ESG+ Newsletter – 16th June 2022

EU to respond to biodiversity awareness with regulatory oversight

According to Robeco’s climate survey, investor awareness of biodiversity and its impact on their investment decision-making is rapidly increasing – more than doubling from 19% to 41% over the past two years. Companies are increasingly embracing the idea that protecting the natural resources they rely on, either directly or indirectly, is about future-proofing their businesses. Investors expect that companies are aware of all their relevant biodiversity-related risks, which should be integrated into their corporate strategy, risk management and reporting.

As investor scrutiny on biodiversity disclosure increases, so too does regulatory oversight – with the EU stating its intention to propose legally binding nature restoration targets. A leaked draft of the report indicated that legislation would cover at least 20% of the Union’s land and sea areas by 2030 and all ecosystems in need of restoration by 2050. In May 2020, the European Commission published its 2030 biodiversity strategy which committed to legally protecting at least 30% of land and sea in the EU. The nature restoration law, which will likely take the form of regulation directly applicable at the national level, will aim to make this a reality, ensuring all ecosystems are in a good condition by 2050, with measurable results by 2030.

It would appear that Europe needs to act fast, as it faces a significant challenge to fundamentally reverse the negative trend where only one in seven ecosystems in Europe is in ‘good’ status. It is clear that, for a reversal to occur, Europe will likely have de-couple its economic growth from resource use, focusing restoring nature on farmland and creating a more sustainable food system.

Employee ownership is a core ‘S’ strategy

While historically not seen as natural bedfellows, private equity may be at the forefront of recognising that the cost-benefit analysis of awarding employees equity is heavily weighted toward the latter. As the Financial Times reports, about 625 workers from CHI Overhead Doors netted $175,000 on average in profits upon the company’s sale. While KKR has pointed to increasing wealth inequality as a reason to encourage worker ownership, there is a wealth of evidence that links employee ownership with better productivity, job stability and firm survival. Despite the documented benefits of the approach, as of 2019, just under half of S&P 500 companies and 38.5% of Russell 3000 companies offered stock purchase plans to employees, a number that increases to approximately 80% in the FTSE 100. As companies grapple with how best to approach the ‘S’ in ESG, how to develop inclusion strategies and face tightening labour markets, it seems that allowing employees to share in the success of a company can play a role in addressing all three issues.

Net-zero pledges face scrutiny in the battle against greenwashing

According to Net Zero Tracker, an initiative run by the Energy and Climate Intelligence Unit and the University of Oxford, there are significant credibility and quality issues with the emissions pledges made by many of the world’s largest companies. In its annual report, it outlines that, of the Forbes 2000, only 702 have announced net-zero plans – and of those only one-third have published a pathway to achieving it. Interim targets, a key progress benchmark for investors, were also cited as an area widely neglected. Following on from Net Zero Tracker’s publication, the UN’s Race to Zero campaign announced it was toughening its criteria for businesses pledging to cut GHG emissions. The new standards, exacted after a consultation period with 200 independent experts, now include a requirement for businesses and banks to curb new fossil fuel projects.  The growing focus on transition plans was covered in last week’s ESG+ Newsletter, which detailed that research showed that companies with thorough transition plans were more resilient and are a stronger indicator than those which score well in ESG ratings. In line with growing scrutiny in this area, Environmental Finance has since reported that Sustainalytics is to launch transition ratings, much like MSCI’s existing transition score.

Scrutiny of ESG as an investing discipline, in part due to the current difficult market and global conditions, has ramped up in recent months. Those with robust net zero plans and ESG strategies should welcome the scrutiny, while companies that may have communicated overly ambitious plans will need to refocus efforts as regulators and third parties search for evidence of greenwashing.

ESG fund ‘reckoning’ approaching

Regulators are beginning to crack down on funds with ESG claims. Last month, police searched the offices of DWS Group following allegations of greenwashing, while this week, the SEC began investigating three Goldman Sachs ESG-themed strategies and the UK’s FCA announced plans to clamp down on real estate greenwashing. As stakeholder interest has risen, ESG has become a top priority for regulators, with the SEC’s specialist task force commencing a number of enforcement actions. According to Sonali Siriwardena, partner and global head of ESG at Simmons and Simmons, regulators are under pressure to take action to encourage asset managers to fall in line. With increasing focus on the credibility of ESG claims, clear regulation is required to set the framework and standards for ESG investing. Some claim that the EU’s ESG rules lack standardisation, with the European Securities and Markets Authority admitting that the European ESG rulebook, the SFDR, is “incomplete and imperfect”. This lack of clear regulation creates a divergence of approaches and limits the meaningful action that can be taken to ensure ESG funds are uniformly adhering to the rules. While the regulation may remain murky in some jurisdictions, it is clear that regulators are seeking to ensure ESG market credibility. As markets await the outcomes of investigations, fund managers would be wise to ensure any current ESG claims are underpinned by robust data and evidence of corporate engagement.

SEC requirements could discourage investors from ESG ratings

As efforts to eradicate greenwashing ramp up, an Environmental Finance article claims that new proposals from the SEC could “drive investors away from ESG ratings”. In March 2022, the SEC proposed rules that would require public companies to make climate risk disclosures and share information on their greenhouse gas emissions, with these proposals being open for public comment until 17 June under an extended deadline. The article cites a Jefferies report which argues that the proposal could “change the overall dynamic” of ESG investing and that it could be “a catalyst for investors to move away from ESG ratings” because the proposed rules would require asset managers to explain how they evaluate the quality of third-party scoring provider data, and the methodologies behind ESG ratings are a “black box”, often leading to investor frustration. Just yesterday, JPMorgan Asset Management’s head of Europe, Massimo Greco, confirmed that the $42.3 trillion asset manager does not “depend on external ESG data”, pointing to a growing level of investment, sophistication and independence at the world’s largest asset managers in terms of evaluating ESG and sustainability credentials.

Short selling as a means of forcing climate action

The perceived consensus in certain circles has been that, when seeking to change company behaviour, investors had two options – divest their shareholding or engage with companies’ management team. However, a recently published study by Managed Funds Association (MFA) presents another alternative strategy – short selling. The study shows quantitative evidence as to how short selling could contribute to increasing the cost of capital at heavy emitting companies, potentially forcing management teams to implement more sustainable business practices. The study’s analysis is based on the 16 biggest emitters of greenhouse gases in the S&P 500 and indicates that a short-selling campaign could force those companies to slash up to $140 billion in capital expenditure. The study could add credibility to hedge fund industry claims that short-selling is a force for good – particularly as it lobbies hard to get regulators to recognize short selling as an ESG strategy. The study’s findings run counter to the previous claims by MSCI that there was no evidence that “shorting a company with poor ESG metrics will raise its cost of capital”. MSCI argued that their research found that a proactive engagement strategy is more likely to influence a company’s behaviour than short selling. While the more cynical view might be that hedge funds are eager to prove that short selling is a legitimate ESG strategy to afford them the opportunity to attract ESG capital to their funds, the study may bolster arguments that short-selling can be an effective tool to hedge against the portfolio risks associated with the climate transition.

Fashion’s self-regulation under the spotlight

With the clothing and textile industry accounting for up to 8% of greenhouse emissions, and a major source of microplastic pollution, its sustainability image is being somewhat undermined. Enter the Higg Index, a rating system introduced by the Sustainable Apparel Coalition (SAC), a grouping of almost 150 major fashion brands and retailers. Established more than a decade ago, it may be relied upon by upcoming regulations in Europe and New York. However, the Higg Index is facing criticism due to its reframing of synthetic materials made from fossil fuels as more sustainable than natural fibres such as cotton. The credibility of the SAC is also in doubt as many of its members are fast-fashion brands who directly benefit from the availability of inexpensive materials such as polyester, raising questions about conflicts of interest and the positive rating for the petroleum-based material.

SAC is standing by its ratings system, stating that it’s grounded in expert-verified data. However, some are sceptical, as much of the data originates from research funded by the synthetics industry itself, without independent verification. Natural fibre industry groups also claim that data used to assess their environmental credentials are outdated or based on overly narrow studies, while the Higg rating also fails to take the full life cycle of material, removing microplastic pollution from the equation. With an increasing clampdown on greenwashing in recent weeks, along with a possible ban in Norway, much like investors and companies, the Higg Index may need to change or face increasing difficulties.

Water mismanagement can no longer be ignored

While it may have taken decades for stakeholders and investors to fully appreciate the impact of the climate crisis on our environment, we do not have the same luxury of time when it comes to water stewardship, according to a recent article by Kirsten James, Ceres, and Jay Famiglietti from Global Institute for Water Security. Water is one of the most critical resources to our global economy; however, it has been critically mismanaged by the private sector and other stakeholders. The broad stakeholder base that is impacted by the mismanagement of this resource further complicates matters, with it being estimated that $4.2 billion in major cities’ annual economic activity is now at risk due to water stress. Thus, the writers argue that investors must step-up to the plate and act now to ensure that water risks are addressed and that any far-reaching financial impacts are not felt across both global and local economies. However, unlike the well-documented concerns over climate change, fewer investors are aware of industries’ impact and growing financial risk around water, which may need similar regulatory or reporting frameworks to other areas, like the TCFD and the TNFD to spur action from stakeholders.

In Case You Missed It

• ISS ESG, the responsible investment arm of proxy advisor Institutional Shareholder Services, has announced its new Modern Slavery Scorecard. The new tool is designed to help investors assess their exposure to modern slavery and improve reporting. The scorecard provides a holistic assessment and is created using data from three ISS ESG solutions that evaluate 25 quantitative and qualitative factors.
• According to a new S&P report, more than 85% of green and climate-focused funds are not aligned with the climate goals of the Paris Agreement. These funds do not perform better than regular, non-environmentally focused funds in terms of alignment with the well below 2°C target. Currently, at least one-third of climate funds are on a trajectory to exceed 3°C, which could have disastrous impacts on the planet and human life.
• SDG Fundamentals is the new solution for investors to measure companies’ revenue alignment with the United Nations Sustainable Development Goals (SDGs). The new dataset tool, which has been developed by BNP Paribas Asset Management and the Fintech company Matter, will assist investors in improving their sustainability analysis approach to integration and regulatory compliance under SFDR and MiFID II, stewardship and exclusion initiatives and portfolio construction and reporting.
• This week, the Irish state broadcaster, RTÉ, spotlighted the climate revolution that is underway in Amsterdam. More commonly known as the ‘circular economy’, the new model for living prioritises reusing raw and other materials over and over again in a variety of sectors across the Dutch capital, aspiring to create the most sustainable community.

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