IFC: How sustainable finance can reach MSMEs

An illustration of protected small savings. [Getty Images]

The knowledge gap on how to use finances in green projects is one of the key barriers towards sustainable investments in micro, small and medium enterprises (MSMEs), an international finance body has detailed.

The Word Bank's investment arm, International Finance Corporation (IFC) has spelt out these gaps in the latest document that contains a guide on how financial institutions can extend sustainable funding to MSMEs.

IFC notes that MSMEs' financial needs, which are largely operational rather than capital, disadvantage them to use proceeds in sustainable projects.

These businesses also have insufficient data when they present their sustainable projects and their expected impact. They also have inadequate capacity for governance and reporting.

The guide by IFC provides a framework that should guide MSMEs and financial instructions to vet what is sustainable finance and the expected impact once the proceeds are received.

The document distinguishes between operational and capital expenditures, provides guidance reporting processes and defines the use of proceeds in some sectors.

The document titled, Sustainable MSME Finance Reference Guide by the International Finance Corporation, is an initiative of IFC's Green Bond Technical Assistance programme.

Director of the Climate Business Department IFC James Fergusson, says in the report that MSMEs are essential to the transition to a low carbon, resilient and sustainable economy.

"Climate action by MSMEs is, however, constrained by knowledge, capacity and access to capital," he says.

This role is emphasised as these enterprises represent 90 per cent of businesses globally and are essential drivers of employment, technological change and social mobility.

However, despite their importance, IFC says access to finance in emerging markets remains constrained.

This not only restricts capital flow for sustainable finance that would help to implement climate solutions but also their business growth.

"Financial institutions (FIs) play an important role in bridging the MSME finance gap while enabling a green and just transition. Sustainable finance can be used to fill this gap while providing benefits to FIs themselves," the guide states in part.

The Word Bank's investment arm points out that there are a growing number of investors with sustainability mandates, such as institutional investors, development financial institutions, and impact funds, among others.

And by providing sustainable MSME finance with the exclusive purpose of financing eligible green and, or social projects, financial institutions may have access to alternative sources of funding, and expand and diversify their investor base.

IFC describes sustainable finance as one that aims to contribute to substantial progress on environmental, social, or governance objectives.

The institution provides two ways in which sustainable finance can be approached: follow the money or follow the impact.

Follow(ing) the money is a structured alignment with Green Loan Principles, Green Bond Principles, Social Loan Principles and Social Bond Principles.

This is where the use of proceeds is restricted to activities and assets that are eligible under the said principles.

Follow(ing) the impact is structured in alignment with sustainability-linked loan principles or sustainability bond principles and the use of proceeds is general but there are financial consequences like step up or step down pricing if targets are achieved or missed.

The guide categorises sustainable MSME finance by type: capital expenditure and operational expenditures.

The document notes that although MSMEs often need to finance their operations, much sustainable finance guidance to date has focused on the use of proceeds for capital expenditures.

"This has created a gap in understanding of how to leverage sustainable finance principles to provide more financing for sustainable MSME operational activities," reads the document.

It adds that sustainable MSME finance for capital expenditure must align with an appropriate use of proceeds.

"If an appropriate use of proceeds cannot be identified (for instance in the case of working capital loans or trade finance), the MSME in question should achieve appropriate green or social standards at the enterprise level, as assessed by an independent third party," the guide states.

IFC says this guide aims to set out a practical approach for financial institutions to translate sustainable finance principles into supporting sustainable MSME finance in emerging markets.

It does this by developing a suitable use of proceeds list for capital expenditures, selecting operational expenditures and an approach for supporting MSME operational expenditures finance needs more broadly.

It also outlines steps for project identification and evaluation - providing resources for financial institution's governance processes, as well as guidance on potential reporting metrics.

"The main audience for this guide is professionals from emerging market financial institutions seeking to address their climate objectives and grow their business by applying and expanding sustainable finance approaches to support MSMEs," the guide states.

The institution outlines one of the steps in operationalising sustainable finance to MSMEs as training staff to identify these opportunities in small businesses.

Financial institutions should also develop a sustainable framework and leverage technical assistance.

When checking the use of proceeds, they should be mapped out alongside the relevant Sustainable Development Goals.

"MSMEs with operational expenditures finance needs with no identified use of proceeds should meet appropriate standards," reads the guide.

Separate accounts will also be required to be set or have the loans ring-fenced. IFC notes that this guide will continue to evolve as the market develops and matures.

"Given the diversity of MSMEs and the evolving nature of sustainable finance, this Guide does not intend to offer a finite and comprehensive overview of activities and projects that could be financed under a sustainable label," says IFC.

"Rather, it is intended to be a living document, which will be reviewed and updated periodically to accurately reflect developments in this financial space."