ESG and financial transactions from a transfer pricing perspective

In 2021, the European Central Bank (ECB) published its final guide on climate-related and environmental risks for banks. It aimed at enhancing the industry’s awareness and preparedness for managing climate-related and environmental risks.

The risks mentioned are commonly related to two main types: physical risk and transition risk.  They have an impact on both economic activities and the financial system of the entities. This impact can occur directly by lowering the MNEs’ profitability, by devaluating the assets, or indirectly through macro-financial changes.

Therefore, it is important for MNEs to demonstrate that they operate a sustainable business model to receive the necessary funding for investing in (ESG) projects and, for investors operating in the financial sector, to prove that their investments are qualified as ‘sustainable investments’.

Sustainable investments are defined under Article 2(17) of the EU Regulation on sustainability-related disclosures in the financial services sector as:

• ‘An investment in an economic activity that contributes to, among other things, an environmental objective that does not significantly harm any of the other objectives and
• ‘That the investee companies follow good governance practices, for example in relation to tax compliance.’

Thus, it seems that there is a link between sustainable financial aspects and tax matters.

Very often MNEs are using sustainability or impact-linked bonds to obtain external funding. Under such arrangements, the interest rate is usually linked to sustainability performance targets and if the targets are not met, the interest rate could increase.

In this context, banks are called to make an assessment ex ante, by verifying that the borrower complies with all the necessary requirements to consider their (production) activity as eco-sustainable and therefore suitable for receiving sustainable loans, and, ex post, by periodically verifying and assessing whether the money lent has been used appropriately.

From an economic perspective, the ESG factors underlying a company’s policies and strategies can act by influencing the debtors’ cash flows, thus affecting the estimate of the probability of default which has an impact on their credit ratings. It seems that there is an indirect link between the ESG risk factors to which companies are exposed and their ratings, the higher the risk the lower the rating. Thus, companies that demonstrate their ESG compliance will likely obtain higher ratings.

It is reasonable to think that banks will also base their valuations on the ESG ratings issued by professional providers such as KLD, Sustainalytics, Moody’s ESG, etc. to assess companies’ credit accessibility. However, ESG ratings from different providers can vary significantly. This will not only make it difficult to evaluate ESG performance but will also reduce companies’ incentives to improve their ESG performance, further causing companies to underinvest in the future[1].

It may be assumed that the criteria used by banks to assess credit ratings, taking ESG into account, could also be used by MNEs in their internal dealings as they should provide a good proxy to arrive at an arm’s length price.

Nonetheless, identifying arm’s length interest rates for impact-linked financial structures is already a difficult exercise. Pricing changes in interest with a downward or upward adjustment because of achieving or missing a sustainability target, is uncharted territory that will surely lead to discussions.

As banks have not published yet the criteria used to establish the impact of the ESG factors on the application of the interest rate on a loan, professionals are left to use the guide published by the ECB to help companies assess their intragroup transactions to replicate how a third party (bank) would price a loan in similar scenarios.

As soon as the relevant criteria’s are made available, the authors will attempt to analyse them to show how intragroup transactions could be assessed, by first evaluating companies’ creditworthiness and later by identifying how ESG criteria can impact interest rates.

[1] “Aggregate Confusion: The Divergence of ESG Ratings”, Florian Berg, Julian F. Ko¨ lbel, and Roberto Rigobon, MIT Sloan, USA, University of Zurich, Switzerland.