ESG+ Newsletter – 25 April 2024

Scrutiny is the opening theme of this week’s ESG+, as the newsletter opens by looking at the role and influence of proxy advisors this AGM season, and the ongoing trials and tribulations at SBTi. The UK’s ESG regulatory efforts are up next, with a review of the FCA’s extension of the scope of its anti-greenwashing Sustainable Disclosure Framework, and efforts by UK Government to support the alignment of the defence sector with ESG investing. Also covered are the implications of a rapidly warming planet on the banking and insurance industries; calls to make nature transition plans mandatory; and the demand for regulating the environmental footprint of AI technologies. But first we begin with our monthly ESG regulatory update.

ESG Regulatory Update

As ESG regulations continue to rapidly develop, FTI Consulting is providing a summary of the need-to-know updates from around the globe. This month we cover ecological taxes in Mexico and the upcoming anti-greenwashing implementation in the UK: FTI ESG Regulations Global Update.

The role of proxy advisors remains under scrutiny 

As proxy season gets into full swing, the annual scrutiny of the role of proxy advisors and their influence over investors has come into focus once again. A recent FT article has reviewed the role that proxy advisors play in the wider corporate landscape, arguing that their recommendations merely represent one input to final decision-making. However, proxy advisors are increasingly facing scrutiny for their influence on investors’ ESG voting considerations, particularly amid the continuing polarisation around ESG investing. As covered in previous editions of this newsletter, proxy advisors faced backlash from anti-ESG campaigners for targeting investment managers for actions and pronouncements on ESG. However, the reality is that, as with traditional governance matters, investors ultimately decide. A recent Financial Reporting Council (‘FRC’) study found that while proxy advisors’ voting recommendations “undoubtedly have some influence on behaviour and voting decisions”, the “nature and extent of the influence may be more nuanced and less clearcut”.

While scrutiny regarding the role and influence of proxy advisors has been ongoing for years, executive remuneration remains the primary focal point of contention between proxy advisors and companies – particularly in the UK in the context of the transatlantic pay disparities. It is already evident that proxy advisors are pushing back against companies who are implementing award structures with significant increases and changes in structures.  

SBTi controversy continues

As reported in a previous edition of this newsletter, the Science Based Targets initiative (SBTi) has been having a pretty tough time of late. A controversial Board decision to allow companies to use carbon offsets to meet climate pledges led to a staff revolt. Now it has emerged that former US Climate Envoy, John Kerry, lobbied the SBTi for more than two years to reverse its opposition to the use of carbon credits, according to the FT. According to the article, US officials wanted the SBTi to take a leading position in supporting carbon credits to channel funds to clean energy schemes in developing countries. The controversy at the SBTi has sparked opinion pieces on both sides, with some saying that these events signal that it’s time for the SBTi to step aside, and others arguing that the SBTi’s proposed position on carbon offsets is a bold step that will help accelerate corporate climate action. SBTi CEO, Luiz Amaral, issued a blog post last week to clarify the situation, asserting that while the conversation is difficult, the SBTi “will not shy away from debate”. While positions are strong on both sides of the argument, perhaps the most difficult conversations are the most important.   

FCA extends scope of Sustainability Disclosure Requirements to portfolio managers  

The UK Financial Conduct Authority (FCA) is extending the scope of its proposed Sustainability Disclosure Requirements (SDR) to portfolio managers to include firms that manage a group of investments for consumers through products and services. Initially targeted at asset managers, the anti-greenwashing equivalent of the EU’s SFDR will now deliver outcomes for a broader base of investors, including high-wealth individuals and retail market participants. As reported by Responsible Investor, the FCA has “carried over the 70% threshold” from the overarching SDR rules which require managers to invest 70% of a portfolio’s gross value in line with a chosen sustainability objective. However, portfolio managers are permitted to allocate capital to funds both with or without an SDR label, providing the investments have adhered to “a robust, evidence-based standard that is an absolute measure of environmental and/or social sustainability”.

In its press release, the FCA’s Director of ESG, Sacha Sadan, was explicit in the UK’s aim to maintain its position at “the forefront of sustainable investing”. Amid the continued discourse around sustainable investment principles, this is notable – not least given London’s status as one of the global leaders in financial services. The SDR label range may have been informed by the movement to positive engagement rather than divestment, and uneven broad equity performance which has left investors reticent to forego strong Oil & Gas momentum ever since the beginning of the Ukraine crisis. In creating a manageable 70% baseline for investments, with a sustainable improvers bucket, the SDR is primed to attract significant inflows from asset owners that are looking for more flexibility than is currently allowed under the SFDR in Europe. The UK’s fund regime allows asset managers to apply labels from 31 July, with the date for portfolio managers being 2 December.  

UK embraces defence sector for ESG investing 

In a further shift of the UK’s ESG landscape, the UK’s HM Treasury and the Investment Association (IA) issued a joint statement which outlined their collective approach to investing in defence companies – viewing these stocks being compatible with ESG investing principles. The statement cited the fact that defence companies protect the UK’s national security, defending civil liberties, while also delivering long-term returns for investors. Importantly, the statement also asserts that both the UK’s HM Treasury and the Investment Association view “good, high-quality, well-run defence companies” as being compatible with ESG as “long-term sustainable investment is about helping all sectors and all companies in the economy succeed”. This statement followed on from UK Prime Minister, Rishi Sunak, promising £10 billion in defence spending and stating that they were “going to put beyond doubt that defence investment does count towards ESG assessments”.

The joint statement and comments by Prime Minister Sunak would appear to be a co-ordinated effort to bolster support for the UK defence industry and comes at a time of heightened geopolitical tensions across the world. This new investment approach to defence sector and ESG comes at a time when UK defence companies have been shunned by investors due to lack of alignment with ESG and, in the EU, where they are debating whether the European Investment Bank can support defence funding without impacting its ESG rating. The UK’s decision is a departure from conventional thinking on ESG investing and defence stocks and, as The Times highlights, it does put the IA on a collision course with a number of the asset managers it represents – like Church of England and National Employment Savings Trust – who have restrictions and ethical options regarding arms investment.  

Dealing with the physical risks of climate: A rising priority for the banking and insurance industries

As reported by Bloomberg, the banking industry is getting increasingly aware of the financial implications of a rapidly-warming planet.  While until recently banks were mainly focused on transition risks including potential losses stemming from the transition to a low-carbon economy, mounting temperatures and the increased frequency of natural catastrophes has forced them to pay more attention to the physical risks of climate change, such as the potential losses linked to extreme weather events and long-term changes in temperatures. Andrew Karp, Global Head of Sustainable Banking Solutions at Bank of America, highlighted that “there’s a growing worry about rising costs and, in some cases, a reduced availability of insurance and what that says about how climate risk will manifest into financial markets.” Petra Hielkema, the Head of EU’s insurance regulator, EIOPA, shared similar concerns about the cost and availability of insurance in an interview with the FT. She argued that urgent action is needed and proposed different solutions including stricter building rules, risk-sharing mechanisms, and a stronger involvement of reinsurance actors. While various forces are already at play, these developments may reinforce companies’ incentives to understand their exposure to the physical risks of climate change and develop robust risk mitigation strategies, as this could potentially result in better borrowing and insurance conditions. 

Governments urged to make nature transition plans mandatory 

Finance for Biodiversity, a pledge of 170 financial institution signatories, is urging governments to make nature transition plans and disclosures mandatory for the financial sector to meet the goals of the Global Biodiversity Framework (GBF). The GBF was signed at COP15 in 2022 and includes targets to restore 30% of degraded ecosystems and conserve 20% of land, water, and seas. The disclosures it requires include impacts, dependencies, risks, and opportunities, and aims to improve access to more standardised and open-source nature data. Moreover, Finance for Biodiversity argues that central banks, regulators, and financial supervisors are necessary to drive commitments from the private sector. The group also called for other government capabilities to be harnessed, including reorientating tax policies and subsidies to help incentivise biodiversity protection. In addition, the International Sustainability Standards Board (ISSB) is launching a research program on biodiversity disclosures, covering what information investors need surrounding biodiversity risks and opportunities, and if more specific disclosures are necessary. The ISSB two-year work plan for this initiative will be published in June 2024. 

Salesforce pushes for environmental accountability for AI use

The Wall Street Journal recently reported on Salesforce’s call for regulation regarding the environmental footprint of AI technologies. Recognising the significant energy consumption and lack of emissions transparency within the technology industry, Salesforce advocates for legislation mandating standardised metrics to assess and disclose AI’s environmental impact. However, Salesforce does acknowledge AI’s dual potential – it can either “exacerbate or alleviate environmental challenges”. If companies using general-purpose AI models disclose their energy efficiency and carbon footprint throughout development and usage, it could lead to greater efficiencies and empower users to make more informed decisions. For instance, every 10 to 50 prompts processed by ChatGPT requires half a litre of water to cool the system, according to research from the University of California. Salesforce’s stance underscores a notable shift in the technology industry’s approach, as environmental considerations gain prominence. US lawmakers introduced the Artificial Intelligence Environmental Impacts Act of 2024 in February. The proposed legislation aims to establish standards for measuring AI’s environmental effects and offers a voluntary framework for developers to report such impacts. Therefore, it is likely we will continue to see an increasing focus on AI and the environment, with data centres and the demand for renewable energy only growing.

ICYMI 

• Eleven wealthy nations, including the US, Japan, France, Germany, and the UK, have collectively pledged $11 billion to support World Bank initiatives addressing global challenges such as climate change and pandemics. This announcement comes as the World Bank is under increasing pressure to provide substantial financial resources, estimated at $2.4 trillion annually, to help developing countries transition to green energy.
• Japan is planning to significantly slash in emissions as part of its review of the nation’s energy strategy. Japan is considering cutting its emissions by 66% by fiscal year 2035, compared to 2013 levels as part of its new climate target submission to the United Nations, under the Paris Agreement, next year.
• Governor of Banque de France, Francois Villeroy de Galhau, advocates for the development of “green securitisations“ in Europe to fund the energy transition. According to Environmental Finance, the head of the French central bank states that this market could receive substantial support at the EU level through initiatives such as a common European issuance platform or through the provision of public incentives such as a European guarantee.