Factoring and the potential of green factoring
8 minute • Tudor N. Pana • 11 mai 2022
An interest in finance, banking law or the functioning of the economy as a whole, calls for a certain level of familiarity with “factoring”, which is a globally relevant, ever increasing, trillion dollar industry. Its compounded annual rate growth (summing up the total value of invoices, over the last 7 years) was 2.53%, with €2.347 billion in 2014, €2.726 billion in 2020 and €3.137 billion in 2021. Even more and evidently so, experts say the market has the potential to reach (and conceivably surpass) €5.000 billion in value by 2028, the numbers speaking for themselves. First, I will give a quick overview of the notion in question, before exploring some novel ideas regarding its applicability to sustainability.
I. Now, what is Factoring?
A financial transaction in which a corporation sells its receivables (debt or bills) to another institution (a factor specialised in such operations) is known as factoring. Simply put, the factor then collects the money owed from the company’s customers, otherwise known as third parties.
Practically, factoring is used by businesses who want to get liquidity rather than wait for their credit terms to expire. Factoring allows businesses to quickly increase their cash flow and pay off any outstanding debts. Overall, this financial procedure offers companies the possibility to free up the money frozen in accounts receivables, simultaneously transferring the default risk to the factor.
💡 In the US there is a terminology difference between factoring and invoice discounting (or an assignment of accounts receivable in American accounting), the two being seen as distinct arrangements not falling under the same operational umbrella (albeit their observable similarities). The key distinction between factoring and discounting (as seen in the US) comes from who owns the sales ledger, and who will eventually collect payment from the end customer.
With the so-called traditional factoring, the factoring (or financier) is in charge of the company’s sales ledger (a list that keeps track of the money received – for the products or services – as well as what is owed), as well as collecting debts from customers. Invoice discounting, on the other hand, allows the originating company to keep track of its sales ledger and collect payments from customers as usual. The key advantage for invoice discounting is that the final consumer does not need to know that the company has a financing agreement in place, which could eventually help build confidence and improve the company’s reputation. However, besides the US, both financial transactions are considered different types of factoring.
We could count approximately 6 different models of factoring agreements that are considered more or less mainstream, but there is no exclusive list, and no settled name for each practice. For useful information on the topic and the different types of factoring and similar financing techniques, access the following links: the ICC Academy, market finance, investopedia, trade finance global, or invoice factoring (from Trade Global). Here you can find a traditional factoring agreement drafted by HSBC.
A factoring operation has multiple facets, and the diagram below shows its most customary steps.
Is there room for improvement? Always.
“Human activity has been continuously harming our planet’s eco-system, and we have reached an unprecedented level of urgency. According to the International Panel on Climate Change, we have caused virtually 100% of the global warming of the past century. Undeniably, finance plays a vital role in decreasing the devastating effects of our own behaviour.”
To stay connected to innovation and to the reality of our society, to the green and blue economies we strive towards, factoring must also turn towards an environmentally friendly outlook. How is this to be achieved will be the next object of focus. As the CEO of one of the most influential banks has recently said: financial institutions might “risk losing their licence to operate”, if they ignore green finance.
II. Joint forces
Green factoring is part and parcel of the wave of green finance activities (or socially responsible investing), promoting deals with a positive impact on the climate and the environment, having the potential to assist companies in their sustainable transition process, and likely help green-oriented start-ups cover their financial needs faster than usual, in spite of not yet having a solid financial record.
Green factoring techniques the market already offers:
- CaixaBank and Siemens Gamesa have completed the first sustainable factoring deal in Spain. In keeping with both companies’ environmental objectives, the operation included environmental targets in the pricing policy of this short-term financing instrument, allowing more favourable terms if the already agreed upon ESH terms are complied with. Additionally, the two entities have also signed a “green” guarantee facility agreement of €1 billion – used to cover the assigned invoices and improve the financial ratios of the balance sheet.
- Green weighting factor approach (e.g.: Natixis): All “green” financing granted by Natixis’ Corporate Banking wing now receives a bonus, while all “brown” financing sees its profitability reduced. Natixis is ultimately aiming for a trajectory for its financing that is consistent with the objectives of the 2016 Paris Agreement. This feature has also been taken into account in their factoring agreements.
- BBVA & Nordex green factoring agreements: The BBVA framework has made it possible to classify as social, green or sustainable transactions whose funding is allocated to projects directly connected to the UN Sustainable Development Goals.
- Sustainability linked factoring (Deutsche Bank): The sustainability-related structure of the ESG linked factoring product is based on specific sustainability performance targets (SPTs) or key performance indicators (KPIs), that will be assessed periodically by experts in the field.
- Green Supporting Factor: The EU has been considering introducing the GSF (Green Supporting Factor) that should promote financing for green(er) companies and penalise the more polluting ones (also called “brown”), that go against the EU climate and sustainability objectives. Similarly, this could and should be reflected in EU located factoring agreements.
If the EU is to meet its climate and environmental targets, the amount of sustainable funding available must be greatly increased, and this must be done quickly. The European Commission is updating its sustainable finance policy, and a public consultation has been taking place on the topic. The new strategy aims to integrate the risks that climate change poses to the European financial system and present a roadmap for new measures that will increase the flow of private investment into sustainable projects, thereby supporting the European Green Deal goals.
One of the questions in the Commission’s consultation survey is whether using the financial sector’s regulatory so-called prudential framework to boost green investment would be effective. This strategy has received support from the Commission as well as a portion of the financial industry. Supervisory authorities, on the other hand, have expressed doubts about repurposing the prudential framework in this way, as it could mean banks might have less buffer against losses.
The prudential framework establishes the minimum amount and quality of capital that a bank must maintain in relation to the total risk on its balance sheet. The required capital’s quality and amount are established by aggregating the risk of the bank’s assets and assigning a relative risk weight to each asset. The higher the weighting assigned to a particular asset, the more capital the bank must maintain to compensate for the asset’s risk.
💡 By extension, the same framework could equally cover green factoring, altering the terms of the agreement based on the ‘green reliability’ of the company funded (or the invoices covered).
According to an IFC report on the Micro, Small and Medium Enterprises Financing Gap conducted in 2017, there are approximately $5.7 trillion unmet MSME financing needs each year, with many MSMEs unable to obtain financial services or being turned down due to an unfavourable credit history. Nonetheless, outstanding invoices make up a significant amount of their overall assets and could be used as collateral in factoring agreements to bridge the funding gap. On this, green factoring could also play a role by providing, in parallel, a bonus and an incentive for this category of companies to start, or support, their sustainable transition, the avoidance of which would (or should) be inconceivable in today’s reality.
Through the above, I tried to create a stimulus for the existing literature on a relatively recent development (in line with the general ongoing trans-sectoral sustainable transition) which did not yet reach an adequate level of maturity. Yes, we could say all factoring will most certainly become green in time (as we run out of alternatives), but for that to occur efficiently (and to avoid the worst consequences of our own behaviour), we must expand the green transition model to operations of the economy/ financial sector otherwise not yet sufficiently touched, but with real prospects to create a positive impact – just like factoring.