ESG+ Newsletter – 7th April 2022

Damning climate report marks change in narrative

The IPCC released the third instalment of their Sixth Assessment Report which outlines the critical need to deliver drastic emissions reductions this century. The report states that opportunities to limit warming to 1.5°C as agreed in the Paris agreement are rapidly fading. The report also gives hope, however, citing examples of climate change mitigation across the world and the possibility of halving emissions by 2030 across all industries. Bloomberg covered five key takeaways from the report, including how the report took social sciences into account for the first time to highlight the possible impact created through collective individual actions such as limiting flying and minimising energy use. The scale of the impact of collective action could have implications for businesses that may need to fundamentally adapt their business models to appeal to consumers’ eco-friendly preferences.

One of the most notable differences between this and previous IPCC reports was the change in tone from UN Secretary-General António Guterres. Introducing the report, he used some of his most damning languages yet, describing the report as a “litany of broken climate promises”, concluding that “it is a file of shame. Cataloguing the empty pledges that put us firmly on track towards an unliveable world”. Guterres used his introduction to the report to call on political and business leaders to do more to prevent a climate catastrophe. As the tone of global institutions changes towards climate action, perhaps we will see a sense of renewed urgency from world leaders to reignite hopes of limiting global warming to 1.5°C.

Climate to take the stage at the AGMs of North American banks and pharmaceutical companies

This AGM season will provide important insights into how companies have been progressing their climate strategies and disclosures, particularly following the regulatory updates that have been implemented since the beginning of this year. The number of climate related proposals last year increased by approximately 3.8% across the US and Europe, with 2021 marking “a record year for investor action, with 50% more ESG proposals receiving majority approval than in 2020”. Interestingly, this focus has been transposed into the proxy voting guideline updates of some of the largest institutional investors, as noted in our recent report, and become a key item on institutional investors’ engagement agendas, with research from Bloomberg noting that oil and gas majors are now more likely to talk to their investors about climate issues than business growth.

While climate resolutions have traditionally targeted energy companies, this has recently expanded to financial institutions, given their significant role in the transition to a net zero economy. This year, and following the significant pledges made by the Net Zero Banking Alliance, shareholders at top US and Canadian banks, will vote on proposals requesting financing consistent with the IEA net-zero 1.5C scenario, and the disclosure of the pathway to achieving net-zero emissions by 2050. Furthermore, as investors are increasingly being called to hold companies accountable on a variety of social considerations, from median pay gap considerations to the implementation of racial equity audits at some of the largest US companies, twelve pharmaceutical companies have this year received shareholder proposals addressing health equity and access to medicines.

As shareholders sharpen their focus on environmental and social considerations, their scrutiny of board oversight has also increased, with the expectation for board members to showcase insight into their companies’ sustainability practices – having a ‘token’ board member representing ESG no longer seems enough.

Challenging ESG – academics’ perspective

In a week where ESMA announced 2020 was a year of outperformance for ESG funds, Aswath Damodaran, Professor of Finance at the Stern School of Business at NYU, details a litany of what he believes to be fundamental issues and flaws with ESG as an investment philosophy and, as a result, why it will ultimately fail. While we do not see the demise of ESG on the horizon quite like Damodaran does, his article does raise valid points regarding some ESG shortcomings – particularly regarding ESG measurement, ratings and disclosures. Additionally, the article also raises an interesting point regarding ‘greenwashing’ – arguing that it is an outcome of making “ESG a system of scores and rankings” and that it will be an ever-present feature, becoming more sophisticated as regulators look to tackle the issue. However, we might argue there are common misconceptions included too, such as “ESG measurement services missed the Russia effect” and the now common claim that ESG proponents “to attribute everything good that has happened in the history of humanity to ESG.” Indeed, ESG funds had $8.4 billion in Russia at the time of the invasion (out of the $2.3 trillion assessed by Bloomberg). If ESG is to blame for being invested in Russia, should all non-ESG investments be subject to similar criticism for investing many times that amount in the same country? Likewise, those that believe ESG is responsible for all progress in the world likely don’t merit a detailed response and seem to be potentially a frequent red herring for critics of ESG, who often use crises as a means of undermining the value of ESG, even through limited focus. Indeed, in response, Adam Fleck from Morningstar argues that Damodaran misses a group of investors who want to better incorporate ESG data into their analysis and aren’t prioritizing “saving the world” in their investment holdings. Instead, this cohort wants to capture as much information as possible when valuing companies, and E, S and G factors can play a role – either when interlinked or individually.

In reality, ESG is not perfect, has limitations and will likely be abused by bad actors – much like the stock market where it operates.  It can, however, be a useful tool that helps incorporate non-financial factors, and their impacts, into long-term decision-making. ESG must become more sophisticated or evolve, but so must its critics. Simply pointing to the fact that it has not foreseen every crisis; or, that a (small) cohort of its proponents claim it will save the world, probably won’t win over the long-term.

California judge strikes down board diversity law

A California law mandating board diversity has been struck down by a Los Angeles Superior Court Judge. The law, Assembly Bill 979, which went into effect in 2020, required public companies in the state to have board members from underrepresented communities, such as people of diverse racial and ethnic groups and members of the LGBTQ+ community. Judicial Watch, a conservative advocacy group, filed a lawsuit against the bill, and in response, a judge ruled that the law violated the State constitution. California is a leader in the US in legislating board diversity, as no other states have enacted mandatory quotas. The SEC recently approved a Nasdaq rule (which is also being challenged in court) requiring companies to either disclose the ethnic and gender makeup of their boards and have at least two “diverse” members or explain why they don’t.

European Commission releases proposal to make products in the EU more sustainable

The European Commission has published a set of interlinked initiatives meant to make sustainable products the norm in the EU. At the heart of the package is the Commission’s proposal for an Ecodesign for Sustainable Products Regulation (ESPR), also referred to as the Sustainable Products Initiative (SPI), which sets the framework for new product design requirements, focusing on (among other objectives) reusability, recyclability and resource efficiency. If adopted by the European Parliament and the 27 Member States in Council, the new proposal would cover nearly all physical goods placed on the EU market and would introduce a new mandatory Digital Product Passport to make it easier to repair or recycle products, and facilitate the tracking of substances of concern along products’ supply chains. The details on the requirements for the specific product categories will be established at a later stage through secondary legislation (known as delegated acts).

The package of new Commission initiatives also includes the EU strategy for sustainable and circular textiles, which aims to ensure that textile products placed on the EU market are “long-lived and recyclable, made as much as possible of recycled fibres, free of hazardous substances and produced in respect of social rights and the environment” by 2030. Upcoming measures will include ecodesign requirements for textiles, clearer information, and a mandatory EU extended producer responsibility scheme. “Fast fashion should be out of fashion”, says the Commission.

Lack of ratings regulation leads to ESG blind spots

ESG ratings are being called into question after it was revealed that on the eve of the Ukraine invasion, $9.5 billion in funds that met European ESG standards were in Russia. Many of these were based on ratings provided by companies such as Sustainalytics and MSCI, despite claims that they consider matters such as democracy and human rights in their assessments. Problems with ESG ratings have been recognised for some time and predate the invasion of Ukraine – with IOSCO in November calling for ratings companies to provide greater transparency on their methodology and to review it on a more regular basis. Traditional credit ratings have the advantage of having been around a long time, meaning they have been honed over time and are well understood. ESG ratings haven’t reached that point yet and, according to the European Bank Federation, there are currently more than 600 ESG standards, frameworks, and ratings. The ‘alphabet soup’ of standards is a symptom of the challenge of trying to capture multiple factors in a single score. ISS has tried to address this and are supplementing ratings by providing more specifics on factors such as human rights and free speech violations to allow investors to make more qualified decisions. Until greater regulation exists, and lessons are learnt from the mistakes made with Russia, investors should be wary of blindly accepting ESG ratings.

Electric vehicle production crisis

The electric vehicle agenda is experiencing significant headwinds as a result of the war in Ukraine, with surging key raw material costs impacting production costs. As highlighted by ESG+ in March, car batteries are heavily dependent on nickel – the world’s third-largest producer of which is Russia. The shortage and subsequent record pricing of the commodity caused the London Metal Exchange to controversially suspend trading last month.

The global shift away from petrol and diesel towards electric vehicles has, to date, been heavily predicated on the manufacture of batteries increasing in price efficiency over time. As a result, a continuation of the current environment stands to have a negative impact on profitability for companies across the supply chain. Fortunately from a carbon emissions perspective, consumer demand for EVs has surged throughout February and March regardless. Whether this continues as producers find the balance between remaining competitive and the bottom line remains to be seen. It may be that we begin to see a level of subsidisation in the sector to help manufacturers or consumers, given how vital the technology is in the push for decarbonisation.

In Case You Missed It

• The UN Secretary-General launched a new Net Zero Expert Group to assess corporates’ pledges to achieve net zero. The group of experts will develop standards to set, measure and track companies’ net zero commitments to ensure they are on track to meet their targets. The group will make recommendations by the end of 2022 addressing four areas: (1) current standards and definitions for setting net zero targets, (2) credibility criteria to assess objectives, measurement and reporting of net zero pledges, (3) processes for verifying progress toward net zero commitments and decarbonization plans, and (4) a roadmap to translate standards and criteria into international and national regulations.
• The UK Government has confirmed £7bn of funding to improve public transport services outside London as part of the “Bus Back Better” strategy. The spending plan aims to “make bus usage a natural choice for everyone, not just those without cars” and will help progress toward the Government’s 2050 net zero target. About two-thirds of the UK will see reductions in fares and more frequent, more reliable and greener services.
• Ecolab’s investments in renewable energy will enable the company to source 100% of its European and North American operations with renewable energy. Ecolab, water, hygiene and infection prevention solutions company, signed a virtual power purchase agreement with the company Low Carbon, which is currently developing a five-turbine wind farm in Finland. Ecolab’s objective is to source 100% of its global needs by 2030.

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