Top Ten: nine à la page ESG matters and a call to action

In recent months (both pre- and during COVID-19) the world has been awash with Environment, Social and Governance (ESG) developments. ESG appears to be weathering the COVID-19 storm, and to be seen, at least in part, as an element of the solution. Though climate change has momentarily (we think) been pushed out of the headlines, we are reminded of the strength of nature and its ability to bring both human and economic activity to a standstill. With that in mind, and with a view to an ESG-friendly (if not ESG-led) recovery, here are ten topical things that we love about ESG.

1. ESG out-performs

“This period of market turbulence and economic uncertainty has further reinforced our conviction that ESG characteristics indicate resilience during market downturns,” said BlackRock in Q2 2020. “Companies managed with a focus on sustainability should be better positioned versus their less sustainable peers to weather adverse conditions while still benefiting from positive market environments.” Investment funds set up with ESG criteria remain relative safe havens in the economic downturn caused by the coronavirus pandemic, according to an analysis released by S&P Global Market Intelligence. In November 2019 McKinsey outlined five ways that ESG-related factors create value:

• A strong ESG proposition helps companies tap new markets and expand into existing ones. When governing authorities trust corporate actors, they are more likely to award them the access, approvals, and licences that afford fresh opportunities for growth.
• ESG can also reduce costs substantially. Among other advantages, executing ESG effectively can help combat rising operating expenses (such as raw-material costs and the true cost of water or carbon), which McKinsey research has found can affect operating profits by as much as 60 percent.
• A stronger external-value proposition can enable companies to achieve greater strategic freedom, easing regulatory pressure.
• A strong ESG proposition can help companies attract and retain quality employees, enhance employee motivation by instilling a sense of purpose, and increase productivity overall. Employee satisfaction is positively correlated with shareholder returns.
• A strong ESG proposition can enhance investment returns by allocating capital to more promising and more sustainable opportunities (for example, renewables, waste reduction, and scrubbers).

2. We now know what an environmentally sustainable economic activity is (at least in the EU)

On 15 April 2020, the European Council adopted a “Taxonomy Regulation” which identifies those economic activities that the EU considered to be environmentally sustainable. The Taxonomy Regulation recognises six different types of economic activities which qualify as environmentally sustainable activities for the purposes of the taxonomy, being climate change mitigation, climate change adaptation, sustainable use and protection of water and marine resources, transition to a circular economy, pollution prevention and control and protection and restoration of biodiversity and ecosystems. Under the Taxonomy Regulation, in order to qualify as an “environmentally sustainable economic activity” (as defined in the regulation), an activity must substantially contribute to one of these six objectives. It must also not significantly harm another of the environmental objectives above, comply with technical screening criteria which is being developed by the Commission and be carried out in compliance with a number of minimum social and governance safeguards. The taxonomy in the regulation is already being deployed in the context of disclosure requirements and green bonds.  However, it appears to be being picked up by a broader range of international actors in different sectors who are seeking to answer the question, “what is green”? It remains to be seen whether the UK will be bound by recent EU ESG developments.

3. It’s all about disclosure….

The Taxonomy Regulation requires firms to disclose the degree of environmental sustainability of mainstream funds and pension products that are promoted as environmentally friendly, or to include disclaimers where they do not. Firms subject to the EU’s Non-Financial Reporting Directive will be required to provide certain information in relation to the Taxonomy Regulation in their related filings. Disclosure requirements in the UK were updated from 2019. UK legislation now requires companies to report their global scope 1 and 2 GHG emissions in tonnes of carbon dioxide equivalent (including all seven gases included under the Kyoto Protocol), and a chosen emissions intensity ratio in their Directors reports for the current and previous reporting periods. In addition, they are required to report their underlying global energy use for the current reporting year, and after the first reporting year, a comparison with the previous year. Scope 3 reporting remains voluntary, but is strongly recommended for material emissions sources. Large unquoted companies and LLPs are subject to similar requirements. Further, the Task Force on Climate-related Financial Disclosures (TCFD) has been set up to develop a set of recommendations for voluntary and consistent climate-related financial risk disclosures. By this time last year, 785 companies had committed to support TCFD and 340 investors with nearly USD34 trillion in assets under management has asked companies to report under the TCFD. There are growing suggestions that TCFD disclosures will become mandatory.

4. … and the circular economy…

In March 2020, the European Commission adopted a new Circular Economy Action Plan (the original having been adopted in 2015). This is one of the main blocks of the “European Green Deal”, also adopted in 2020, and which sets out Europe’s new agenda for sustainable growth. The Plan announces initiatives for the entire life cycle of products, targeting for example their design, promoting circular economy processes, fostering sustainable consumption, and aiming to ensure that the resources used are kept in the EU economy for as long as possible. It introduces legislative and non-legislative measures. The Plan sets out measures to make sustainable products the norm in the EU to empower consumers and public buyers; to focus on the sectors that use most resources and where the potential for circularity is high such as: electronics and ICT; batteries and vehicles; packaging; plastics; textiles; construction and buildings; food; water and nutrients; to ensure less waste is created; to make circularity work for people, regions and cities; and for the EU Lead global efforts on circular economy. All companies will need to be part of this effort.

5. … so we need to get better at supply chain management and due diligence (quickly)

On 29 April 2020, the European Commissioner for Justice announced that the European Commission will develop legislation that would require EU companies to carry out human rights and environmental due diligence. The Commissioner confirmed that a legislative initiative would be introduced by 2021. Details of the exact legal mechanism will follow, but according to the Commissioner, any legislation would be “inter-sectorial, mandatory and of course with a lot of possible sanctions”. The announcement follows the publication of a study in February 2020, commissioned by the European Commission, which revealed widespread support among business respondents for EU-level mandatory human rights due diligence legislation. The Study also illustrated that there is a significant variance in how businesses currently manage human rights and environmental risks in their supply chains. More than two-thirds of business respondents reported their due diligence practice to include training on human rights or environmental impacts, contractual clauses, codes of conduct and audits. Internal and external investigations and engagement with human rights and environment experts were other steps adopted by a minority of business respondents. In the view of FTI consulting, “While traditional corporate governance will remain an area of focus—particularly around initiatives to improve board quality, shareholder rights and management incentive structures—the governance of environmental and social (E&S) issues will take center stage for investors and boards. The management of E&S risks will emerge as the new standard of comprehensive corporate governance practices. Expect the corporate social responsibility efforts of companies to move beyond simply “giving back to society” to also incorporate sustainability as a tool to systematically manage risk and create long-term shareholder value. Additionally, understanding a company’s impact on the environment and society will feature as essential expertise at the board level, with sustainability experts becoming key additions to many boards.”

6. Green, social and sustainable financial activities are on the rise

How will all this get paid for? In early 2020, Environmental Finance forecast that “the strong growth momentum in Green Bond issuance will continue in the current year. We expect the Green Bond market to grow in 2020 by around 45% to 370 billion US-Dollar, hence exceeding the 300 billion US-Dollar mark for the first time.” In addition, Environmental Finance predicted that the diversification of the market in terms of both issuers and bond types will continue in 2020 and the following years. New issuance of ESG, Sustainability and Sustainable Development Goals Bonds as well as Social Bonds will continue to support the growth of the total Sustainable Bond market. The number of Sustainability-linked Bonds will rise encouraging outcome-focused sustainable finance. The European Commission is currently consulting on updating its action plan on sustainable finance. The EU has also introduced its own EU Green Bond Standard, which is underpinned by the Taxonomy (see above). The Climate Bonds Initiative has a long-established framework for certifying bonds and climate-friendly. ICMA already has standards for green bonds, social bonds and sustainability bonds.

7. The world is heading to net zero by 2050

Net zero is a statutory target set by the UK’s Climate Change Act 2008 for at least a 100% reduction of UK greenhouse gas emissions by 2050 (compared to 1990 levels). Nestlé, Repsol, Qantas, Duke Energy ThyssenKrupp, HeidelbergCement, Vale and BP, have all committed to net zero emissions by 2050. According to PRI, “Short and medium-term targets will likely be needed to ensure these companies are set on strong implementation paths. Will the methods these companies use to achieve their targets be credible? Robust emissions reduction methodologies, such as science-based targets, will likely be needed to measure and track progress over time.” However, by the end of December 2019, according to the World Economic Forum, Just 67 countries and eight US states had a net-zero ambition.  Even fewer have sufficient policies and legislation in place. The European Commission set out its vision for a climate-neutral EU in November 2018, looking at all the key sectors and exploring pathways for the transition. The Commission's vision covers nearly all EU policies and is in line with the Paris Agreement objective to keep the global temperature increase to well below 2°C and pursue efforts to keep it to 1.5°C. As part of the European Green Deal, the Commission proposed on 4 March 2020 the first European Climate Law to enshrine the 2050 climate-neutrality target into law. This is likely to be passed during the course of 2020.

8. And because of all this, ESG data is a big new thing

The market for ESG data could reach $1 billion by 2021, according to a March 2020 research report from Optimas. Those seeking ESG comparators have increasing access to ESG data. For example, Refinitiv states that its ESG data covers nearly 80% of global market cap and over 450 metrics. Firms can use Refinitiv’s ESG Contributor Tool to upload ESG data to the Refinitiv ESG database to ensure thousands of investors are able to retrieve the full view of a company. Al Gore, former Vice President and co-founder and chair of Generation Investment, has said “The sustainability revolution is powered by new digital tools. It has the magnitude of the industrial revolution and the speed of the technology revolution. It is the single largest investment opportunity in all of history.” Sustainalytics, a globally recognised provider of ESG ratings and research, has 25 years of experience covering more than 40,000 companies on hundreds of ESG performance indicators. Its 650 employees provide sustainability ratings for more than 20,000 companies that can be customised to clients’ specifications.

9. Securities regulators are fully on-board

The Board of the International Organization of Securities Commissions (IOSCO) published its final report on ‘Sustainable Finance and the Role of Securities Regulators and IOSCO’ in April 2020. In its report, IOSCO noted that sustainability- and climate-related issues raise important challenges to securities regulators in meeting their core regulatory objectives of protecting investors, reducing systemic risk, and maintaining fair, efficient and transparent markets. However, IOSCO has served as a forum for regulators to discuss coordinated approaches, identify cross-border issues, avoid regulatory conflicts, and knowledge-sharing to address such challenges.

Market participants should be aware that many securities regulators now carry out supervisory functions relating to risks associated with greenwashing of financial products, albeit under already existing general miss-selling provisions or, more specifically, under rules of misrepresentation and wrongful disclosure on listed and unlisted capital market products, in the current absence of specific rules directed at ESG greenwashing.

10. Over to you

Even the nine factors outlined above might seem overwhelming, but they can be divided into bite-sized and manageable chunks. There is a wealth of regulatory and technical advice available to draw upon, as well as a range of international standards to help anyone wanting to take action to get started. Equally, those who are already way up the ESG curve are not short of matters that they can work on to ensure that their ESG principles are fully embedded within their businesses.

Our ESG recommendations are:

• Ensure that corporate risk management systems identify and evaluate ESG in the context of the company’s strategy. As well as identifying potential ESG risks, this should involve consideration of whether there are opportunities to make the business more attractive to investors from an ESG perspective. Consider an audit of whether systems are being properly applied and values are been fully embedded.
• Consider how ESG factors are managed, including in the supply chain. Create an action plan to tackle priorities and areas in need of improvement. Formalise due diligence measures – particularly in respect of third parties.
• Evaluate reporting of ESG factors, including voluntary reporting to inform investor decision making and to stay ahead of emerging reporting trends.
• Review existing policies and procedures for environmental and social risk management, and consider what obligations are created, including whether a parent company is responsible for any overseas operations. Ensure that policies are in line with international standards such as the OECD’s guidance on responsible business conduct.
• Participate in industry best practice schemes and discussions.
• Consider how big data can help. How do you measure up, what information do you have that could help you and what information do you need?