Indonesia has made ESG disclosure mandatory through the Financial Services Authority (OJK) Regulation No. 51/2017 on sustainable finance. But disclosure is only the first step, and it does not do enough to push banks and portfolio managers to internalize ESG principles when assessing projects that land on their desks.

Indonesia’s banks are not yet ready to fully account for ESG in their internal procedures and management systems. As a result, we have seen voluntary commitments to ESG policies being used as a framework to shift investment portfolios into greener projects, and we have also seen others sticking to high carbon-emitting projects with strong yields. Strategically planned steps are therefore crucial to help banks and financial institutions strengthen their contributions to climate finance while also successfully undergoing sustainable business transformations to meet the upcoming financial industry standards.

A crucial step toward embracing ESG investing is accounting for the climate risks associated with all investment portfolios and financing activities. These risks include physical risks, such as floods and heatwaves, and transition risks resulting from new technologies and a policy shift toward a more sustainable economy. While a comprehensive, quantitative assessment of climate risks may be complex, an initial qualitative understanding of how climate-related risks may affect financed assets can be a useful starting point.

Banks can gradually enhance their risk management frameworks to better reflect the impacts of climate risks on their operations and comply with disclosure standards. At the national level, banks should start aligning their portfolios with the Indonesia Green Taxonomy 1.0, launched in January 2022, as a key guideline.

And while fully adopting international standards may entail greater commitment, integrating more climate-focused disclosure benchmarks into existing risk management frameworks is strategically important in helping stakeholders understand, measure and manage climate risks.

A notable related development is the Basel Climate Principles (introduced in June 2022), which require internationally active banks to assess financially material climate risks throughout the credit lifecycle, from client onboarding to the ongoing monitoring of clients’ climate-related credit risk profiles.

The next step is to integrate ESG concepts into sustainable finance products. This is particularly promising for wholesale corporate banking, as corporate clients are increasingly encouraged to adopt responsible business practices.

The Loan Market Association (LMA) recognizes various sustainable loan types, each with its own specific features. Green loans are dedicated to financing environmentally friendly projects, while social loans aim to fund initiatives with positive social impacts. Special attention is given to the sustainability-linked loan (SLL) as a particularly promising choice. Unlike traditional loans, SLLs tie loan terms to the borrower's ESG strategy and performance, ensuring not only economic but also reputational benefits.

Under SLLs, borrowers are rewarded with lower interest rates and relaxing loan terms for achieving predetermined sustainability performance targets (SPTs). Conversely, missing targets can result in financial penalties. SPTs may vary based on the borrower's goals and industry trends, and cover metrics related to carbon emissions reduction targets, energy efficiency, waste management, diversity and other relevant ESG criteria. For corporate clients seeking flexibility in fund utilization and adaptability in the creation of performance targets, SLLs provide the ideal corporate finance solution.

The Japanese Green Finance Portal records that, as of June 2023, the number of sustainability-linked loans has steadily increased since its debut in 2017, with over 1,200 deals committing nearly US$900 billion. The first notable global SLL was led by ING and Philips in April 2017, when a consortium of 16 banks agreed on a $1.2 billion syndicated loan.

There were deals totaling more than $2 billion in 2018 involving multinational consumer goods company Danone, which used SPTs as a tactic to achieve higher ESG scores, including through greenhouse gas (GHG) emission reduction. Italian multinational energy company Enel secured an $11 billion SLL with SPTs aimed at increasing its renewable energy portfolios, and Etihad Airlines made the first SLL deal in the aviation industry, worth $1.2 billion, in late 2021 with HSBC and First Abu Dhabi Bank (FAB).

In Indonesia, sustainability-linked financing emerged in 2018 through a multi-tranche sustainability bond organized by BNP Paribas (BNPP) and issued by Tropical Landscape Finance Facility (TLFF) for Royal Lestari Utama (RLU), a natural rubber company owned by Michelin Group, a multinational tire business. However, sustainability-linked products still exist within a niche in the loan market in the country.

As of 2022, published SLL deals include a 5-year SLL for iron steel company Gunung Raja Paksi valued at Rp 500 billion ($33.33 million), a syndicated SLL worth Rp 6 trillion for state-owned cement company Semen Indonesia Group in late 2022, as well as smaller loans for Japfa and DSNG, companies in the agri-food and forestry sectors, respectively.

As investor priorities shift towards ESG metrics and the corporate sector faces increasing obligations to integrate sustainability components in response to climate change, the demand for ESG finance solutions like SLLs is expected to expand and become a larger market opportunity in Indonesia.

As ESG is a novel concept in Indonesia's robust and well-established traditional banking industry, integrating it into banking operations requires capacity building efforts, such as reskilling and upskilling bankers and including analysts, relationship managers, risk officers and relevant managerial levels.

As Indonesian companies increasingly commit to net zero targets, the need to manage climate risks is a competitive opportunity for value preservation and creation that can be offered by banks to their clients. A continuous and comprehensive syllabus-based approach is recommended, drawing inspiration from initiatives like the World Bank's Green Banking Academy (IFC-GBAC) in Latin America, which has provided climate financing training for bankers.

Strong collaboration among banks, financial regulators, research organizations, think tanks and development banks is crucial to establish a comprehensive program for green banking capacity building in Indonesia.

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The writers are analysts at Climate Policy Initiative. The views in this article are their own.