9 A Pentland Centre Research & Impact Digest, 2023 If companies are to meet ESG targets, there need to be incentives to do so. Dr Agryro Panaretou and her colleagues are looking at how reporting of financial instruments must adapt in this field. Financial instruments are agreements between lenders and borrowers that take on a variety of forms, with some of these now containing contractual terms related to Environmental, Social and Governance (ESG) factors. An example is a loan issued by a bank, where the interest rate is reduced if the customer meets their carbon footprint reduction target. As these are novel conditions, existing accounting standards do not provide explicit guidance on their treatment. The International Financial Reporting Standards require that financial instruments bemeasured at ‘fair value’ if they introduce risks other than credit and liquidity. ‘Fair value’ is a way to determine value and focuses on what something could be exchanged for in the market on a particular date (note – bank loans can be bought and sold). The existing standards imply that a bank shouldmeasure ESGlinked loans at fair value, unless a clear link can be demonstrated between ESG criteria and the credit quality of the loan. Under fair value measurement, assets are recorded in financial statements at a current market value, with changes in the value recognised in the income figure (this means that increases and decreases in the fair value of a loan will affect the profit figures year by year). While our research indicates that fair value measurement for financial instruments provides the most useful information to the market, it is often not welcomed by banks as it introduces volatility in their income. This led us to the following question: Are the current accounting rules appropriate for ESG-linked instruments? The answer is important, because accounting rules can have significant unintended consequences. The requirement to demonstrate and document the link between the ESG criteria and credit quality of the instrument means banks will need to carefully assess the risks they engage in, potentially improving their risk management. However, if the link is weak, banks will have to measure ESG-linked instruments at fair value. In practice, this can result in banks refraining from issuing such instruments or modifying the ESG features so they are not financially important. Such modifications can enable banks to avoid fair value measurement but at the same time reduce the incentives of the other parties to meet ESG targets. Find out more about the work of Dr Argyro Panaretou by emailing a.panaretou@lancaster.ac.uk How to account for ESG-linked instruments? The Innovation Catalyst is based on LUMS open innovation research, and brings together businesses, industry experts, academics, public sector bodies and others to build a system that has the ability to solve both individual and shared challenges. Ultimately aiming to build a sustainable place-based innovation ecosystem that can transform places, innovation ecosystems are collaborations of and for their place. The Innovation Catalyst, delivered in part by the Centre for Global Eco-Innovation (see P19), has been deployed in various contexts and places within the North West of England, including Cumbria’s food and drink sector. Here, organisations working in and around the sector considered the challenge and opportunities posed by the Net Zero agenda. The InnovationCatalyst enabled delegates to access academic expertise and collaboratewith like-minded peers to collectively develop solutions to the challenges pertinent to them. Broader stakeholderswere engaged throughout to ensureCatalyst outcomes were enacted and sustained, these includedCumbria Tourism, local authorities and theCumbria Local Enterprise Partnership. Highlights from the Cumbrian Innovation Catalyst included one delegate, a hotelier, being invited to take a stand at COP26 in Glasgow, to share the solutions she developed for her business as a result of her Catalyst experience. The Cumbrian group also identified food packaging and land management as key issues in Cumbria, and as a group they committed to trial new packaging. In addition, another delegate implemented a newmethodology on a selection of farms within their supply chain, designed to stop ploughing, which will contribute to a reduction in carbon usage. Find out more about the Innovation Catalyst here: www.lancaster.ac.uk/lums/business/sme-programmes/cuspinnovation-catalyst/ Innovation Catalyst
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