ESG+ Newsletter – 17th March 2022

Financial institutions call on companies to disclose environmental data through CDP

A group of investors managing $130 trillion in assets has written to more than 10,000 companies this week, calling on them to supply environmental data to non-profit disclosure platform the Carbon Disclosure Project (CDP). Letters started going out to companies from the 680 institutions, on Monday last requesting they disclose information on climate change, deforestation, and water security.

Non-disclosure will not be an option for many companies as a series of mandatory environmental disclosure requirements are coming out this year in the EU, Japan, New Zealand and India. The TCFD disclosure framework for UK companies is also being introduced next month. Where regulation doesn’t force the publication of data, investors will ramp up pressure on companies to increase transparency.

Regulatory and investor pressure is already driving an increase in transparency, with the CDP last year recording higher corporate disclosures than ever before, a trend likely to continue this year.

European Central Bank finds lack of progress on climate disclosures in latest analysis

On the issue of disclosure, a supervisory assessment undertaken by the European Central Bank has, according to a member of the ECB’s executive board, revealed that the climate disclosures of eurozone banks are “a lot of white noise” with “no real substance” that have only improved marginally since November 2020.

The analysis, comprising of 109 banks, also concluded that not one bank meets the basic requirements laid out by the ECB in its Guide on climate-related and environmental risks. The ECB has subsequently sent individual feedback letters to all banks it supervises which, says Frank Elderson – the noted executive board member- sets out “the key gaps in their disclosures” and conveys the “explicit expectation that they will take decisive action to address these gaps”. Elderson goes on to suggest that the ECB’s next move could be to publish publicly those who are falling short.

In its coverage of the assessment, Environmental Finance comments that the findings coincide with the ECB’s first climate stress test, which was launched in January, while citing the report’s conclusion that approximately 75% of the 109 banks do not disclose whether climate and environmental risks have a material impact on their risk profile.

Disclosure has now well and truly entrenched itself as a central theme of 2022, with exposure to ESG trends and opportunities becoming secondary to clarity over risks. Every industry and asset class has seemingly been on the receiving end of pressure from regulators, industry bodies, or the market. The ECB’s frustration is tangible – we wait to see if they follow through on the threat to name and shame.

‘Deconstructing’ ESG scores to enhance ESG returns?

Moving from disclosure to ratings and returns, a recently published paper by the Bank for International Settlements has found that investors could overcome the inconsistencies and limitations of ESG ratings by “deconstructing” them. The paper asserts that ESG scores combine “fundamentally different” factors that can offset each other, and investors can overcome the “aggregate confusion” created by consolidated ESG ratings by focusing on themes that are most relevant to their investment mandates.

Focusing on specific themes, supported by the underlying data, would help investors better track the ESG performance of their investments – for example, if an impact investor’s objective is to protect the environment or promote universal human values, then they should target themes such as emissions reduction or human rights initiatives. Over time, this focus would also enable investors to develop their own ESG assessment models, with these models being supported by specific company data and appropriate ESG ratings. Importantly, it would also reduce the reliance on ESG rating agencies, which do not currently have a centralised reporting framework.

Regular readers of this newsletter are well aware of the ongoing push from regulators and investors to tackle the perceived lack of transparency in ESG ratings calculations and help combat any potential ‘greenwashing’. In the absence of regulatory oversight to support the consistent disclosure of clear and publicly available information by rating providers, investors may be forced to adopt different approaches – such as a thematic focus – to ensure their ESG investment returns.

How meaningful is the link between ESG Goals and Executive Remuneration?

With rising disclosure requirements and companies embedding ESG objectives and strategies across their business, ESG targets are  now also being added to short and long-term incentive compensation plans, as noted in a recent edition of this newsletter.

A Bloomberg Law article of the past week highlights that the structure of executive compensation has been shifting from the traditional tie to financial metrics to also including considerations around carbon footprint reduction, employee wellness and retention, and supporting human rights. While this is viewed positively by the majority of investors, some are concerned that companies may be rushing to adopt ESG pay metrics before having well-established goals and strategies for these ESG priorities. In the US, according to a study by Glass Lewis, approximately 25% of US companies included “some type of E&S considerations within their executive incentives”. These deliberations have also been part of the SEC’s open consultation around pay for performance, and the incorporation of ESG goals in the remuneration policy for large US companies.

As the expectation increases for companies to implement ESG targets into their remuneration plans, a recent Harvard Law School paper raises some questions around the limitations of these practices. It notes the narrowness of ESG metrics, given the difficulties in quantifying important ESG considerations, while questioning the ability of them in driving meaningful results – the reason being that “it poses the danger of creating vague, opaque, and easy-to-manipulate compensation components, which can be exploited by self-interested CEOs to inflate their payoffs, with little or no accountability for actual performance.” 

As these metrics become more common, and demand for greater alignment between remuneration and non-financial performance measures, ensuring implementation is part of a well thought out process, that is also explainable to shareholders, will be increasingly more important.

Lack of diversity is costing trillions

Bank of America (BofA) has released a study demonstrating the huge financial costs associated with a lack of diversity in businesses. The report states that a lack of action on diversity and inclusion over the past 30 years has led to $70 trillion in foregone economic output, driven by less innovation, lower employee retention, and weaker revenue.

BofA’s Kay C Hope, the Head of ESG for Global Fixed Income, told Yahoo News that corporates can introduce inclusive policies to help improve diversity, equity and inclusion (DEI) within the workplace, such as more inclusive benefits, parental leave policies, insurance coverage, and flexible working allowances.  However, she said it is not enough to simply introduce inclusive policies, employee perceptions need to reflect these efforts. BofA stresses the importance of ensuring company culture and values reflect DEI pursuits, noting that without the reflection of DEI friendly policies in culture and values, corporates are unlikely to create a truly inclusive workplace.

The report also highlights the difference between regions in improving gender diversity at board level, with women holding 30% of board positions in the S&P 500 compared to 36% across the average European listed large-cap company in 2021. The EU hopes to improve these figures over the coming years by giving the initial green light to proposals mandating that firms appoint women to at least 40% of non-executive director roles or 33% of all board jobs by 2027. With the regulatory and financial imperatives for action on diversity becoming increasingly clear, companies will need to ensure they are acting to improve diversity at all levels of the business. The true test in whether companies can reap the rewards of increased diversity will be how well the company acts to create an inclusive culture throughout the organisation.

TNFD releases draft recommendations

On 15 March, the Taskforce on Nature-related Financial Disclosure (TNFD) released draft guidance on accounting for nature related risks and opportunities. The draft recommendations are the first of four iterative drafts that will be released ahead of the final version in September 2023. The TNFD framework aims to define nature-related risks and opportunities and encourage the incorporation of these considerations into financial decision-making. The initial recommendations cover three topics:

1. Key concepts and definitions: Including definitions of nature, dependencies, risks and opportunities, as well as an overview of how nature affects financial risk and investor performance.
2. Disclosure recommendations: The TNFD disclosure recommendations exactly mirror those of the TCFD, covering governance, strategy, risk management, and metrics and targets.
3. Guidance on nature-related risk and opportunity assessment: The TNFD has responded to feedback from market participants that practical guidance would be helpful to enable organisations to incorporate nature considerations into enterprise risk management processes. In response to this feedback, the TNFD has developed the LEAP approach.

In other nature-related news, the UN Conference on Biological Diversity (COP15), which was due to take place between 25 April – 8 May, has been postponed for a fourth time, to a yet to be released date in Q3 2022. This further delay will pushback consensus on the adoption of common goals and principles for biodiversity.

Finally, 13 leading NGOs and environmental groups have urged the UN to adopt a biodiversity framework with the global goal to reach “Nature-Positive by 2030”. The groups have been pushing for the adoption of clear goals to halt and reverse nature loss by 2030, and to achieve full recovery of nature by 2050. Official negotiations will take place in Geneva this week to revise and finalise the draft for the new Global Biodiversity Framework (GBF).

SEC proposes updated rules for cybersecurity management, reporting, and governance

The SEC last week proposed updated rules to improve disclosures related to cybersecurity. When proposing these amendments, SEC chair Gary Gensler acknowledged the increased cybersecurity risks that public companies are facing and that investors want to know more about how companies are managing those risks.

The SEC also acknowledged current failings in cybersecurity disclosures, in particular the inconsistent reporting of incidents. Under the proposed new rules, “material” incidents would have to be reported within four business days of an incident occurring. There are also several governance aspects to the proposals, such as the requirement for periodic reporting of companies’ cybersecurity policies and procedures, and management’s role and expertise in overseeing these policies and procedures. Notably, the proposal would require reporting of board cybersecurity expertise, or lack thereof.

This development is yet another sign of how regulators are clamping down on cybersecurity and how companies will need to have the appropriate structures and expertise in place to effectively manage cybersecurity risk. As we’ve discussed in this newsletter recently, accountability for cyber risk is expanding across the business and business leaders will need to be equipped to handle it.

New guide launched to help businesses tackle supply chain emissions

The Paris-based International Platform for Insetting (IPI) has launched a new guide to help companies transform their supply chains towards net zero. ‘Carbon insetting’ refers to investments in projects that generate carbon removals and emissions reductions across value chains, for instance through forest conservation projects. Kering, Chanel, L’Oréal, Nespresso and Accor are all founding members of the IPI and aim to encourage other companies to tackle their Scope 3 value chain emissions by investing in emissions reduction projects within their own supply chains. This approach is different from the more common carbon offsetting projects, which tend to have no direct connection to the operations or supply chains of the companies that purchase them.

The IPI’s Practical Guide to Insetting provides recommendations for sustainability professionals, including 10 learnings, from internal mobilisation to collaboration with partners on the ground, and five opportunities to scale insetting as a strategic practice. Looking forward, the IPI is striving for insetting to be better recognised by international carbon reduction frameworks, for instance the Science-Based Targets Initiative (SBTi).

In Case You Missed It

• The United Nations has agreed on a treaty to end plastic pollution in the “biggest environmental deal since Paris”. A draft legally binding agreement is expected to be finalised by the end of 2024. The treaty will cover plastic’s entire lifecycle including the production, design and disposal. Recycling plastic waste is increasingly on the radar of impact investors.
• Fossil fuel companies will no longer be eligible for SBTi, following an update to the organisation’s policy. SBTi will no longer recognise commitments or validate targets for companies in the fossil fuel or oil and gas sectors. The goal of the organisation is to increase the robustness of the initiative. More updates on the development of the guidance are expected later in 2022.
• The Sustainability Accounting Standards Board (SASB) will integrate into the new International Sustainability Standards Board (ISSB). The ISSB’s standards will develop general (ESG), thematic (climate) and industry-based requirements (with the starting point provided by SASB standards). There is no expected change in the short-term though the longer-term vision is to provide a streamlined landscape for financial and sustainability reporting.
• Climate Action 100+ has released an updated Aviation Sector Strategy which outlines the urgent actions for the aviation sector to take to align with a 1.5°C scenario. The strategy highlights the need to significantly increase the use of Sustainable aviation fuels (SAF), to maintain business travel at 2019 levels, to cap long-haul leisure flights of more than 6 hours at 2019 levels, and to shift demand to high-speed rail infrastructure where possible.
• The UK’s Stewardship Code has approved 74 new signatories, resulting in a total of 199 signatories. The Code, which was substantially reformed in 2020, sets reporting requirements for investors. The stewardship activities reported by the signatories are reviewed annually by the Financial Reporting Council.

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