of Commerce (ICC).[x]
In short, the more trade grows, the more likely it is to have negative climate impacts in the short term but to enable transition to more sustainable business models, create jobs and enable economic growth and development over a longer period of time. Indeed, those countries where the negative contribution of trade to sustainable development goals are the greatest are in countries with higher levels of economic development, stronger consumption of consumer goods and lower overall contributions to carbon emissions.[xi]
This conundrum will present a problem for those of us who advocate the long-term benefits of international trade until a mechanism has been found to transition to more sustainable business models; most importantly, these models must include social as well as environmental metrics.
There is more resource globally being committed to reducing emissions and helping communities adapt to climate change, but even if every country in the world delivers on its current climate pledges, the International Panel on Climate Change calculates that the world will still not avoid levels of warming about the critical 1.5°C above pre-industrial levels to mitigate the worst impacts of climate change,[xii] including destruction of jobs, environmental-related migration and conflict.[xiii] For example, in 2022 alone, climate disasters displaced some 32.6m people around the world[xiv] with inevitable consequences for human rights, and equitable economic development.[xv] In effect, climate change is creating a major foreign policy challenge.[xvi] This will itself undermine the social priorities that are so central to the future sustainability of world trade and supply chains, especially in emerging economies.
We need to take this problem seriously
The “too big to fail” phrase is often associated with the rescue of systemic banks during the Global Financial Crisis. Arguably this is precisely the basis of moves now to regulate the global financial institution so that its financial stability is assured even if there is a climate disaster. In short, the broad frameworks accept that there are difficulties assessing the link between climate events and financial risk, not least because the rate of climate change itself is uncertain but is likely to grow over time.[xvii] The goal therefore is to protect the financial system from systemic risk exposure rather than to regulate for the causes of climate change.[xviii]
Considered against the existential threat to the world represented by climate change, this may seem an inadequate response. However, regulators, especially in the EU and the UK, are becoming more stringent in their assessment of the adequacy of sustainability reporting and risk mitigation with the US following swiftly behind.[xix] Moving ahead on the basis of a precautionary principle to “do no harm” and understand and mitigate risk reflects the “we have to start somewhere” approach that is so frequently articulated in trade finance circles and was reflected in the recent ITFA report focused on the challenges of regulatory reporting.[xx] It is now the responsibility of the banking sector generally and the trade finance industry in particular to work together with the regulators to create common, consistent and comparable audit standards. Unless this happens, and soon, there is a risk that the commercial realities of return on equity, managing systemic risk and other forms of “business as usual” militate against a long term transition. This has to be a shared and collaborative effort. The consequences of not doing it are too big for us to fail.
[i] McKinsey and Company, Financial Services, (November 2021): Reconceiving the Global Trade Finance Ecosystem https://www.mckinsey.com/industries/financial-services/our-insights/reconceiving-the-global-trade-finance-ecosystem.
[ii] Bloomberg, December 2022: Global Trade Surges to $32 trillion in 2022, UN Says https://www.bloomberg.com/news/articles/2022-12-13/global-trade-surges-to-32-trillion-record-in-2022-un-says
[iii] Rebecca Harding (2023): “Measuring the World – economists can’t ignore sustainability.” https://rebeccanomics.com/rebeccas-blog/f/measuring-the-world-economists-cant-ignore-sustainability
[iv] Dr. Rebecca Harding and the ITFA ESG Committee (May 2023): The Regulatory Reporting Reality of Making Trade Sustainable” https://itfa.org/the-regulatory-reality-of-making-trade-sustainable-may-2023/
[v] https://iccwbo.org/news-publications/policies-reports/icc-trade-register-report/
[vi] London School of Economics and Political Science, Grantham Research Institute on Climate Change and the Environment (June 2023): How does trade contribute to climate change and how can it advance climate action’? https://www.lse.ac.uk/granthaminstitute/explainers/how-does-trade-contribute-to-climate-change-and-how-can-it-advance-climate-action/#:~:text=Around%2020%E2%80%9330%25%20of%20global,efforts%20to%20mitigate%20climate%20change.
[vii] IMF climate change dashboard, data extracted 10th September 2023: https://climatedata.imf.org/pages/bp-indicators#cb1.
[viii] https://www.worldbank.org/en/topic/trade/overview#:~:text=Trade%20is%20an%20engine%20of%20growth%20that%20creates%20better%20jobs,higher%20income%20after%20a%20decade.
[ix] Values of the World Trade Organisation can be viewed here: https://www.wto.org/english/thewto_e/whatis_e/what_stand_for_e.htm
[x] https://iccwbo.org/news-publications/policies-reports/icc-trade-register-report/
[xi] Rebecca Harding, 2022: Trade’s Sustainability Challenge https://flow.db.com/trade-finance/trade-s-sustainability-challenge
[xii] Intergovernmental Panel on Climate Change (March 2023): Climate Change 2023 – Synthesis Report – Summary for Policy Makers https://www.ipcc.ch/report/ar6/syr/downloads/report/IPCC_AR6_SYR_SPM.pdf
[xiii] https://www.unhcr.org/what-we-do/build-better-futures/environment-disasters-and-climate-change/climate-change-and
[xiv] https://www.migrationdataportal.org/themes/environmental_migration_and_statistics
[xv] United Nations Human Rights Commission, 2022: The Slow Onset of Climate Change and Human Rights Protection https://www.migrationdataportal.org/themes/environmental_migration_and_statistics
[xvi] Mia Prange (December 2022): Climate Change Is Fuelling Migration. Do Climate Migrants Have Legal Protections? Council on Foreign Relations https://www.cfr.org/in-brief/climate-change-fueling-migration-do-climate-migrants-have-legal-protections#:~:text=Why%20is%20climate%20migration%20on%20the%20rise%3F&text=Climate%20migration%20occurs%20when%20people,seas%20and%20intensifying%20water%20stress.
[xvii] BIS methodologies: Basel Committee on Banking Supervision – Climate related financial risks – measurement methodologies (April 2021): https://www.bis.org/bcbs/publ/d518.pdf
[xviii] Update to PRA climate change report March 2023: https://www.bankofengland.co.uk/prudential-regulation/publication/2023/report-on-climate-related-risks-and-the-regulatory-capital-frameworks
[xix] [xix] Financial Conduct Authority: https://www.fca.org.uk/publication/correspondence/dear-ceo-letter-esg-benchmarks-review.pdf and https://www.ing.com/Newsroom/News/How-the-US-is-slowly-catching-up-with-Europe-on-ESG-and-climate-policies.htm.
[xx] ITFA ESG committee and Dr. Rebecca Harding (2023): The Regulatory Reporting Reality of Making Trade Sustainable” https://itfa.org/the-itfa-esg-report-the-regulatory-reality-of-making-trade-sustainable/#:~:text=It%20argues%20that%20the%20current,globally%20in%20the%20long%20run.
