Are global investors finally rising to the ESG challenge?

As one of the key parties called into question by the global sustainability debate, one could say the financial services industry has, historically, done a questionable job of distinguishing between good growth and bad growth.

by | August 20, 2021 | bobsguide

As one of the key parties called into question by the global sustainability debate, one could argue the financial services industry has, historically, done a questionable job of distinguishing between growth as such and sustainable growth. For example, since the 2015 Paris Accord on climate, 60 of the world’s largest commercial and investment banks have collectively put $3.8 trillion into fossil fuels.

Over the last couple of years the tide finally seemed to be turning as high-profile investment groups signalled a shift to a much more proactive ESG approach, in line with mounting pressure and increasingly dire warnings from – and towards – the global policymaking community.

Kickstarted by BlackRock’s announcement last year that the group would stop investing in companies that didn’t commit to environmental, social and governance (ESG) parameters, the ESG narrative has risen to fame among both the investment and the corporate management communities, boosting momentum in favour of portfolios that would not just extract revenue, but rather funnel investment into more sustainable future growth.

However, critics have highlighted that some relevant mismatches persist – between net-zero pledges and shorter-terms business plans that often involve continued growth in fossil fuels-based activities, on the corporate side, and between ESG commitment and actual voting behaviour, on the investment community side. Several data points may thus corroborate ongoing concerns that the re-positioning of the institutional investor community, as well as of the corporate universe it has been calling upon, remain more cosmetic than substantial.

An opposite, more encouraging signal came in late July from a group of 53 global investors managing over $14 trillions of assets, who called for the implementation of new governance measures that hold companies to account how they are delivering on their net-zero transition commitments. The intervention came via the Institutional Investors Group on Climate Change (IIGCC), which counts more than 300 members overseeing over $45trn of funds.

Companies’ public ESG positioning coming under closer scrutiny

Companies not seen to be doing the right thing are facing a shareholder backlash, showing how investors can ramp up the pressure.

Recent developments at Shell, for instance, well exemplify how global climate-change scrutiny is filtering through to increased shareholder activism: In May, the Anglo-Dutch energy giant faced a 30 percent investor vote to deliver more stringent and shorter-term targets to slash its carbon emissions – a level of endorsement that mandates the company to report back on the issue within six months.

Shortly after, the group was hit by a Dutch court ruling that requires it to speed up its Co2 reduction to 45 percent of 2019 levels by 2030 – in contrast with the firm’s 20% target.

The way energy companies react to these multiple points of pressure is also becoming more relevant per se. Shell’s chief executive Ben van Beurden may have stumbled upon a comms faux pas that could aggravate the credibility of the group’s net-zero strategy, when he played down the validity of the Dutch ruling and reinstated the company will stick with existing plans.

At the opposite side of the spectrum, last week BP’s CEO Bernard Looney showcased a much more fine-tuned approach to the sustainability discourse by publicly supporting the findings of the UN Intergovernmental Panel on Climate Change’s (IPCC) momentous report and committing to more thorough decarbonisation plans.

Institutional investors and large financial services companies are also looking to bolster their own ESG credentials. At the beginning of August, Moody’s announced its acquisition of RMS, a leading global provider of climate and natural disaster risk modelling and analytics in a deal worth $2bn, in a bid to boost its innovation capabilities and sustainable growth profile.

“ESG issues – and especially climate change – have moved into the mainstream,” Suni Harford, president of UBS Asset Management – one of the high-profile signatories of the IIGCC initiative – told bobsguide.

“We’re seeing rising scrutiny from investors, regulators, and wider society, who are demanding considered, meaningful action and transparent reporting from companies.”

Mark O’Sullivan, head of corporate reporting at PwC UK, added: “Investors are becoming increasingly vocal. The Financial Reporting Council (FRC) released its thematic review on climate change in November 2020 highlighting that ‘all parties’ need to do more.”

Translated into practical terms, “institutional clients are demanding ESG-related investment options,” said EY’s global sustainable finance leader, Gillian Lofts. Assets allocated to ESG strategies have grown rapidly and 75% of wealth clients are looking to integrate ESG parameters into their portfolios, she said.

“Investors also have a growing appetite for better information about the risks and ethics associated with their investment decisions.”

“Company disclosure of material sustainability risks and opportunities, and how these are being managed, is a critical input into our investment decision making,” added Stephanie Maier, global head of sustainable and impact investment at GAM Investments.

This, however, is the crux of the problem. While ESG reporting should rely on a shared minimum standard for all companies, at present there isn’t a single global reporting framework for it apart from the Task Force on Climate-related Financial Disclosures (TCFD) standards. Complicating things further, ESG criteria should cover a lot more than climate risk.

Mounting sustainability pressure clashing with rule and data fragmentation

More progress on developing international standards came in July last year with the ​​EU taxonomy, a science-based classification system that establishes a list of environmentally sustainable economic activities and that is well positioned to become the benchmark for global ESG guidelines. The taxonomy added to the bloc’s regulation on Sustainable Finance Disclosure Regulation (SFDR), which aims to provide greater transparency on the degree of sustainability of financial products.

“The EU taxonomy will be useful for drawing some objective lines between what can and can’t be called sustainable – a helpful step forward in a world filled with greenwashing and unverified claims,” said Pablo Berrutti, senior investment specialist for Stewart Investors, Sustainable Funds Group, and founder of sustainable finance resource centre Altiorem.

However, the ESG specialist warned that the taxonomy only represents a starting point – and quite a partial one that “will struggle to cover the many enabling and supporting products and services that make sustainable industries possible.”

“Nor will it address how companies deliver their products or their corporate quality,” he noted.

“So, while it is a useful marker, being a sustainable business requires continuous evolution and improvement behind products that genuinely help the world address some of the biggest challenges humanity has ever faced.”

EY’s Lofts also pointed out that, while asset managers are taking steps to comply with the regulatory and data requirements from both the SFDR and the taxonomy, at present “the data availability and quality for both these areas is still quite low,” which means they are often unable to “invest in those investee companies that fail to provide SFDR and taxonomy data – at least not within an ESG fund.”

On the positive side, Lofts said that, overall “the regulatory push for transparency against an evolving EU taxonomy increases the pressure on investee companies to report based on the degree of taxonomy alignment.”

“Over the short-term, there will be a benefit from more investee companies reporting on the required data, thus improving investor certainty and reducing any risk of greenwashing,”

Yet the scarce granularity and coverage of taxonomy data that can be sourced from companies remains a crucial hurdle.

“The lack of financial data – Capex/OpEx in particular – is a major stumbling block preventing more firms from demonstrating taxonomy alignment,” she said, “which means that so many investors are not yet able to manage their ESG investments based solely on this data.”

O’Sullivan agreed that the lack of clarity over what ESG includes remains an important stumbling block. “It’s clear [that] more needs to be done to meet investors’ desire to understand company disclosures.”

“Through PwC’s ongoing review of FTSE 350 annual reports in the 2020-21 reporting season, we identified that only 40% of companies with commitments provide detail on what they cover, articulate how they will be implemented, or explain how progress will be monitored and achieved.

“As a result, it’s not easy to determine either what the impact might be on the business model or its financial implications, and whether management is on track to deliver on the commitment,” he warned.

Fast-changing climate frameworks no excuse for lack of corporate commitment

What investors actually want to see depends on a number of factors and varies based on industry, location, supply chains and business model. Overall, “investors want to understand the types of risks and opportunities a company faces and how they are managing them,” said Berrutti.

However, he argued that “many investors focus purely on operational aspects in this regard,” while it’s be more beneficial to invest in companies “that are well positioned to contribute to and benefit from sustainable development, which is about the social and environmental impacts of a company’s products and services over their full life-cycle.”

Berrutti pointed out that, despite some persisting challenges, there is growing help at hand for companies to determine the type of disclosure investors are demanding – so reporting should be about more than ticking a box.

“While frameworks like the Global Reporting Initiative (GRI) provide a comprehensive set of metrics, and the Sustainability Accounting Standards Board (SASB) can help companies narrow down the materiality of different issues by industry, understanding what these issues mean for individual companies is something only their management can do,” he argued.

“The Integrated Reporting Framework provides a really helpful guide for how to think through these issues, and when combined with GRI and SASB, most companies will have the tools they need to report relevant and useful information.”

“There is an increasing number of issue-specific demands placed on companies, for example for climate change or modern slavery, and it is important these issues are properly integrated into a company’s strategy, operations and reporting, rather be treated as add-ons.”

“Having inconsistent add-on disclosures like this will carry a lot of reputational risks for companies who don’t follow through on their commitments,” he warned.

GAM’s Maier added that processes and services that boost transparency on the nature of a company’s investment strategy and underlying holdings keep evolving and growing.

“We are starting by providing our clients with standard ESG scores and score breakdowns, as well as the carbon intensity relative to the benchmark for key funds.”

“We expect this to evolve as data, methodologies and ‘literacy’ in understanding these metrics develop,” she said.

Lofts agreed that the “application of data and analytics is fundamental to the successful integration of ESG, and in-house research and screening techniques will need to evolve rapidly over the next few years.”

She saw the emergence of the Blockchain Proof of Concept (PoC) use cases to help financial institutions “both with increasing the trackability of the supply chains of their investee companies and […] of ESG factors assigned to an investee company either internally or via a third-party provider.”

Overall, the ESG experts seemed to back a view that the EU taxonomy and financial disclosures requirements lay the ground for increased transparency, traceability and assurance of companies’ net-zero transition and ESG – but signalled that, at the present stage, the rules still require significant interpretation.

Besides, the fact that the current regulatory framework is a work in progress may be seen as proportionate to the fast-changing knowledge and data around the causes, trajectory and ramifications of the climate crisis – which will require both investors and investees to step up their game accordingly and accommodate for evolving targets.

Additional reporting by Anna Brunetti

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