ESG+ Newsletter – 28th July 2022

Biodiversity, ESG’s latest hot topic

Biodiversity is rising up the ESG agenda. This week we released a report outlining how a company can create an impactful biodiversity strategy and navigate the complex system of reporting frameworks and measurement tools. As we have seen through this newsletter, corporate impacts on nature are coming under increasing scrutiny, from evolving regulation to a recognition of the link between biodiversity and climate action.

This week saw the Finance 4 Biodiversity (F4B) initiative host a first-of-its-kind sustainable sovereign debt facility. The sovereign debt facility is being established to assist the development and scaling of nature-linked sovereign debt through technical support, ensuring the validation of KPIs and supporting the development of standards. This comes a month after F4B launched a report warning that nature-related risks can have significant impacts on sovereign credit ratings.

While the investment community is beginning to become aware of the need to tackle nature-related risks, a strong global framework is required to support action. With COP15 due to begin in December, experts are expressing concern at the lack of progress in negotiations towards a global agreement to protect and restore nature. With awareness building among investors, regulators and corporate leaders, a global agreement on nature could push biodiversity to the top of the ESG agenda

Reducing ESG to emissions

The Economist this week published a detailed article on ESG and sustainability as it applies to businesses. The article covers issues including greenwashing, the ongoing political backlash against ESG in America, and measurement and rating inconsistencies. The overarching argument is that ESG should be simplified to consist only of emissions, which the Economist believes will help zero in on goals and targets. The issue with social factors is “that there is no one template” as “in a dynamic, decentralised economy individual firms will make different decisions about social conduct”. Regarding governance, it is “too subtle to be captured by box-ticking”, and listed firms in the UK are already “dismal” in performance when comparing to the FRC’s corporate governance code.

Although ESG certainly needs refining, in no small part due to nascency, our view is that it needs to (and will likely) remain broad and focus on each of the three pillars. Greenwashing, for instance, is of course an issue, both at fund and asset level. But the direction of travel from a regulatory perspective is clear, with the EU leading the way with its Sustainable Finance Disclosure Regulation and the UK and US in the throes of following suit. On ratings agencies, it is worth remembering that each has its own individual use and methodology – and can be used as a collective to give an overarching view – or as a tool for investors.

Ultimately, ESG in its essence is a market tool for the evaluation of risks and opportunities. Not providing disclosure around material ESG factors depending on sector and issues facing the business may be a due diligence failure. It was never promised to be a silver bullet that will stop fraud or invasions, instead focusing investment on three core areas which are material for both businesses and investors. How else can an investor look to navigate the labour crisis, for example, without understanding what its investees are doing to retain top talent? Mental health support, community engagement initiatives, and diversity progress are all factors that hit the bottom line. To ignore S (or any material factors facing the business), therefore, is now being viewed as a potential breach of fiduciary duty.

The nature of ESG has changed with current market conditions, with more focus on risk aversion than on mining of opportunities. Once the cycle moves on, it will change again. Ultimately the market will decide what works and what doesn’t.

Misconceptions around the SEC’s Draft climate disclosure rule

A recent article by Janet Ranganathan (Executive Vice President of Strategy, Learning, and Results at the World Resources Institute and Co-Founder of the Greenhouse Gas Protocol) breaks down the SEC’s draft climate disclosure rule and dispels common misconceptions. The draft rule, which was unveiled in March 2022, is intended to help investors and companies manage and assess risks associated with climate change and has been the subject of debate among companies and policymakers alike.

Ranganathan argues that climate change poses a real financial risk to companies due to climate regulation and a competitive risk to companies that choose not to adopt increasingly popular low-carbon technologies. She explains that, contrary to popular belief, there are standards governing corporate GHG accounting and disclosures, with over 90% of Fortune 500 companies reporting to CDP using GHG protocol. She also dispels what she views are misconceptions around Scope 3 emissions. While the SEC will mandate such disclosures in some circumstances, Scope 3 emissions have been around for over 20 years, and they are becoming increasingly important and easy to calculate in the ESG reporting space. Ranganathan also argues that companies can often influence their Scope 3 emissions and that they can often indicate real financial risk. While the SEC’s rule has yet to be finalised, it is clear that public companies will need to enhance their understanding of ESG and reporting principles in light of increasing regulatory pressure.

Deadline Looms for New York State insurers to integrate climate risks

Insurance industry regulators in the US are acknowledging and reacting to the increasing severity and frequency of large-scale natural disasters. On the 10th anniversary of Superstorm Sandy, which struck the New York and New Jersey coasts in October 2012 and caused $28 billion in national insured losses, the New York Department of Financial Services (“NYDFS”) has issued supervisory expectations for domestic insurers pertaining to the management of climate-related financial risks.

The final guidance that was issued in November 2021 requires two tasks of domestic insurers by August 15, 2022:

1.  incorporate the NYDFS’s climate risk expectations into board governance, and;
2. have specific plans in place to integrate the expectations into the organizational structure.

The NYDFS outlined additional, more complex expectations in the guidance but recognises that these will take firms longer to implement. The NYDFS’s Guidance for Domestic Insurers on Managing the Financial Risks from Climate Change represents one of the US’s first industry-specific climate risk regulatory actions. Because the NYDFS is one of the industry’s leading indicators of supervisory disposition, the guidance is a harbinger of actions by other state- and national-level regulatory agencies. Therefore, it is crucial for US domestic insurers to respond thoroughly to the requirements outlined in the guidance. While it is principally focused on preventing and mitigating the financial risk to insurers due to climate change, the NYDFS fully expects domestic insurers to actively participate in the transition to a low-carbon economy and continue supporting communities vulnerable to the effects of climate change.

Is the Combined Chair/CEO role on the decline?

The independence of the Board Chair has been the subject of debate for many years. As per corporate governance theory, the less affiliated Directors are with the company, the lower the potential conflict of interest and the greater the ability for those Directors (and, by definition, the Chair) to objectively oversee the efforts and performance of the Executive team. On the other hand, advocates of the combined Chair/ CEO role note the value of industry knowledge and insight into the company’s day-to-day operations.

Despite these diverging views, a recent Fortune article notes that an increasing number of companies are appointing independent directors to the role of Chair. A recent study shows that “the percentage of S&P companies that combine the board chair and CEO roles dropped from 49% in 2018 to 44% in 2022, while the percentage of companies with an independent board chair increased from 31% to 37%” within the same period.

While Board succession has been identified as an instigator for this shift, one of the key drivers for the rise in Chair independence is related to Chairs’ increased workload. As companies have to manage and respond to a multitude of crises, undergo transformations across their businesses, address ESG issues and are expected to quickly respond to their shareholders, a larger number of companies are seeing the advantages of having two leaders at the helm. The article highlights that this separation seems to be heavily weighted towards small caps, with only 25% of the larger companies in the S&P combining the two roles. While the data from this year’s proxy season is promising, it remains to see whether this separation will be accepted by some of the largest companies in the world that have historically combined these roles.

Sustainability loans on the rise but with greenwashing concerns

A study developed by the Principles for Responsible Investment on the growth of sustainable lending globally has revealed that the sustainable loan market has grown exponentially from US$6 billion in January 2016 to US$322 billion in September 2021. The growth is driven by the widespread use of general-purpose sustainability-linked loans, which have terms contractually tied to the sustainability performance of the borrowing company.

Borrowers often use the loans as a signal to external stakeholders of their ESG commitments, while lenders are incentivised to supply ESG-linked loans because of downside risk protection or government and regulatory pressure. The result of this means the loans can be used for greenwashing purposes by banks and companies who are under external pressure to signal a commitment to ESG without actually taking action. The disclosure related to these loans was also found to be of poor quality and includes widespread variation in terms of information disclosed. This makes verifying the validity of ESG loans difficult, as noted by the study. Given the continued rise in issuance – and the parallel increase in scrutiny around practices which could be seen as greenwashing’ – companies and their stakeholders and companies need to be vigilant and encourage transparent disclosure around loan issuance and how that capital is deployed to align with its intended purpose.

In Case You Missed It

• The FCA’s inaugural climate disclosure report identifies challenges in using risk management frameworks and calculating Scope 3 emissions as significant barriers to high-quality reporting and financial market disclosure. Aligned with the TCFD, the FCA aims to reduce its Scope 3 emissions by 90% but acknowledges that this will require greater availability of data and enhanced climate scenario analysis.
• The UK Government’s Jet Zero Strategy outlines the pathway to net zero aviation by 2050 – an industry responsible for 2-3% of global emissions. Complementing the UK’s Net Zero Strategy and Transport Decarbonisation Plan announced in 2021, the proposals include improving aircraft efficiency and developing sustainable aviation fuels to help decarbonise domestic aviation and airports.

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