ESG+ Newsletter – 16 May 2024

This week’s newsletter covers much of the latest regulation on ESG and sustainability across the globe, from efforts to approve the EU’s nature restoration law, to differing approaches to regulating ESG funds in the US, EU and UK. We also review the potential impacts of an increase in pass-through voting on investor stewardship, analyse the latest developments on ESG ETFs, and look at whether the tide is turning for carbon credits and offsets.

Last-ditch attempts to save nature restoration law 

Despite being passed by the EU Parliament in February, the EU’s nature restoration law is in peril. Following a last-minute position change from Hungary, the EU nature restoration law was not ratified, failing to secure a majority at a leaders’ summit in March. The law would require member states to restore at least 20% of land and sea habitat by 2030, increasing to 60% by 2040 and 90% by 2050. Now, environment ministers from 11 countries are hoping to convince countries opposed to the deal to change their minds, according to the Guardian. Led by Ireland’s environment minister, Eamon Ryan, the ministers are warning their counterparts in countries such as Hungary, Sweden, Belgium, and Poland, that not ratifying this law would risk undermining the EU’s international leadership on environmental issues, in turn undermining upcoming global negotiations at COP16, the biodiversity COP. The next opportunity for a vote is 17th June. Just one country needs to switch sides for the law to be ratified, highlighting just how significant these ongoing negotiations are. 

Political backlash appears to infect ESG ETFs 

The latest data for global ETF trends is out and makes stark reading for ESG ETFs. In the first quarter, ESG ETFs experienced their largest ever net outflows, losing $4.8 billion, coinciding with the closure of 30 ESG ETFs globally. This means that ESG ETFs are on pace to beat their previous record of $8 billion of outflows and exceeding the annual closure record of 72, set in 2023. What has been pushing the demise of ESG ETFs? According to the Financial Times, political pressure in the US has been a key driver behind the contraction. While global geopolitics and relative underperformance of ESG ETFs have also impacted its attractiveness, investors are increasingly cautious about ESG related investment products due to the political climate. Indeed, separate sources in the Financial Times article describe ESG-related investment products as “political footballs”, which have become a “political lightning rod”. With the political scrutiny of ESG investing in the US unlikely to abate in the near-term, ESG ETF investment strategies are likely to remain under the microscope. Whether this leads to a continued decline in their use, or an evolution of their structure and branding, remains to be seen. 

Regulators focus on ESG funds globally 

While ESG ETFs suffer pushback and outflows (as detailed above), regulators in the US and Europe are also taking action to ensure the accuracy of ESG funds, in terms of naming and construction. In the US, the Democratic Party has asked the Securities and Exchange Commission to continue and conclude a ruling, which initially gained traction in 2022, requiring increased transparency on fund holdings and investment strategy from managers that market their products as sustainable. Simultaneously, the European Securities and Markets Authority (ESMA) has published its final report for fund use for ESG and related terms in naming, the objective being to protect investors against unsubstantiated sustainability claims while providing measurable criteria for managers so that they may use these terms. The key criteria are needing to place at least 80% of a fund’s AUM into ESG, as defined by the EU’s Sustainable Finance Disclosure Framework, while funds must also adhere to the Paris-Aligned Benchmark exclusion metrics to use the terms. There remains scope, however, to name a fund as “transition” or similar, to allow investment in companies which derive part of their revenues from fossil fuels.  

The guidance is therefore in line with the UK’s upcoming Sustainable Disclosure Framework regulation, which also provides this distinction. The protection of investors from misleading claims and products has been at the forefront of ESG regulation for years. The two latest efforts are a reminder of the differing lens that US and EU regulators are taking in this space, with the rigour and regulatory burden higher in Europe, with opposing sides arguing that this is either harming the competitiveness of capital markets or is a key step to driving resilience and the transition of economies to a more sustainable path. 

Pass through voting’s impact on investor stewardship 

Pass-through voting is the practice of asset managers allowing asset owners to take greater control of proxy voting for the shares managed on their behalf. In an interview with Responsible Investor, Keith Guthrie, Head of Sustainability at Cardano UK, claimed that such practice could lead to a “race to the bottom” for asset manager stewardship efforts. In particular, he notes the disconnect that could emerge between asset owner votes and asset manager engagements with issuers. He says: “you send mixed messages when you vote one way, but your manager talks to them about doing something else.” Simultaneously, there could be a reduced focus on stewardship from asset managers, who may increasingly feel that they will not ultimately be responsible for how votes are lodged. Guthrie argues that, instead of taking back control of (and responsibility for) voting, asset owners should be more selective when choosing their asset managers, delegating the management of assets to houses that will act consistently with their views and values. The potential pitfalls with pass-through voting are not confined to the investor side though. Issuers themselves may face challenges, with feedback developed as part of engagement strategies perhaps no longer aligning with voting outcomes at general meetings. While the roll-out of pass-through voting may appear to bring benefits in terms of shareholder democracy, it may have the unintended consequence of dampening the efficacy of investor stewardship as well as reducing incentives for public companies to engage extensively with their shareholders. 

SBTi softening stance on carbon credits 

The Science-Based Targets initiative (SBTi) has unveiled further details of the major revision of its Corporate Net-Zero Standard, where the SBTi is evaluating the incorporation of environmental attribute certificates (EACs), such as carbon credits. Although the update is taking place in line with the organisation’s regular review cycle, it comes at a time of widespread debate about the SBTi’s mission and impact. More specifically, in April 2023, the SBTi Board of Trustees’ announcement regarding its recommendation to change the SBTi’s corporate Net Zero standard to allow the use of EACs against scope 3 targets, generated significant backlash from employees and industry stakeholders, noting concerns about the nature of the changes and process behind its development. To ensure the robustness of the ongoing consultation process, the SBTi announced that it “will publish an assessment of evidence on the effectiveness of carbon credits in corporate climate targets in July, alongside an independent third-party systematic review of the topic based on peer-reviewed literature” as set out in a recent Environmental Finance article. While there appears to be an increasing acceptance of the role of carbon credits in addressing climate change, a litany of examples of “useless” credits means they still represent significant reputational risks for companies including them in their transition plans and strategies. In response, companies should place significant emphasis on identifying high class credits with demonstrable impact, which will support effective transition plans and associated communications. 

ICYMI 

• The Hong Kong Monetary Authority (HKMA) issues green taxonomy targeting EU-China interoperability. The HKMA has published sustainable finance taxonomy tailored to local needs, aligning with both EU and Chinese green taxonomies, Responsible Investor While focusing on renewable energy sources and climate change mitigation, it lacks a policy around Do No Significant Harm (DNSH), though the HKMA intends to explore DNSH in future iterations. 
• The European Commission urged to scale up of the biodiversity credit market. According to Environmental Finance, an EU sustainable finance expert group has highlighted the need for various mechanisms, such as biodiversity credits, to attract private sector investment into nature, especially in biodiversity-rich low- and middle-income countries. The expert group did not set out exactly how this should be done, but noted that the establishment of a compliance market, alongside ‘additional’ policy such as mandatory disclosures, might be necessary.
• Radiators are getting a climate friendly upgrade. Kelvin, a startup based in New York, has developed a smart radiator cover called ‘the Cozy’ to enhance the efficiency of steam radiators commonly found in older buildings. According to Bloomberg, the Cozy reduces energy consumption, greenhouse gas emissions, and heating costs while improving comfort for residents by regulating heat output based on room temperature.