The Hindu Business Line : Accounting for people, planet and profit

Financial institutions do not have a major ecological footprint but they are in a unique position to channel capital towards clean development and play a catalytic role in the transition towards sustainability, says RANA KAPOOR.

Banks must frame policies that discourage lending to environmentally-polluting businesses.

Indian companies can be divided into two broad groups based on their approach to sustainability. The first and larger group, accounting for close to 80 per cent of all companies, approaches sustainable development as a philanthropic cause, driven by the promoter’s legacy initiatives. This group usually bases its actions on a variety of reasons — an ethical/moral necessity, brand equity advantages of associations with sustainable causes and regulatory penalties that might be levied on socially and environmentally errant behaviour.

Regardless of the motivation, the contribution of this group to India’s development by providing access to healthcare, education and low-income housing cannot be disputed.

The second group of companies, in keeping with global thoughts and trends, sees the merit of looking forward and incorporating sustainable initiatives with a more programmatic approach. This group is not led by regulatory requirements, but realises that there is a significant business opportunity in addressing under-serviced market segments. The rapid economic progress of recent years has brought with it increased pressure on natural resources and has accentuated the inequalities plaguing those sections of society that have been denied access to resources, whether it be education, healthcare, water, sanitation or financial capital.

There is a gradual understanding that the ‘bottom of the pyramid’ (BOP) is a viable business risk, around which business models can be developed that offer a product or service where the BOP is either a producer or consumer. Therefore, businesses that see the merit of conserving rapidly depleting resources or providing access to traditionally ignored sections of society are essentially addressing the fundamental economic premises of servicing unmet demand and maximising resource utilisation.

Building capacity

For instance, the success of microfinance institutions has demonstrated the clear advantages of addressing the social and for-profit agendas in one mandate. Given the shortage of quality labour, companies are realising that it is insufficient to simply invest in current human resources through stock options and state of the art facilities but, instead, see the necessity to build human capacity and capabilities for future productivity and growth.

With oil crossing $140 per barrel and peak power shortages, companies that have undertaken clean and captive power generation are benefiting commercially while reducing the demand for more polluting fuels.

Moreover, companies are recognising the significant business opportunity that distributed power generation can offer while serving as an effective solution for rural electrification. Companies participating in the Clean Development Mechanism are fast realising that investing in clean technologies and carbon abatement can deliver financial returns.

Until now, for the most part, limited access to reasonably priced capital, lack of exposure that restricts optimum scaling of ventures, low awareness of corporate best practices and poorly trained management teams and personnel are some of the shortfalls limiting the growth of smaller entrepreneurs addressing sustainability issues from a bottom-up perspective. While decentralised solutions are important in combating sustainability issues — there is a trade-off between localised operations and the efficiencies that scale can bring.

What is essential, though, is that the operations of the venture, in a steady state, must provide sufficient profit to cover the operating costs, provide a return on equity and subsequently build a balance sheet strong enough to access mainstream commercial capital for further expansion. It is important, then, for these companies to have the institutional support that banks and mainstream financial institutions can offer, not only in terms of capital but also strategic and advisory assistance.

Market-driven solutions

Global financial institutions are realising that social problems can best be addressed through market-driven solutions — solutions that are scaleable, permanent, efficacious (cheaper and better with time) and efficient, provided that these solutions are appropriately funded. Sustainable investment funds — public and private equity — have begun to channel capital to clean technologies, carbon abatement projects and, on a broader level, socially responsible enterprises.

Large pension funds in the US have also laid down specific principles that take into account the responsibility of businesses while investing.

For instance, pension fund house CALPERS has specific guidelines in terms of alternative investment (into VC/PE funds) which mandate the type and nature of businesses their funds can support.

In India as well, banks and financial institutions, in their capacity as intermediaries and facilitators, have to take the lead in introducing sustainable development to a wider audience through “Triple Bottom Line” accounting that takes stock of People, Planet and Profit.

Climate change is one area within the broader area of sustainable development where financial institutions can immediately play a role. The need to address climate change has become increasingly important, given current environmental conditions and future projections. With the risks looking increasingly alarming, it is imperative for financial institutions to swiftly adopt new operating and risk paradigms to effectively address the issue.

Sustainable concerns

Being part of the services sector, financial institutions do not have a major ecological footprint but are in a unique position to channel capital to address some of these concerns. For instance, climate change can impact portfolio businesses through property damage and production reduction.

This will cause considerable disruption in credit markets, demanding an immediate shift in the methodology used by FIs to model these risks into their practices. For example, recent natural disasters and changing agricultural patterns have highlighted the importance of accounting for climate change, particularly through the insurance sector.

Public pressure as a result of awareness and education is a great motivating factor for companies. As society at large begins to value sustainability, working with businesses that do not account for all their externalities can cause a significant loss of trust and reputation for the financial sector.

Environmentally polluting businesses are already facing the kind of ‘image damage’ that has plagued the tobacco industry. As a result, international frameworks like the Global Compact and the Carbon Disclosure Project have gained significant momentum.

Proactive approach

While most FIs have built in some safeguards in their lending policies, this has limited practical impact. More banks need to incorporate concrete policies in their lending memorandum which impose restrictions on the type of businesses which can be lent to, the nature of activities the funds can be used for and, as an ultimate weapon, allow the banks to recall financing in case of severe and continued breach.

There also needs to be a more proactive approach to encourage businesses that are socially responsible. That means not just restrictive financing options but progressively channelling funds to deserving businesses that score well on the triple bottom-line metrics. New and novel financing structures need to be devised that are best suited for such companies.

In addition, as institutional frameworks, trading platforms (such as the cap and trade systems) develop significant opportunities will be presented to financial institutions to participate as intermediaries to bring in similar efficiencies that they have traditionally brought into other markets across the economy.

While many FIs and businesses are espousing such principles, it is only through universal adoption that the issue of climate change can be effectively addressed.

Looking ahead, a clear and consistent regulatory framework that ensures environmental, social and financial sustainability of projects would help make financial institutions as well as businesses account for the external impacts of their operations.

On the whole, the financial sector, given its unique intermediary position in an economy and their vast ambit of influence over diverse stakeholders, can play a potentially catalytic role in the transition towards sustainability.

(The author is Managing Director and CEO, YES Bank)