ESG: The real consequences of playing on words

February 15, 2021 | Nicole Anderson

‘No matter what anyone tells you, words and ideas can change the world’ – Lawrence G Lovasik

Like me, I am sure you feel a combination of growing weariness and a good dose of frustration when delving into the world of sustainability themed financial literature. The terminology, taxonomies and narrative used to describe the greening of finance are confusing even for seasoned veterans.

I find some level of comfort from years of working in innovation.

There is so much similarity in how concepts are refined in a typical innovation cycle and how we can look at the intersectional world of ESG. 

While climate change has been a debated topic since the start of the UN’s Framework Convention on Climate Change – March 2014, The Kyoto Agreement 2005 and Paris Agreement of 2015, the financial community is in its infancy in deciphering ‘green’. It’s in the typical Horizon 3 scenario seen in the diagram below:

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In this phase, aggregating information and oscillating opinion are needed. These frequent pivots allow for the refinement of ideas that land and can be converted into a product or service.

Horizon 3 is a very special place. It normally allows time for an idea to ‘settle’ and risk to be eliminated. Then a refined concept will be pulled into Horizon 2.  

The difference now is that ESG has gone ‘mainstream’.

ESG is transversal in its importance from micro to macro economies, from public to private companies, across industry verticals and is a very complex concept to refine, then apply universally.

For the first time ever, we are drawing on specialities that are rarely accustomed to intersecting, let alone conforming to new rules and ‘standards’. 

Stakeholders from finance, science and policy are colliding in a scattergun attempt to make sense of the work required to educate, transform and reverse much of the damage caused to precious natural and human capital in the pursuit of economic progress.

And this is forcing timescales, accelerating a shift from the analogy above from emerging to maturity – or said in another way – from experimentation to business as usual.

When change is forced – less is more 

We would all be better served by greater uniformity and harmonisation but instead are restricted by more ESG bodies and associations than ever. This dilutes and confuses interpretations and issues.

The roles of global forums in spreading the word of greening finance are invaluable and necessary. The G20 is an international forum for finance ministers and central bank governors from 20 major economies to collaborate to drive green finance. Below are just some of the other active players in ESG, each with different membership participation and drivers:

This makes active participation and adherence by the finance industry costly and resource intensive.

Added to this, ESG scoring continues to evolve organically with private market data companies delivering insights and analysis to finance and other industries. However, there continue to be data-gaps, benchmarking differences or simply differing interpretations.

Already the lack of a clear definition introduces several issues including the potential for greenwashing, confusion for over which funds are ESG compliant, and inconsistency about which funds should be included under the acronym.

Harmonisation and standards – the sooner the better 

There are some solid moves to tackle this lack of consistency of ESG terminology in industry:

  • The global umbrella body for securities regulators is seeking to harmonise the patchwork of rules governing how companies disclose sustainability risks. This move could be a game-changer for the fast-growing green finance sector. The International Organization of Securities Commissions said it would work to identify “commonalities” among the vast range of sustainability disclosure standards from across the world in order to make it easier to compare information. This has given rise to a wide range of initiatives aimed at defining disclosure standards, such as the Task Force on Climate-related Financial Disclosures (TCDF). 
  • The EU Green Deal will give rise to a regulatory storm that will stretch way beyond Europe’s borders. This is based on the new EU Taxonomy (EUT), a central tool for the actual implementation of the EU Green Deal, specifically in financing Europe’s sustainable growth. 

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  • By 1st January 2022 financial market participants will be required to complete disclosures following the EUT, covering activities that substantially contribute to climate change mitigation and/or adaptation. The analysis covers the reporting year 2021.
  • By 31st December 2021 technical screening criteria for the remaining environmental objectives of EUT will be issued, as developed by the EU Platform on Sustainable Finance.
  • As of 2022, companies will be required to disclose the percentage of their turnover, investment and expenditures that are taxonomy-aligned for two objectives: climate mitigation and adaptation. The analysis covers the reporting year 2021.

However, while these moves represent a significant step forward in the correct direction of travel, they are some way to be aligned, understood and plans for adoption set in place.

What to do while we wait for the dust to settle:

The market is ahead of regulation for the most part. Global fund managers in particular are being forced to act ahead of regulatory harmonisation. 

The common ways ESG is interpreted into investment processes are as follows:

  • Stewardship – engaging with companies as a shareholder and using voting rights and direct negotiation to effect change.
  • Integration of ESG factors into the investment decision-making process.
  • Themed investing e.g. sustainable investment in cleantech or waste management.
  • Impact investing with the aim of achieving a specific measurable positive impact on the environment or society.
  • Exclusionary screening for activities not aligned with investors’ values – e.g. weapons manufacture animal testing, pollution.
  • Sometimes ESG is associated with active rather than passive funds. However, customers whose pension assets are in passive default funds also benefit from stewardship on ESG issues. Stewardship is a powerful way to hold corporates to account and protect long-term investments.

Getting primed for ESG as a standard:

ESG is ultimately driving the evolution of historic performance and self-reporting world of disclosure to that of real world, real time independent reporting. 

Innovation in data solutions are growing in order to address the challenge in many areas such as artificial intelligence, spatial technology, blockchain and IOT. Terminology issues also reflect a shortage of climate expertise across the top echelons of business. In the last US Congress, less than 10% of elected officials had scientific qualifications. In Britain, which will host the crucial COP26 climate conference in November, only 16% of MPs have backgrounds in science.

So while policy and regulatory standards are a major driver for harmonisation, so is the very urgent need for science and technology understanding in classic commercial activity. Add to that the urgency for adaption and adoption and you have a perfect storm of innovative minds using technology to shape new business models far and wide.

The consequences for interpretations are very real – climate change has been a central theme in BlackRock CEO Larry Fink’s annual letter to corporate leaders

His latest letter calls for companies to develop climate-friendly business plans supported by data revealing their emissions. He writes:

“There is no company whose business model won’t be profoundly affected by the transition to a net zero economy—one that emits no more carbon dioxide than it removes from the atmosphere by 2050.”

However, further on in his message, Fink states that his ultimate goal for companies is for them to become consistent with “a global aspiration of net-zero greenhouse gas emissions by 2050.”

This replacing of carbon dioxide with greenhouse gas emissions is a small error but one which can be confusing. Carbon dioxide only accounts for some of the emissions contributing to global warming. So this leads to a lack of clarity for corporates or CEOs reading. 

This interpretation neatly encapsulates the great challenge for the investment community. The devil is in the detail and, with all the good will behind BlackRock’s messaging, this needs to be on point with science and investment working in tandem. If they don’t, then the impact on our ambitions around sustainability will be hampered. If a powerful force for good like Larry Fink can misinterpret this, you can be guaranteed that where he goes, others will follow. 

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