Member Article

Uncovering the climate risk of small businesses: a key ESG challenge for lenders

Rating corporates according to environmental, social and governance (ESG) standards is an increasingly visible mechanism in the fight against climate change. With societal awareness at an all-time high, it’s vital that all businesses are taking the necessary steps to participate and be part of the solution.

This is particularly true for lenders as for them climate risk works in two ways - the ‘risk from’ and ‘impact on’ climate change. On the former, alongside managing credit risk, the Prudential Regulation Authority is now insisting that they quantify, and manage climate-related financial risk both directly to themselves and indirectly via their borrowing customers.

Relating to lenders’ climate impact, the FCA is demanding an increasing number of corporates and financial service businesses to measure and disclose their climate impact, including direct emissions and indirect, Scope 3 emissions. For lenders, these indirect, or financed emissions, are those produced by their borrowing customers.

With a new and intensifying focus from regulators, it’s fundamental that lenders are shining a light on the climate status within their customer portfolios - particularly small businesses who cannot yet reasonably be expected to provide their own carbon footprint data.

While we are seeing many larger corporations making headline commitments to address this mounting pressure, the impact of small businesses in supply chains and customer portfolios cannot be forgotten, as they will ultimately enable these pledges to be met.

The SME blind spot

There is a near-total lack of accurate emissions information for small businesses. In fact, research suggests that only 3-7% have done work themselves to calculate their carbon footprint. With small businesses making up 99% of the UK’s total business population, it has never been more important to acknowledge their true environmental impact. There is undeniable pressure for lenders to report ESG factors, and with small businesses being responsible for 34% of the UK’s total emissions they are far more than an insignificant long tail.

Climate data is difficult to collate across a portfolio of small businesses, with many lenders dependent on unsophisticated manual questionnaires as part of the onboarding process, which can be error-prone and lack frequency of incoming data.

Other alternative approaches to fill in the blanks are either to ask them to undergo an onerous full emissions assessment, which causes customer friction and dissatisfaction, or to rely on emissions data proxies. However, while proxies can give instant full portfolio coverage, all proxies are not equal. Pinning portfolio emissions on bluntly inaccurate proxies will create a continuity problem in future iterations when better data does become available.

Unfortunately, common purely sector-based estimation processes fail to take into an array of discerning factors beyond sector. They fail to differentiate between, for example, a small independent bookshop in an urban area versus a UK-wide frozen food retailer in an out of town location where all staff could be expected to commute by car. These would typically exhibit wildly different carbon intensities.

Experian research suggests that these methods overestimate small business carbon emissions by an average of nearly 200% - such overestimations often leaves lenders unable to establish a reliable baseline for financed emissions and consequently struggle to manage their portfolios towards sustainability.

The road ahead

It’s key for lenders to understand more about their small business customers than ever before. That means looking for a data partner with an extensive collection of relevant data attributes and firmographics, and the ability to apply this to solve the data gap.

In this current climate, lenders cannot afford to ignore the financed emissions of their portfolio. However, any estimate of total downstream emissions not based on accurate and detailed small business data will be unreliable. And with the regulator watching, lenders must be prepared to fill in any data blind spots with the best proxies they can.

With a reliable baseline, lenders can confidently build their climate strategies and make informed decisions that benefit their customers, the environment, and their own business.

This was posted in Bdaily's Members' News section by Scott Harrison .