Scottish National Investment Bank: Fairer Scotland Duty assessment

Introducing Loan Covenants

Introduction

49. The majority of organisations to which the Bank lends money will not have an inherent impact on reducing socioeconomic disadvantage in the way that the evidence demonstrates rural SMEs and employee-owned businesses do. As identified by the Fairer Scotland Duty Assessment Panel, however, its role as an investor gives the Bank a unique opportunity to influence the behaviour of those organisations to which it lends money incentivising practises that contribute to reducing inequalities of outcome arising from socioeconomic disadvantage. The primary mechanism through which the Bank can seek to influence the behaviour of those businesses that it lends to is through attaching conditions to its investments designed to encourage the introduction of practices that reduce disadvantage and avoid engaging in those that entrench it.

50. The idea of attaching conditions to investments is not new. Loan covenants are used frequently by banks and other financial institutions as a means of managing the behaviour of businesses that they lend money to. In effect, loancovenants are conditions attached to commercial loans that either require the borrower to fulfill certain requirements, forbid them from undertaking certain actions or restricts specific activities to circumstances when other conditions are met. Attaching conditions to loans issued by the Bank would therefore be in keeping with methods widely used by other commercial lenders.

51. Despite the significant potential in utilising loan covenants to incentivise businesses to deliver social value, the Fairer Scotland Duty Assessment Panel and other stakeholders were of the view that the Bank should avoid taking a one-size fits all approach to introducing these and that it should not be necessary for all companies to comply with these conditions before they are considered eligible for investment as long as there was a clear roadmap towards implementation of Fair Work principles within that business. There are significant variations in the business community across Scotland and the sort of conditions that are appropriate for a certain type of organisation may not be suitable for another, the Bank's approach to introducing any type of loan covenant must reflect this. Moreover, research has demonstrated that loan covenants can have unintended consequences that impact negatively on businesses and their employees. The rationale for the Bank adopting a nuanced approach to introducing loan covenants is explored in more detail below.

Fair Work First

52. Over the past ten years the UK has seen a spike in instances of in work poverty, that is to say the number of individuals or households that have employment but are classed as being socioeconomically disadvantaged has risen sharply since 2008.^[41] The Final Report of the IPPR Commission on Economic Justice highlights that stagnating wage growth, insecure employment and falling workplace participation have collectively contributed to this rising tide of in work poverty across the UK.^[42] The Scottish Government has introduced a variety of policy measures aimed at counteracting the proliferation of workplace practices which mean that work is no longer a reliable route out of poverty. Foremost among these has been the introduction of Fair Work First, a policy initiative designed to encourage and embed the following within Scottish employers:

• investment in skills and training;
• no exploitative zero hours contracts;
• action on gender pay;
• genuine workforce engagement, including with trade unions; and
• payment of the Real Living Wage.

53. In October 2018, the First Minister extended the scope of Fair Work First to more of the Scottish Government's contracts and support grants. This is in addition to existing announcements by the Scottish Government that it will demonstrate leadership in adopting Fair Work principles in its role as an employer, a commitment that encompasses the Bank. Fair Work First is in its infancy as a policy and so there is limited data available to draw any conclusions regarding whether it has been successful in alleviating socioeconomic disadvantage but research suggests that it has significant scope to reduce the prevalence of in work poverty in Scotland. A recent report by IPPR Scotland, for example, highlighted the potential of workplace representation in boosting productivity and wage growth.^[43]

54. Given that those businesses successful in applying for funding from the Bank will be in receipt of substantial sums of public money, it is not unreasonable to request that they have practices and policies in place which support the delivery of social value. Indeed elements of Fair Work First have already been attached to RSA Grants awarded by the enterprise agencies.

55. In addition, the Building Scotland Fund (BSF), a precursor to the Bank, is considering collecting data on the prevalence of Fair Work principles within the businesses that it invests in. Responses to the Committee's Call for Evidence on the Bill have highlighted strong support among stakeholders for attaching Fair Work conditions to investments made by the Bank. Further analysis is required, however, regarding the introduction of Fair Work First to commercial investments as distinct from procurement contracts and support grants and the data collected by the BSF will be important in informing this approach.

Adopt a tailored approach

56. Studies have shown that borrower discouragement can vary significant between different countries. In the US, for example, evidence suggests that 30% of those businesses that don't apply for capital when they have a requirement to do so are creditworthy. The equivalent figure for the UK is 50% demonstrating that there are localised factors at play which exert a significant influence on levels of borrower discouragement.^[44] Of these localised factors, research indicates that loan covenants are a significant reason for borrower discouragement. A survey exploring reasons for borrower discouragement among high growth firms in the UK found that 20% of those businesses that responded felt that the nature of loan covenants had a strong influence on their decision about whether to seek finance. Significantly this figured increased the smaller the firm with microbusinesses particularly reticent about the impact of loan covenants.^[45]

57. It is therefore important that the Bank adopts a tailored approach to introducing loan covenants aimed at encouraging Fair Work First within the firms that it lends to. More work is necessary to determine what a tailored approach means in practice and this should be informed by detailed discussions with businesses and trade unions but initial research suggests that the Bank should utilise its ongoing relationship with companies to encourage them to adopt Fair Work First. This will require the Bank to have the appropriate corporate and staff structures in place to monitor implementation of Fair Work First across the organisations that it invests in and will require staff who have the appropriate skills and are incentivised to build a strong rapport with business owners.

58. Work will also be required with those organisations that are commissioned to administer funds on behalf of the Bank to understand how Fair Work First can be implemented sustainably. The Bank may also be able to utilise incentives to encourage businesses towards the adoption of Fair Work practices examples of which can already be found in the financial sector.

Training and upskilling of staff

59. Each of the Fair Work principles adopted by the Scottish Government have a distinct and important role to play in addressing the growth of in work poverty. Skills and training is perhaps the most important yet most easily neglected of the five principles. Implementing the Real Living Wage within businesses, for example, will act to lift staff members out of poverty but giving them skills will enhance their employability and earnings potential giving them the opportunity to increase their income exponentially. Studies have shown that there is both a supply and demand-side skills problem in the UK which means that there is not only a skills shortage in the UK but that those skills which do exist are, in many cases, not being utilised effectively by firms.^[46] A recent report by IPPR Scotland highlighted the need for increased expenditure on in work training with a particular focus on upskilling those working in low paid sectors of the economy.^[47]

60. Research has found that lower levels of human and social capital (fewer qualifications, less experience in the labour market and less developed professional networks) can also lead to lower incomes, increased working hours and less stable employment among those who are self-employed. The academic literature has termed this phenomenon 'self-exploitation'.^[48] Instances of self-exploitation are particularly prevalent among those groups who experience disadvantages in the labour market due to lower levels of human and social capital. Self-exploitation can act to entrench inequalities of outcome not only by further depressing the incomes of those who are disadvantaged but also by damaging both physical and mental wellbeing.^[49]

61. In addition, where individuals have utilised external capital to establish a business which then becomes unsustainable the chances of that debt being unserviceable are even higher. This FSDA therefore draws specific attention to the skills development and training dimension of the Fair Work principles as a means of supporting people to lift themselves out of poverty.

Focus on the benefits of introducing Fair Work Principles

62. Studies have shown that Fair Work is not only good for employees, it is also good for employers demonstrating that businesses with a motivated, engaged and appropriately skilled workforce enjoy substantial benefits.^[50] As the Scottish Government's Fair Work Action Plan highlights, those businesses that have embedded Fair Work in their policies and practices are more likely to benefit from sustainable growth.^[51] In encouraging the adoption of Fair Work principles within the firms that it invests in the Bank should highlight the benefits that businesses typically enjoy by adopting these. This could involve utilising the experience of other companies that have introduced Fair Work policies in the Bank's marketing strategy to ensure that loan covenants do not discourage borrowers.

Requirement to be part of a business Association

63. The IPPR Commission on Economic Justice Report identified three distinct and important roles for business associations in creating a cohesive and organised economy. The report states the following:

" They [business associations] represent the interests of their members to the state, enabling sectors to make coherent requests of government for particular policy interventions. They act as mechanisms for the diffusion of innovation from one business to the other through the exchange of good practice and by creating greater fluidity between firms. And by building relationships, they create direct commercial opportunities for business-to-business commerce, and as a gateway for international trade"^[52]

64. Although the relevance between business association membership and reducing inequalities of outcome arising from socioeconomic disadvantage may not be immediately apparent, economists have established a clear link between innovation and wage growth via productivity gains precipitated by firms that engage in innovation. As highlighted by the IPPR Scotland Report entitled 'How Productivity could Deliver Inclusive Growth in Scotland', productivity growth is low in Scotland and measures to improve it could lead to significant improvements in wage growth, particularly in low paid sectors of the economy.^[53]

65. Membership of business associations in the UK is particularly low which means that SMEs, and the wider economy, do not enjoy these benefits to the same extent as firms in other countries. In Japan, 24% of firms are members of a business association with this number rising to 50% in the USA, the comparative figure in the UK is just 3.5%.^[54] The Bank should therefore give consideration to whether it should encourage those businesses that it invests to join a business association or to find other networking opportunities that will enable them to learn and share best practice with those who have similar growth, innovation and business practice ambitions.

Adopting Community Benefit Clauses

66. The concept of Community Benefit Clauses have grown in popularity in recent years particularly within the Scottish Government who have introduced these clauses into public procurement contracts over £4 million. The Procurement Reform (Scotland) Act 2014 establishes a national legislative framework for public procurement that supports Scotland's economic growth by delivering social and environmental benefits, supporting innovation and promoting public procurement processes and systems which are transparent, streamlined, standardised, proportionate, fair and business friendly. The Bank may also wish to consider how it can introduce community benefit clauses as loan covenants to high value investments aimed at reducing inequalities of outcome arising from socioeconomic disadvantage.

67. This could include encouraging organisations who receive large sums of money from the Bank to review their procurement practices to ensure that they incorporate more Scottish and locally-based companies into their supply chain where it is possible for them to do so. This also utilises Community Wealth Building principles adopted in Preston and mentioned in responses to the Committee's Call for Evidence on the Bill whereby the wealth generated by anchor institutions are retained within local communities.