Balancing Risks and Returns on Social and Impact Finance: New Insights from Herbert Smith Freehills

A new report from global law firm Herbert Smith Freehills reveals a growing focus on Environmental, Social, and Governance (ESG) considerations in business investment decisions in Australia. However, it uncovers ongoing barriers, with financial return being the primary concern.

The report, titled Stuck in the Middle? Unlocking ESG Investment in Australia 2024, provides an in-depth analysis of the rapidly changing ESG landscape and its impact on Australian businesses.

The report, based on a survey conducted by Herbert Smith Freehills, shows that 72% of respondents' business investment criteria or due diligence expressly include ESG considerations. However, 66% say barriers remain to ESG-aligned investment, with lack of stable financial return being the top barrier (cited by 45%).

The report highlights the role of government partnership and support in making the capital structure attractive for investors. "Commonwealth grants, loans and availability programs are helping super funds that want to invest in social and affordable housing," says Lucy McCullagh, Herbert Smith Freehills Partner and Head of Finance.

"Regulatory compliance is part of it, but the economic return is front and centre for most organisations. The report underscores the market's interest in moving from promises to real results where ESG is concerned.

“Lenders are already running debt analysis over an ESG lens. Organisations need detailed information to ensure they have the data they need to not only report on compliance, but on impact. We could see, very soon, lenders prioritise debt for those who can.

“Society wants us to open opportunities for sustainable investment. One way that we can do this is to take a long term view on competitiveness with non-ESG assets, to align capital allocation with our community.

“When assessing the barriers to unlocking investment in ESG, the volume and complexity of regulations is the first high hurdle. We encourage people to stay calm and use the successful change models that have worked previously to build the change program and uplift required.

“Recent legislative changes need to be contextualised and operationalised by businesses to ensure a solid foundation, this includes an assessment of overlapping legislation for multi-nationals. It is the first line of defence when avoiding critical issues, such as greenwashing.

“Challenges in project valuations are creating their own barriers. Critical for establishing financial returns, valuations that factor in regulations, such as carbon offsets, are particularly challenging. Investors and funders are backing their values to support sustainable investment, over the long term.

“While there has been a recent dampening in sustainable finance, in both volume and returns, macro economic factors are at play, but we are excited to see novel partnerships and innovation acting as a remedy. Particularly when philanthropic capital is working with traditional funding to deliver outcomes that achieve corporate results and community outcomes.

McCullagh believes the gradual evolution of local regulatory requirements, particularly around mandatory sustainability reporting, will give greater confidence to the investor market. "Banks look at a borrower’s financial reports. And once they become mandatory, sustainability reports will also form part of the investment analysis," McCullagh concluded.

The report combines survey data from 161 business leaders with insights from Herbert Smith Freehills' ESG lawyers, providing a comprehensive overview of the challenges and opportunities Australian businesses face amidst escalating ESG regulations and stakeholder expectations.

Report findings:

Realism about ongoing barriers

• 72% of respondents say their business investment criteria or due diligence expressly include ESG considerations

• However, 66% say barriers remain to ESG-aligned investment

• Lack of stable financial return is the top barrier (cited by 45%), then lack of proven technologies (41%), government policy (30%) and access to capital (25%)

Incorporating ESG risks and opportunities in deciding where to allocate resources has become business-as-usual in Australia. A total of 79% of respondents say ESG is important for new strategic initiatives, 74% for operational decisions, 58% for capex expenditure and 51% for mergers and acquisitions (M&A), and broader investments.