ESG+ Newsletter – 6th October 2022

Research finds regional differences are key in divergent investor opinions on ESG

Research by Morningstar has revealed that asset managers are divided in opinion when it comes to the details of climate and sustainability reporting standards. Despite the International Sustainability Standards Board’s (ISSB) first draft of reporting proposals receiving widespread support, the investor community differences occur across three core areas: defining materiality, greenhouse gas disclosure depth, and how to align with existing frameworks. Morningstar’s Director of Investment Stewardship research, Lindsey Stewart, cites geography as a key factor, highlighting that US asset managers are not of the same view as their European peers with regards to double materiality – the idea that ESG materiality should not only account for what is financially material to a business but also the impact of a business on the environment and society. On GHG disclosures, Stewart found that the majority of those in favour of mandatory Scope 1,2, and 3 emissions reporting were European, whereas the position of large US investors is to either phase in Scope 3 over time or only require disclosure in certain circumstances. The final area of difference is less clear cut when looking at regional perspectives, but the research did find that there are concerns about the alignment of the ISSB’s draft standards to the Taskforce for Climate-related Disclosure (TCFD) and the Sustainability Accounting Standards Board (SASB). While some praised this, recognising that both the TCFD and SASB have been extensively tested, European investors noted that the proposals left a significant gap between the ISSB’s baseline and the EU’s double materiality position.

Many will view the findings critically, shaping them into another anti-ESG argument predicated on inconsistencies and differing methodologies. So long as the direction of travel on inflows and regulation continues to progress though, these may be moot points. One notably area of focus from this research is how the definitions of conventional materiality and double materiality will evolve; and, how companies need to understand that ESG expectations change by region and by investor type. Likewise, regulators are increasingly requiring businesses to define ESG risk in the supply chain, meaning that operating responsibly has a direct bottom-line impact, while a new generation of employees and consumers base their career and commercial choices on alignment with personal ideals.

Stricter rules for ESG labelling may deter fund managers

Efforts to tighten up rules around the classification of ESG funds are facing backlash from investors and businesses, both in the US and EU. In an attempt to create greater consistency across ESG disclosures, the SEC has proposed rules that would require fund managers to outline what factors are considered in their sustainable labelling, with future rules being considered that would require the naming of funds to accurately reflect their investments. Proponents of these changes say that, while they may lead to a reduction in investments in the short-term, they will ultimately generate greater confidence in ESG products over the longer-term. However, fund managers, including BlackRock, have pushed back on the SEC proposals saying that funds shouldn’t be required to disclose proprietary metrics, and accused the SEC of focusing excessively on environmental matters and neglecting social and governance factors. Meanwhile, in Europe, the EU’s Sustainable Finance Disclosure Regulation (SFDR), which applies to investment managers targeting EU clients, is causing some managers to simply avoid ESG designations for fear they could be accused of selling an inaccurately labelled product, potentially leave them exposed to litigation. However, while investors argue there is a lack of clarity from the regulation, the EU may well be happy that the revised regulations are spurring some soul-searching on what constitutes sustainable or green – the entire point of raising the bar on what may have been an industry all too willing to assign certain characteristics to funds. Across the investment chain, we are likely going to see increased levels of black and white (or green and brown) on investment products and company practices.

Nature-related risks and the mandate of central banks

Frank Elderson, a member of the executive board of the European Central Bank (ECB), has claimed that nature-related risks are part of central banks’ mandates. Recognising the crucial role nature plays in the economy, and by extension the financial system, Elderson outlined the importance of recognising the materiality of not only climate but also nature-related risks. Elderson also stated that nature ultimately needs to become “fully embedded in the work of central banks, supervisors, regulators and international standard setting bodies”. The ECB is not alone in stressing the importance of viewing environmental risks as wider than just those relating to climate. Executives from the central banks of France, Mexico and the Netherlands also used speeches at the conference to encourage action on biodiversity. As financial institutions begin to get their heads around climate, and the associated risks of both climate change impacts and the transition to a low carbon economy, central bankers are beginning to stress the need to take a more holistic approach. Collaborative bodies such as the Network for Greening the Financial System are supporting companies that are learning how to tackle these joint issues by creating a new task force on nature-related risks. As these vocal central bankers have highlighted, financial institutions must consider environmental crises beyond climate to avoid transition risks and stay abreast of regulation.

Anti-ESG rules are blurring the lines of proper risk-management

The recent wave of ESG criticism and revised regulation in terms of ESG investment has started to encourage lenders to increase risky loans. Earlier this year, Texas began to exclude funds that were deemed “hostile” towards energy companies and, in response to this, firms – most notably US banks – began to write letters to State legislators highlighting that their funding of energy companies was proof that they were not hostile to the Oil & Gas sector. Sarah Bloom Raskin, the former deputy Treasury secretary, highlighted that some banks may start to cut corners and offer more “risky” loans to these energy companies to appease political pressures. Many of the firms targeted have ESG mandates and Raskin believes that, in an effort to curb the pressure to reduce ESG focuses, lenders and investors may fail to continue to integrate proper risk management techniques.

A social taxonomy to focus the mind of investments

As alluded to in an earlier article, recent years have been marked by calls to clearly designate what is a sustainable (or not) activity, as a means of spurring investment in same as pushing the world onto a more sustainable path. The lack of clear definition has constituted a significant roadblock in the assessment of these activities, particularly those concerning socially responsible activities. While there is growing legislation looking to tackle the environmental considerations of sustainability, social sustainability – and a clear conceptualisation of what that entails – remains in its infancy. The Platform on Sustainable Finance (PSF), published its final recommendations on the development of a social taxonomy in February 2022. This suggested structure will retain some structural aspects of the EU Taxonomy, particularly in defining the types of social contributions, retaining the ‘do no significant harm’ and setting minimum safeguards. The main objectives of the social taxonomy would be focused on addressing the key stakeholders affected by business activities, including i) own workforce and strengthening social dialogue, ii) end-users/consumers and ensuring the application of decent living standards; and iii) affected communities with sub-goals such as equity, inclusive growth and sustainable livelihoods.

Ultimately, a social taxonomy could be a step on the way to strengthening the social dimension of the EU. A robust framework would be one that focuses on the overall activity of a company and its impact, whereby a ‘substantial contribution’ would be recognised if criteria such as availability, accessibility, acceptability, and quality are fulfilled and none of the three main objectives violated.

In Case You Missed It

• Local and regional politicians have voiced preliminary support for a fast-tracked set of recommendations that focus on the reconstruction of Ukraine. The recommendations place an emphasis on emergency response, restoration of critical infrastructure and services, reduction of greenhouse-gas emissions by 65% by 2030 and rebuilding social infrastructure in order to attract Ukrainian refugees and displaced persons back to their pre-war homes.
• European Supervisory Authorities (ESAs) announced new proposals to add to Sustainable Finance Disclosure Regulation (SFDR) for nuclear and gas investments. Under the new proposals, providers of investment products classified under SFDR as Article 8 or Article 9 would be required to provide a yes/no disclosure regarding the product’s intention to invest in nuclear or gas, and, if yes, to provide a graphical representation of the proportion of investments in such activities.
• Nestlé strengthens its commitment to sustainable coffee sourcing and doubles its spending by investing over 1 billion Swiss Francs by 2030. The company, which had previously pledged to source 100% responsible coffee by 2025, announced that it will also aim to source 20% of its coffee from regenerative agricultural practices. Nestlé’s announcement comes on top of similar pledges by several other multinationals in the fight against climate change, such as IKEA’s pledge to make 100% of home deliveries by electric vehicles by 2025.

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