ESG+ Newsletter – 15 June 2023

Regulating the raters

This week, the EU Commission published a new package of measures aimed at strengthening the EU sustainable finance framework and, while the package included additional criteria to the EU Taxonomy, the real news was the proposal for regulating the ESG rating sector. As avid readers of the ESG+ Newsletter will be aware, there have been prolonged calls for the ESG rating sector to be regulated, with recent reports revealing a growing dissatisfaction with ESG ratings and confidence issues amongst investors and companies. The proposed regulation by the EU would give the European Securities and Markets Authority (ESMA) regulatory oversight of the ESG ratings sector and will also require ESG rating agencies to receive authorisation before publishing their ESG scores.  The objective behind regulating the sector was to make it easier for investors to “identify environmentally sustainable investments and ensure that they are credible” by providing greater clarity on how ratings are reached, and to ensure that the ESG ratings provided by different agencies are transparent and comparable.

At the ESG+ Newsletter, we have consistently highlighted the role of third-party providers in helping inform sustainable investing decisions and to better understand ‘non-financial’ risk. ESG ratings have played an important part in this, helping shape the development of ESG disclosures by companies and help investors make informed investment decisions.  Due to the complexity of the data and divergence in methodology from provider to provider, it is probably not surprising that there is a lack of clarity in the EU’s proposal and that it does not prescribe ESG assessment methodologies. However, the implementation of a regulatory framework should help in determining what ESG ratings are for, and how should they be used. As differing approaches allow for focus on different areas and provide a diversity of opinion on the myriad of ESG related risks and opportunities, maybe the next logical step is to make a clear separation between ESG research, data, and ratings?

EU draft reporting standards pivot to focus on materiality

Moving from one EU legislation to another – the EU Commission recently published an updated draft of its European Sustainability Reporting Standards (ESRS) on Friday. The publication received a mixed reaction, with the central and possibly most controversial aspect being the pivot to a materiality-led approach, rather than a standardised, one-size-fits-all bank of non-financial metrics. Driven by the European Financial Reporting Advisory Group (EFRAG), the ESRS is a key aspect of the EU’s broader Corporate Sustainability Reporting Directive (CSRD) – “the overarching framework for a responsible and sustainable approach to global value chains”. The ESRS is the central disclosure framework outlining the information companies should include in their sustainability reports to demonstrate sustainable operations and practices. The guidelines aim to act in harmony with the Task Force for Climate-related Financial Disclosures, and Global Reporting Initiative.

Critics, which include investor and campaign groups, have argued that the approach will provide space for greenwashing by allowing for a potential decrease in quality and comparability of information – meaning that financial institutions may both inadvertently and advertently greenwash. While there are grounds for this argument, given the reliance of the Sustainable Finance Disclosure Regulation’s on the Principal Adverse Impacts indicators and Do No Significant Harm framework, it is difficult to be too disparaging of a third-party verified materiality-led approach that weights importance in strategy to the most crucial areas of sustainability. Sector-level materiality assessments are already deeply integrated into the industry, and if this process necessitates a deeper level of analysis then that is not necessarily a bad thing.

ISS defends its stance on ESG-related shareholder proposals

Many ESG-conscious funds would likely argue that ISS should support more environmental and social shareholder proposals. However, the proxy advisor has also been criticised for supporting too many of these resolutions, being branded by its detractors as a “woke activist” and “social engineer”. Following these attacks, ISS CEO, Gary Retelny, felt compelled to issue a rebuke, and his message is clear – the firm’s proxy advice is apolitical. He explains that, for the majority of the shares voted on behalf of clients, recommendations follow tailored policies based on “the clients’ unique circumstances and preferences”. He also details that clients who do not opt for a custom-made policy may choose between different in-house policies, ranging from one broadly aligned with management recommendations to another that enables shareholders to vote in line with their religious beliefs. According to the commentary, this policy resulted in support of 52% of environmental and social shareholder proposals in 2022.

Retelny sees the critiques faced by ISS as part of a broader attack against ESG investing and that ESG sceptics consider ISS recommendations in favour of ESG proposals as contrary to investors’ fiduciary duties. He argues that ISS clients may benefit from recommendations tailored to their preferences, and that many of them do believe that sustainability factors can be financially material, justifying their inclusion in the investment and stewardship processes.

Stronger climate targets are needed to achieve net zero

A recent report by Oxford researchers into the status and trends of net zero target setting across countries, sub-national governments and companies has revealed some fascinating findings. The report, titled Net Zero Stocktake 2023, emphasised that stronger targets are urgently needed to effectively address climate change. While net zero targets have been widely implemented, the report reveals that there is significant work needed to achieve the climate goals set in Paris. Many national governments have committed to net zero, but the quantity and coverage of these commitments has stalled over the past year. Some entities, including those within the G7, still lack any emission reduction targets. The private sector remains a key player, with action essential to support nations in meeting their climate goals. Professor Thomas Hale of Oxford’s Blavatnik School of Government suggests incentivising and supporting companies and sub-national governments to set rigorous net zero targets.  It is clear from the report that greater collective efforts to address climate change across society’s divides is needed if we are to achieve net zero and avoid the worst impacts of climate change.

The sustainable food conundrum

With global food and agriculture responsible for an estimated 34% of global CO2 emissions, it is no surprise that the sector receives scrutiny for its sustainability credentials. Despite its contribution to global emissions, last year a Climate Policy Initiative report revealed that only 4.3% of climate finance was spent on agrifood systems in 2019 and 2020. These figures present an obvious question – are there efforts underway to address this imbalance and accelerate progress towards more sustainable food systems? In the EU, it seems that part of the answer may lie in upcoming regulation. According to ESG Investor, food system reform has been on the cards since the launch of the EU’s green deal in 2020, and the EU Commission plans to publish its proposal for the Sustainable Food Systems Law (SFSL) in September. The law is intended to complement the EU’s overarching Farm to Fork 10-year strategy to drive sustainable food production. The SFSL is expected to lay out criteria for sustainable labelling, procurement of food products, and governance and monitoring of food supply chains. The EU Commission ran a consultation on the SFSL last year, with 94% of respondents noting that the current system is not ready to meet future environmental and climate change challenges.  In a highly fragmented sector, with responsibility split between food producers, processors, and retailers, creating rules to improve the industry’s environmental credentials while considering health impacts and food security will be a challenging balance to achieve, but one that is essential to ensure long-term sustainability.

EU Deforestation law may force investors to exist consumer goods firms

Sticking with the consumer sector, the adoption of an EU law which would prevent companies from selling commodities in the EU that are linked to deforestation around the world – such as coffee, beef, and soy – could have a profound impact on shareholders in these companies. The legislation is expected to be implemented by the end of 2024 for ‘big operators’, with companies potentially being fined up to 4% of their turnover if they are found to be non-compliant. Reuters has reported that this has forced some investors to rethink their exposure to these companies and is placing an increased focus on identifying the potential risks with such investments. This is reflected through an engagement survey conducted by a leading European investor aimed at assessing the impact of deforestation on the supply chain of consumer good companies. The survey revealed that only 25% of responding companies had set deforestation goals.

ICYMI

• Swedish carrier Vastflyg will exclusively use sustainable aviation fuel (SAF) on its network. The Swedish regional carrier is claiming to be the first airline to use only SAF on its flights. By using a mixture of Neste MY renewable fuel, which is wholly produced from sources such as waste cooking oil and animal fat, Vastflyg claims it will be immediately reducing its greenhouse gas emissions for all flights.
• Treated hoardings in cities could ‘cut air pollution’. According to a think tank run by a government planning adviser, treating hoardings around construction sites by coating them with a chemical compound could cut air pollution by trapping harmful pollutants. There have been two trials of using coating titanium dioxide (TiO2) on hoardings in London, and the chemistry is uncontested: TiO2 can convert nitrogen oxides (NOx), a precursor to NO2, to nitric acid. However, it remains unclear whether the coating could irreversibly convert meaningful amounts of NOx in the air and be truly effective in combatting air pollution.
• Banks ditch sustainability as economic headwinds slows progress. According to new research, only 60% of UK banking leaders say that sustainability is important in their strategy compared to 100% only one year ago as it falls down the list of priorities in the sector. Since last year, the percentage of banks with a board level executive responsible for sustainability strategy has fallen from 83% to 54%.
• What we don’t know about wildfires might kill us. As the climate changes, the frequency and intensity of toxic smoke from wildfires in Canada smothering the eastern US is increasing. The toll of this hazardous smoke on the global economy is probably enormous, but there is an alarming data gap in understanding quite the extent to which wildfires and smoke will harm the economy.

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