SMEs are often referred to as the backbone of economies, and for good reason. They are diverse in size, strategy and sector and, in many countries, make up more than 90 percent of enterprises. They also account for 70 percent of employment worldwide, taking skills and income to underserved communities creating social cohesion and addressing inequality issues. SMEs are themselves some of the world’s greatest emitters of greenhouse gases. They are therefore uniquely placed to contribute to a just transition to a climate-friendly and sustainable future.
Despite this, access to finance has remained a key challenge for SMEs. Whilst it is difficult to estimate the financing gap for SMEs globally due to the diversity of organizations involved, according to the International Finance Corporation (IFC), there is a micro, small, and medium enterprise (MSME) financing gap of over $5 trillion, with women-owned businesses accounting for 32 percent of that financing gap.
Governments and regional bodies around the world are focused on creating sustainable and digital strategies such as the "EU SME Strategy for a Sustainable and Digital Europe" but it is important that any SME financing strategy is also aligned with these strategies, enabling them to access the finance in order to digitalize and "green" their own business models, products, services, and processes. Additionally, SMEs will need support gathering data on their own business practices to monitor and disclose their progress on sustainability.
Main challenges facing SMEs in accessing finance
SMEs have historically faced a range of internal and external barriers affecting their ability to access finance directly and indirectly. These have included: lack of resources and experienced employees and managers; lack of, or insufficient, collateral for the purposes of security and guarantees; and information asymmetries between financial institutions and SMEs. Typically, SMEs have also lacked access to a diversity of finance limiting their potential for growth and scaling up.
These challenges and barriers are often more pronounced for new organizations, innovative ventures, and also underserved groups including women, youth, seniors, and migrants. The development and evolution of mainstream sustainable finance is not, for the most part, specifically addressing the challenges that SMEs face with the unintended consequence of amplifying rather than lowering these barriers.
There is a significant opportunity for both policy makers and SMEs moving forward to engender greater participation in the commercial economy and reduce some of these barriers. It is important that jurisdictional taxonomies and frameworks do not focus just on large public companies, as if often the case. SMEs represent 99 percent of all businesses in the European market and ensuring that policy, frameworks, and legislation are targeted directly at the core of this economic engine is critical to the success of any roll-out of green finance to this segment.
With the race to net zero, it is also important that policy makers do not lose sight of other important ESG factors like gender, racial, and social diversity. Developing incentives for SMEs to achieve this type of diversity through labor support schemes and tax incentives can help accelerate the segment in its contribution to net zero objectives by mobilizing a more diverse workforce and reducing some of the existing social and economic barriers. This can be especially effective in supporting areas of (historic) regional unemployment and immigration influx.
Digital solutions to enable SMEs to access finance
Recovery packages across the world, such as the EU's SME Strategy, are including support for a transition to sustainable and digital economies and business models with extensive support programs for “greening” of SME activities. This includes, for example, setting up a Green Tech Investment Initiative to support digital innovations and green tech solutions in the EU. New digital infrastructure which is easily accessible by SMEs is being put forward as an important solution to many of the issues identified above, particularly in the context of data collection and information gathering.
Before COVID-19, new technologies, data, and players were emerging to enhance financial innovation. This included a fintech revolution with rapid progress in the area of payments and lending and the use of advanced disruptive technologies such as blockchain, artificial intelligence (AI), cloud and high performance computing. All of these can enhance the competitiveness and potential of SMEs. Innovative fintechs have improved financial inclusion in many developing countries using the existing mobile phone infrastructure, and this technology can also improve SMEs’ access to finance in those countries. One example is M-Pesa, which allows the unbanked in Kenya to transfer money between accounts linked to their mobile phones. This makes sending and receiving payments much simpler. According to one study, nine in ten Kenyan SMEs use M-Pesa.
More sophisticated technologies such as tokenization, based on blockchain, can connect SMEs to investors with a matching investment profile and SMEs can also raise money through crowdfunding using cryptoassets. One major advantage of using cryptoassets is the ability to access a wider pool of investors from anywhere in the world. This is potentially easier than raising traditional bank or venture capital funding. As a result, innovative SMEs with a contribution to make to a greener recovery will be able to scale faster than they otherwise would.
AI and cloud computing can give SMEs greater flexibility and efficiency. For example, AI can automate administrative tasks allowing employees to focus on more productive activities for the growth of the business. Access to cloud computing allows SMEs to use a computing service flexibly when they need it, rather than committing to a fixed arrangement with a supplier. Although each individual application may only have a relatively small impact, taken together they could have a significant effect on SMEs' ability to grow sustainably. These technologies complement recovery packages such as the EU's Green Tech Investment Initiative. The recovery packages direct the SMEs in an environmentally responsible direction and digital solutions can then accelerate their growth, contributing to a more sustainable economy overall.
The diversity of financing options which are accessible to SMEs through technology also include non-traditional players and data-driven technologies, and products in the fintech sector such as supply chain financing. Supply chain financing, amongst other things, improves sellers' cashflow by reducing the time they wait for payment of invoices at funding cost based on the buyer’s credit rating. Supply chain financing can also directly encourage sustainability. For example, in 2016, Puma, BNP Paribas, and the International Finance Corporation (IFC) used supply chain financing to reward sustainable suppliers. Suppliers with favorable sustainability scores awarded by Puma would receive more favorable financing from BNP Paribas or the IFC. Arrangements like these could be powerful incentives toward sustainable practices.
Digital solutions offer the diversity and flexibility to create the tailor-made finance solutions for SMEs that are essential given the diversity and range of SMEs. For example, Recognise is a UK bank dedicated to SMEs. These types of financial institutions aspire to tailor options to individual clients based on their business needs; the promise of a personalized relationship is key to how they distinguish themselves from traditional banks. Recognise worked with Mambu and various fintechs to provide a software-as-a-service platform that could enable this level of flexibility.
Sustainable finance and SMEs
The growth of the sustainable finance sector (with the Organisation for Economic Co-operation and Development (OECD) estimating over $30 trillion of global assets incorporating ESG factors in 2020) has been accompanied with a proliferation of law and regulation, soft law and voluntary codes, trade association principles, and reports and guidance on every aspect of sustainable finance and related issues. The challenge for all organizations (regardless of size) is to decide what is necessary, useful, and relevant depending on their operations, business model, sector, region, and country.
A key challenge for the sustainable finance sector remains data (both qualitative and quantitative) and disclosure - crucial not only because sustainable finance and investment decisions are based on data and disclosure, but also due to the increased focus on ESG risk and sustainability "washing." The market has moved to enhance transparency, reduce risk, and ensure the credibility and integrity of sustainable finance products, with the European Banking Authority (EBA) publishing its "Report on management and supervision of ESG risks for credit institutions and investment firms” and trade associations such as ICMA, the LMA, APLMA, and LSTA tightening up product-related principles and guidance with a view to dealing with the risk of green/ sustainability “washing”.
It is recognized that SMEs often lack the resources and experience to navigate the fragmented and complex sustainable finance legal, regulatory, and information landscape. As a result, they may lack knowledge of sustainability-related risks and opportunities for their businesses, and of sustainable funding options and products, and related eligibility. This may prevent them from integrating sustainable business, models and practices.
The sector challenge relating to data and disclosure has also emphasized rather than lowered information asymmetries between financial institutions and SMEs. SMEs are often unable to invest in the relevant infrastructure and processes required to identify and collect relevant information, and for the purposes of on-going monitoring, disclosure and reporting of sustainable information.
The focus on ESG risk, climate stress testing, and sustainability washing have all led to a tightening of internal lending conditions. This can have an adverse effect on the sustainable finance options for SMEs, which have historically relied on bank funding. The absence of relevant sustainable data, policies, strategies, and information has created issues for SMEs trying to access mainstream sustainable finance products such as sustainability-linked loans. The lack of data and information also manifests itself as a general market failure. Compared to software startups for example, green or clean tech SMEs are seen as high-risk, capital intense, and with longer or more complex financing needs. The result is the substantial underinvestment in innovative SMEs. In the longer term, if SMEs do not integrate sustainable business models and practice, they may find themselves losing their competitive edge and unable to access sustainable finance or otherwise paying a premium for that finance.
Since the challenges of gathering and verifying data and communicating it to lenders and investors appears to be part of the problem for SMEs, it is perhaps not surprising that digital is part of the solution. Technology ought to be able to help break down the information barriers and help sustainable-finance-focused investors gain the confidence to invest in SMEs.
Recently, The City of London Corporation and the Financial Conduct Authority have collaborated on a Digital Sandbox to create a digital testing environment and to support financial services’ innovation. The virtual ecosystem addresses challenges in tech development such as access to data and industry collaboration and is innovative in the tools and features it provides. This includes the testing and development of new products and services for the purposes of ESG data and disclosure.
The pilot phase concluded in February 2021. Although it is still too early to measure long-term outcomes, the pilot’s evaluation report indicated promising results based on data from surveys, interviews, and other sources. Amongst the benefits were faster product development, the testing of technology such as AI, and networking opportunities. A second phase is about to begin – applications for firms and individuals will close in October 2021 and testing will begin in January 2022. The aim of the sandbox is to enable transparency in disclosure and reporting on sustainability, especially on the characteristics of corporate assets and the profile of their supply chains (e.g. open source and eco-friendly decentralized ledgers, centralized platforms), and the automation of the assurance of a listed issuer’s ESG data and validation of its ESG-labelled corporate bond issuance (e.g. Internet of Things, decentralized ledgers, centralized platforms, satellite imaging, AI). A further objective is to make the ESG qualities of particular products or services more transparent to consumers.
In turn, these features should allow improved access to finance for SMEs. Recovery plans such as the Green Tech Initiative are directing SMEs in an increasingly sustainable direction. Digital solutions can help those SMEs attract investment and then gather data on their own sustainable practices to attract further green financing. This virtuous circle, enabled by digital solutions, has the potential to make the economy as a whole more sustainable.
In conclusion, a sustainable future depends on an SME sector that is well financed and empowered to embrace sustainable practices. The sustainable finance sector not only needs to focus on large companies that have established sustainability strategy policies and reporting, but also needs to find a way of engaging with and funding SMEs that do not. Digital solutions are starting to help with that, as well as offering innovative financing tailored to the SME sector. This ought to help the sector play its part in building back better.
This article was first published by Global Digital Finance in the "Digital Assets: Laying ESG Foundations" report.
Authored by Sukhvir Basran, John Salmon, and Andrew Carey.
