ESG+ Newsletter – 01 February 2024

This week’s newsletter opens with remuneration, looking at the Investment Association plans to review its principles of remuneration and reports of a potential plateau in the use of ESG metrics in executive compensation. The newsletter also reviews the flow of funds into SFDR in 2023 with a read through for sentiment around ESG investing; looks at the rise of climate litigation; the debate around ESG and value; and renewed efforts to tackle greenwashing. 

The IA reveals plans for a “fundamental review” of its principles of remuneration”

The Investment Association (IA) announced that it is planning a “fundamental review” of its principles of remuneration, in line with evolving member expectations. According to Sky News, the draft of this year’s letter to FTSE 350 remuneration committee chairs, acknowledges the challenges faced by UK firms in attracting US executives and competing in the US market, in light of the differences in pay opportunities between both countries. In response to these concerns, the draft letter reveals that considerations for hybrid incentive schemes will be part of this year’s guidance, in line with feedback received from shareholders and issuers. Moreover, the IA also airs concerns that measures such as malus and clawback, a topic of significant focus in the 2024 revisions of the UK Code and typically viewed as a tool to improve the long-term alignment between executives and shareholders, may have a “disproportionate” impact on the value of “remuneration received“. 

The revamped approach proposed in this year’s letter seems to mark a departure from the IA’s traditional approach which has sought to “hold boardroom pay chiefs to account over perceptions of excess in boardroom pay practices”. Historically, the IA’s principles have set the foundation for proxy advisor and institutional investors’ voting guidelines on remuneration-related matters and effectively influenced company practices across a number of material issues such as executive pension contributions, windfall gains and the pay practices for lowest-paid employees. This shift in approach, that shies away from “dictating market practice” may also prove controversial amidst ongoing concerns about living costs and opposition to multimillion-pound corporate pay packages.

ESG metrics for compensation “may have plateaued”

A new WTW study showed an increase of 14 percentage points in the use of at least one ESG metric when creating executive incentive plans since 2020. Additionally, a Glass Lewis report found that from “2019 to 2023, the percentage of US companies incorporating E&S considerations in executive incentives surged from 16% to 38.7%. Among S&P 500 companies, 68% integrated E&S metrics in 2023, compared to 39% in 2020”.  This trend may be surprising considering the political pushback ESG has seen recently. Ken Kuk, WTW’s Work and Rewards Senior Director suggests this practice has likely plateaued, saying “it’s hard to make sweeping comments about this, as every organization is likely making their own calculation as to how they would react to these market sentiments… [but] for companies that already have ESG metrics in place — and some have put them in not too long ago — removing them presents bad optics.” In the current market environment, companies must consider the potential political pressures against publicizing ESG achievements versus implementing ESG-based CEO metrics.

Unpicking the state of play of ESG investing

Morningstar has published its quarterly SFDR ESG fund flow research for Q423, with a number of interesting takeaways which give insight into the current and future state of play in Europe. While the headline  is undoubtedly the record outflows by both Article 8 and Article 9 funds, and the latter group experiencing them for the first time, total Article 8 and Article 9 combined AUM rose to a new high of €5.2 trillion. This represents 60% of the EU market. Additionally, Morningstar identified 256 funds that altered SFDR status in the fourth quarter, with the vast majority being those that upgraded to Article 8 from Article 6.

The conclusions demonstrate the growing complexity surrounding ESG. Asset managers in the EU, as per the status upgrade trend and 10% uptick this quarter in new product launches, continue to back ESG-aligned investment strategies – influenced by the noted growth in AUM and the preferences of asset owners to support the investment class. This is evidenced anecdotally by news this week from a Morgan Stanley study, “Sustainable Signals”, which concluded that a large majority of investors believe in a strong correlation between ESG practices and better long-term returns. 54% of those surveyed said they expected to “increase the percentage of their portfolios allocated to sustainable investments with the next 12 months”.

The outflow data is therefore a bit of red herring if you are looking to understand market sentiment. Ultimately, it is a result of the continuing struggles that equity markets are facing, with investors increasingly favouring bonds, and specifically government bonds, due to challenging macroeconomic conditions. This is a corner of the market which has seen difficult ESG integration to date. The noise around the sector has no doubt been an influence too, plus underweight energy stocks and overweight technology which have stunted growth, but investors in Europe still view ESG as additive to long-term growth.

Climate litigation on the rise

While investors have so far mainly faced indirect climate litigation risks from their investments, an article from ESG Investor says they are likely to face increasing direct litigation moving forward. Direct risks include lawsuits alleging mismanagement of climate risk, breaches of fiduciary duty, greenwashing, or financing environmental and human rights harms. Strategic litigation by NGOs could also pressure investors to divest from polluting companies. Though risks remain largely indirect currently, institutional investors are not immune to direct legal actions similar to those faced by financial institutions have faced. Scrutiny and threats to investors are rising. Climate lawsuits have more than doubled in five years to nearly 2,500 globally, increasingly targeting corporations and financial institutions. Recent examples include various banks being sued over financing fossil fuels or over alleged breaches of duty of care in financing major emitters, airlines have faced greenwashing allegations, while major oil companies have been forced to cut emissions by the end of the decade.

Investors still underestimate indirect risks of climate lawsuits negatively impacting share prices of investee companies. Cases forcing companies to recognize stranded assets, accelerate net zero plans, or pay environmental damages could cause industry shocks and investor losses. ESG litigation is expanding quickly and investors face rising direct and indirect threats. Climate lawsuits could force impacted companies into emissions cuts and settlements, with financial and reputational consequences for responsible investors.

ESG, DEI – delivering value beyond acronyms   

A recent Bloomberg Opinion article has looked at ESG in the context of rising business costs, with the author calling it a “luxury good” whose value is not apparent. According to the author, this lack of value to a company’s bottom line and costs of DEI policies is part of the reason why ESG has fallen down the priority list for both business leaders and investors. The article also points to the lack of convincing evidence that companies with higher ESG ratings outperform those which not and the little evidence that shows that DEI policies improves long-term share price performance either. This article follows on from widespread concern that ESG’s reputation has become too politicized and become mired in ‘culture wars’, leading some to think it needs to evolve. Alex Edmans, a former Morgan Stanley banker who now teaches at London Business School, recently published a paper detailing his belief that the original acronym has lost its purpose and instead advocates for the use of the term “rational sustainability”, which focuses on creating long-term value by considering all factors, regardless of whether they fall under the ESG label. This, he believes, would guard against “irrational sustainability bubbles”, forcing the focus onto evidence and analysis of which companies are truly sustainable, discounting ESG factors that aren’t material.

Debate around ESG’s purpose across the corporate landscape and around the acronym itself, will likely continue. However, its role in investment decision-making and incorporation into financial risk assessment from an investor perspective is embedded; therefore, there will remain a requirement for companies for ESG disclosures. Speculation on its contribution towards company value, ESG’s image, and the future of the term, will likely just remain that, speculation.

Accounting standards body proposes new ethics code to tackle greenwashing  

The International Ethics Standards Board for Accountants (IESBA) this week revealed new draft standards that set out best practice for verifying sustainability claims in financial reporting. These new standards come ahead of regulations such as the EU’s CSRD rules, the SEC’s forthcoming climate disclosure rules, and the recently launched IFRS climate and sustainability reporting standards by the International Sustainability Standards Board (ISSB), that will bring about mandatory sustainability disclosures in many jurisdictions. The code sets out two standards, the first setting out a framework “of expected behaviours and ethics provisions” for assurance practitioners and accountants who are engaged in sustainability reporting. The second standard provides guidance for auditors by setting out detailed instructions for the effective auditing of sustainability claims, such as the calculation of greenhouse gas emissions, relying on outside experts, and identifying and tackling conflicts of interest. The first standard is out for consultation until 10 May, with the second ending on 30 April. The aim of the new standards is to improve the quality of sustainability disclosures and increase confidence in the public reporting for firms by mitigating the incidence of greenwashing which risks undermining the trust of both investors and consumers.

ICYMI

• A recent Responsible Investor net zero survey has revealed that less than 50% of investors availed of external expertise before making a net-zero commitment. The outcome of the survey comes at a time when companies face a litany of challenges and obstacles on the road to net zero progress. 
• The US Department of Energy announced investments of over $250 million. The US Department of Energy investments include $171 million for 49 selected projects to reduce industrial greenhouse gas emissions, and the opening of applications for $83 million of funding targeting hard-to-decarbonize sectors, such as chemicals, steel, food, and buildings. 
• World Bank and Citi launch $100 million plastic credits bond. The joint $100 million bond is aimed at combatting waste, with repayments partly determined by the sale of plastic and carbon offset credits. The bond will fund plastics collection and recycling projects in Ghana and Indonesia and highlight the growth of exotic debt structures for environmental causes.