ESG+ Newsletter – 26th May 2022

The importance of demonstrating ‘S’ in a post-pandemic world

While the pandemic thrust ‘S’ to the fore, there is a danger that progress may be lost due to difficulties in measurement compared to its E and G counterparts. ‘S’ continues to come under scrutiny post-pandemic, and pressure on companies to be more socially responsible is increasing. This is being driven not only by a tight labour market where workers are evaluating prospective employers based on how they treat their staff and the wider community but also investors who are looking at ways to measure companies’ social credentials. Asset Manager Schroders is attempting to address this through an “internal culture” score which will provide a rating to complement existing environmental and governance ratings. The score will look beyond typical diversity measures and instead assess how workplace practices may impact broader performance. It’s also becoming important to take a more holistic approach to ESG and factor in “S” impacts when attempting to meet E and G objectives, for example by considering how the shift to renewable energy may impact areas which have traditionally depended on the non-renewables for industry and employment. A word of caution, however, for companies embarking on social responsibility initiatives; investors and consumers are being increasingly sophisticated, so any ‘S’ commitments will need to be authentic and achievable.

Investor concerns with the future of ESG ratings, including Musk

A new survey from 2° Investing Initiative (2Dii) has highlighted that there is a growing disconnect amongst the investment community regarding the future of ESG ratings. The survey, which was conducted amongst over 160 investors and market participants with the majority being ESG financial professionals, revealed that more than half of the responders believe that aggregate ESG ratings should be abolished and more than 80% believe that the individual ‘E’ ‘S’ and ‘G’ scores should be split out. The latter point is echoed in a recent article by Tom Lyon, Professor of Sustainable Science, Technology and Commerce and Business Economics at the University of Michigan, who argues that splitting out ESG ratings would help investors make a more targeted approach, accounting for different investors having different investment objectives.

The survey comes at an interesting juncture for ESG ratings. As highlighted in previous ESG+ newsletters, ESG ratings are firmly under the regulatory microscope. Over the past week, ESG ratings have also garnered further media attention, when Tesla CEO, Elon Musk, tweeted that they were a “scam” following the removal of the electric car manufacturer from the S&P 500 ESG Index. What may worry raters far more is that, among non-ESG finance professionals, 70% agreed with the statement on abolishing aggregate ESG ratings.

Engage your equities, deny your debt

Could Lothian Pension Fund’s “engage your equities, deny your debt” dual approach become the new gold standard for investors wishing to improve the environmental performance of their portfolios? An article in the FT explores how Lothian, one of Scotland’s largest public-sector pension funds, believes that engaging with companies in which it holds shares can be an effective way to encourage improved environmental performance whilst denying debt to those with strategies that do not align to the goals of the Paris agreement. The idea of a dual approach in which investors engage with investee companies whilst also denying debt to companies who underperform on environmental topics, is relatively novel. To some, it may seem hypocritical to deny debt funding to companies while simultaneously deciding to not sell shares in those same companies. Debt denial, though, provides an alternative to the usual divestment or engagement debate, a sibling perhaps of pressuring banks not to finance fossil fuel projects. The debate on divestment versus engagement continues, with ongoing arguments about which is more effective. Some see divestment as an incredibly important market signal to both companies and legislators who may view divestment in environmentally unfriendly companies as an invitation to set more ambitious regulations. Others argue that owners should retain a seat at the table and put pressure on their investee companies. While regulators have a clear role to play, markets can push corporates toward the ambitions of the Paris agreement, but whether engagement, divestment, debt denial or a combination of all three will be the most effective means remains to be seen.

Texas approach to divestment wins favour elsewhere

A few weeks ago, a Texas lawmaker announced that he would file legislation prohibiting Texan banks from limiting investments in fossil fuel companies.  This is the latest development in continued efforts by officials in Texas to boycott green financing, i.e., investments which support sustainable or ESG-friendly activity. In September 2021, Texas became the first state to pass a law that denies investments to institutions that boycott fossil fuel companies. Under the Oil & Gas Investment Protection Act, any financial institution that boycotts fossil fuel companies will be subject to divestment from Texas’ retirement systems and school funds. In March 2022, Texas Comptroller Glenn Hegar sent letters to 19 major financial institutions, including BlackRock, JPMorgan, and Wells Fargo, to request information on their fossil fuel investment policies and procedures. Hegar commented that “identifying such companies [can help] ensure Texas is not investing public funds alongside those engaged in this duplicitous scheme,” referring to ESG-related initiatives. The concept of boycotting green finance is spreading, with at least seven other states having considered or passed similar legislation. While social pressure on investment firms to divest from fossil fuels grows and a broader transition to a more sustainable economy gains momentum around the globe, efforts by certain states in the US to curtail those efforts may add a level of confusion for investors and companies themselves.

A bill to democratise proxy voting

Legislation was introduced in the US last week calling for voting choices to be made available to those investing in passive funds, particularly where money managers own more than 1% of a company’s voting securities. The growth in popularity of index funds in recent years has allowed large asset managers, such as BlackRock, Vanguard and State Street, who now collectively manage $20trillion in assets, to rapidly grow their asset base and accumulate significant voting power at almost every public US company. These large positions have allowed them to play a significant role in pushing companies to improve practices on certain topics, including diversity, climate change and disclosures overall.

In October 2021 BlackRock announced that it was developing technology to expand proxy voting options for its clients, and has already made itself available to work with Congress in response to proposed proxy voting legislation. Further, Vanguard has been publishing its Investment Stewardship Insights in recent years “to provide investors and public companies with timely perspectives on important governance topics and key votes”. While the principle that investors should be given a voice addresses the potential concentration of power from large holdings – and it is indisputable that owners of shares should be allowed to exercise their rights as they see fit – unless done effectively, the impact here may be a dilution of proxy voting pressure, a growing element of spurring change at public companies.

Carbon market distorted by new capital

The voluntary carbon offsetting market has been distorted by a flurry of new activity, according to Climate Impact Partners – a business which develops and delivers carbon financed projects. As reported by Environmental Finance, the last six months have seen significant levels of new capital entering the market, which CIP believes has come from “over-zealous” investors who “don’t know how it works”. The result has been overpriced projects due to investor keenness. The article goes on to note that pricing is a key difficulty of carbon offsetting more broadly, with the lack of standardisation in quality a specific driver of that. Vaughan Lindsey, CEO of Climate Impact Partners, emphasises the role of investors who, he says, “wouldn’t know a good cookstove project from a bad one if it hit them in the face”.  The heavily scrutinised Voluntary Carbon Market has also featured heavily in discussions at Davos this week, with Standard Chartered CEO Bill Winters particularly vocal on the need for investment while carbon removal technologies ramp up.

Food crisis could impact global food chains

The Bank of England governor has warned of a ‘apocalyptic’ food price rise which is fuelled by the war in Ukraine, climate change and inflation. Russia’s invasion of Ukraine has greatly impacted the availability and price of stables such as wheat, barely and sunflower oil. The Ukraine and Russia produce about 30% of the global wheat exports. As is often the case with these issues, it is expected to disproportionately impact those on lower incomes. There is widespread concern for developing countries, especially those reliant on food imports. The World Food Programme estimates about 49 million people face emergency levels of hunger, with around 811 million going to bed hungry each night. There is fear that this food shortage will spread to global food chains, and impacts will be felt beyond low-income countries. The impacts of increased food insecurity include political turbulence, humanitarian crises, instability, and geo-strategic rivalries. A major hurdle increasing the problem is the blockaded Black Sea and Azov Sea ports. The UN has called for these ports to be reopened so grain exports can resume.

European Commission launches consultation on third-country benchmarks with ESG focus

The European Commission is seeking views on a possible enhancement of the rules concerning benchmarks administered outside of the European Economic Area, also known as third-country benchmarks. Benchmarks are an intrinsic part of financial markets, acting as indices used to price financial instruments and contracts or to measure the performance of an investment fund. The relevant provisions, due to apply as of 1 January 2024, will introduce a specific set of rules on the use of non-EEA benchmarks by EU entities.

Considering the economic relevance of third-country benchmarks in the EU, the new regime is likely to have a significant impact on EU market participants. An area of specific focus is the use of third-country benchmark that advertise ESG features. Ahead of the 1 January 2024 deadline, the Commission is gathering views from stakeholders, in particular administrators of benchmarks both located in and outside of the EU, supervised entities in the EU which use benchmarks administered in a third country, and businesses and investors who are end-users of benchmarks for investment, hedging or other purposes. This comes in addition to ongoing work on the possibility of creating an EU ESG benchmark label. The targeted consultation runs until 12 August 2022.

In Case You Missed It

• Private companies are falling well behind public companies in disclosing climate impact. A report by Bain & Company and the CDP revealed a transparency gap between public and private companies reporting on decarbonisation progress to the CDP. From the researched companies, only 37% of the private companies have set emissions reduction targets while 73% of public companies have. Private companies have highlighted challenges around resource constraints, capability gaps and leadership immobility as limiting progress.
• The conversation has moved from reporting progress to embedding ESG metrics into business strategy . The World Economic Forum’s International Business Council has identified 21 core stakeholder capitalism metrics which companies in all sectors or geographies can report on. It suggests companies who are true to their purpose and measure progress against these indicators will build long term value.
• The Australian Sustainable Finance Initiative (AFSI) announced a 44 person-strong expert group to provide technical input in developing its ‘green’ taxonomy. The AFSI announced that the taxonomy being developed will adhere to ‘science-based’ recommendations to ensure international credibility. Ensuring credibility in the taxonomy makes it easier to identify opportunities, create sustainable assets and activities, and guide capital to support climate and environmental objectives.

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