ESG+ Newsletter – 25th November 2021

Credit rating agencies vs ESG rating agencies – objective vs subjective?

Tracy Alloway, Executive Editor at Bloomberg, wrote a recent article about issues relating to ESG investing through the prism of an Ohio bank. The interesting article touched on many ESG topics; however, one interesting aspect of the article was the differences between credit and ESG ratings. The author argues that ESG rating agencies are out of sync, citing recent research from JP Morgan which revealed that they vary substantially when compared to credit ratings – with S&P and Moody’s agreeing with each other more than 75% of the time when evaluating a company’s creditworthiness, while only about 17% of ESG ratings from MSCI and S&P match up in the same way. Credit ratings, which are primarily based on financial disclosures, are largely objective, while it can be argued that some aspects of ESG ratings are subjective. However, the variance in rating scores does highlight potential flaws in both rating agencies’ approaches – too much groupthink in one, too much inconsistency in the other.

This lack of consistency, particularly on data, from rating agencies, would appear to be the growing focus of market regulators. Earlier this week, the International Organization of Securities Commissions (IOSCO) – which is a group of securities watchdogs from Americas, EMEA and APAC – published a global framework on ESG ratings, and one of the recommendations was for ESG rating agencies and data providers to consider including written procedures that underpin their ratings and to make them public. While ESG rating agencies have only gained prominence over the last 10 years as ESG investing has grown, as ESG investing continues to grow so too will the level of oversight and regulation that is applied to its data providers.

Calls for collaboration to reconcile global sustainability standards initiatives

During COP26, the IFRS Foundation announced the establishment of an International Sustainability Standards Board (ISSB). The ISSB will merge the Sustainability Accounting Standards Board (SASB) and the Climate Disclosure Standards Board (CDSB) to create a consistent international standard for sustainability reporting. There have long been calls to standardise sustainability reporting; however, a key sustainability standard-setter appears to have been left out of consultations. Despite 20 years’ experience developing sustainability standards, the Global Reporting Initiative (GRI) has not been included in the ISSB and instead is part of the Global Sustainability Standards Board (GSSB). The efforts to create a single sustainability standard to improve disclosure are being undermined by the creation of two separate groups with the same goal – the ISSB and GSSB. Carol Adams, Professor of Accounting at Durham University Business School writes that “Collaborating with GRI and seeking to support those standards also being mandatory would give the IFRS Foundation’s financial-related sustainability disclosure requirements credibility and context.  And it would give governments and other stakeholders more confidence that companies were being held accountable for their impacts.” With GRI set to have a major impact on the impending standards from the EU, perhaps there is a longer road toward consistency than those who saw the COP26 announcement as a watershed.

The clock is ticking for the refurbishment of ‘brown buildings’

A recent SustainUK article outlined the central role that the real estate sector will play in the carbon transition, particularly as pressure from lenders, tenants and regulators grow. As banks are increasingly factoring in net zero environmental and sustainability considerations in their portfolios, it is becoming urgent for leaders in the real estate sector to start taking action, to ensure access to capital for the refurbishment of the so-called ‘brown buildings’, which are buildings viewed as having poor energy efficiency and deemed not as environmentally friendly as newer buildings. The path to doing so may be somewhat confusing with increased pressure and overload of information, certifications, and benchmarking in the industry. A 2018 study by Princeton University concluded that “if people feel guilty, they are in fact less likely to make an effort to take steps to improve climate change”. With the difficulties in benchmarking and the increasing reliance on ‘green’ certifications, there is a need for a more standard measurement and disclosure of whole-life cycle carbon assessments of every building. These seek to inform and encourage more carbon and cost-efficient construction, renovation and operations and align to the interests of real estate owners, financiers, developers and consumers.

UK executive pay and the stakeholder view

The Investment Association (IA), a leading industry group for asset managers, has urged companies that received financial support from the UK government to limit executive pay and bonuses this year. COVID-19 has resulted in many employees being furloughed, asked to take pay cuts or even large-scale redundancies. As the instability remains, the IA has re-emphasised the role of remuneration committees to balance the need to continue to incentivise executive performance, whilst keeping in mind the wider stakeholder experience – including shareholders and the wider workforce – re-emphasising the guidance issued in April and November last year. There is an expectation among investors and proxy advisors that executives should not receive bonuses – regardless of their effort and impact during COVID-19 – where employees have been detrimentally affected by the pandemic and where the business has benefitted from Government support or drawn additional capital from shareholders. As companies are increasingly incorporating ESG risks and opportunities into their long-term strategy, the IA calls for these to also be factored in their executives’ variable remuneration. Given the increased scrutiny on executive pay practices, FTSE companies are expected to select metrics that are quantifiable and linked to company strategy.

Eurozone banks need to do more to tackle climate change

A report from the European Central Bank (ECB) has called on banks to “urgently” improve plans and set ambitious strategies to protect their businesses from climate change risk. The report revealed widespread shortcomings in banks’ approach to climate change as it found no bank under its watch was close to meeting the expectations required. Banks could eventually face higher capital demands as it integrates climate risk assessments with their regular work. The report reveals the biggest risk to banks comes from the exposure to energy companies that do not plan to pivot to sustainable activities, as well as exposure to high emitting sectors such as aviation.  Another shortcoming is around the lack of stress testing of various climate change scenarios and how they will impact the banks. Despite this, the report did say two-thirds of banks had made “meaningful progress” in factoring climate risks into lending decisions. Pressure will continue to mount for lenders to start doing more in the face of the climate crisis.

New U.S. Rule Orders Banks to Flag Cybersecurity Incidents

Climate change is not the only risk that banks need to address. This week U.S. banking regulators finalized a rule that directs banks to report any major cybersecurity incidents to the government within 36 hours of its discovery. In particular, the rule mandates that banks must notify their primary regulator of a significant computer security breach as soon as possible, but no later than 36 hours after discovery, and also requires that banks notify customers as soon as possible of a cybersecurity incident if it results in problems lasting more than four hours. The requirement applies to any cybersecurity incidents expected to materially impact a bank’s ability to provide services. It was approved by the Federal Reserve, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency. In tandem, the banking industry said it completed a cybersecurity drill that aims to ensure big banks are prepared to respond in the event of a ransomware attack. The two developments represent the growing threat that cybersecurity incidents pose to financial stability and are likely to face increasing scrutiny as part of the ‘G’ in ‘ESG’ to ensure robust corporate governance.

Big Tech offer a solution to disconnecting from work

As reported in a previous edition of this newsletter, Portugal recently introduced legislation banning employers from contacting staff out of hours. However, a notable absence from the legislation was a full “right to disconnect” that would allow staff to turn off their devices outside of work. Despite an EU directive on right to disconnect, most countries have been slow to regulate it, and Bloomberg is suggesting that the very technology that fuelled ‘always-on’ culture may in fact offer a practical solution to switching off. Big names in tech such as Microsoft and Apple have implemented ‘disconnecting’ features that allow employees to switch off with a simple click. Microsoft’s ‘Quiet Time’ feature in Teams and Outlook allows users to block notifications on certain days or times. Apple has a similar ‘Personal’ feature on its iPhone that can block work-related notifications. It can also go one step further and hide the stress-inducing red notifications on the phone, mail, and messages icon. As work-life balance continues to be in focus following the rise of remote working, technology may offer a simple solution. However, businesses should be wary of seeing this technology as a panacea but rather as an enabler of a work culture that supports employee well-being, a key tenet of the ‘S’ in ESG.

FTI’s ESG insights

Following on from COP26, FTI has published several thought leadership pieces detailing insights on ESG. In ‘The Mainstreaming of ESG Investing Through Policymaking’, we look at why staying on top of international trends and the Government’s legislative agenda will be imperative for investors moving forward particularly as ESG and sustainable financing continue its exceptional growth across the capital market landscape. Upon the conclusion of COP26, ‘How insurers can ride the wave of change’ assess the opportunity ahead for insurers as the world starts to take meaningful steps towards achieving its objective of limiting global warming to 1.5°C and net-zero emissions.

In Case You Missed It

• This week, HSBC announced the launch of new indexes that screens firms for biodiversity risk. Developed by HSBC Holdings, Euronext NV and Iceberg Data Lab SAS, the Euronext ESG Biodiversity Screened Index series will exclude companies found to pose a threat to nature and aims to offer investors an opportunity to screen for biodiversity risks.
• Bank of England will only buy bonds that meet its ESG standards, Bloomberg reported. For the first time, the London-based central bank will enforce its green criteria in corporate bond purchases in a way to encourage and guide investors to “green their portfolios”. BOE will also start scorecards that grade bonds by their issuers’ levels of emissions intensity, among other metrics.
• To help combat ‘greenwashing’, market regulators set out a global framework to police ESG investment ratings, Reuters reported. As the International Organization of Securities Commissions (IOSCO), and its members Britain and the EU, have expressed concerns over the lack of rules for ESG raters, IOSCO launched new data and disclosures recommendations to begin shining a light on how ratings are compiled.

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