Is a dam environmentally friendly or not? That question, confounding analysts of ethical investment, is about to be answered. As a form of renewable energy, hydropower is less polluting than coal. But barrage construction destroys major wildlife habitats as well as flooding human communities. Some investors concerned with environmental, social and governance (ESG) factors consider it green. Others screen it out. And it is not the only type of installation open to ambiguous interpretation. Other examples include fossil fuel sites which contain a few low-carbon features. As a result, an inconsistent patchwork of investment has emerged described as socially responsible and environmentally friendly, often well intended but also easy to manipulate.
But if the new pronouncements of a core of forward-looking financial experts are accepted by government, these shifting definitions will come to an end. Concerned about delays in cleaner development, the group has made a series of major recommendations to the European Union on sustainable finance. Further proposals are expected in the UK.
Among their concerns are more transparency, comparability and consistency on ESG factors in reporting, decision-making and transactions for all investment. Known as the High Level Expert Group (HLEG) on Sustainable Finance, the group established by the European Commission (EC) in December 2016, wants investors once and for all to distinguish the brown from the green, equal opportunity from social exclusion, and to view all investment decisions through an ESG lens. Members of the group represent not just ethical investment institutions but also more diverse organisations, such as Christian Thimann, senior advisor to the chairman of AXA, and Steve Waygood, chief responsible investment officer at Aviva Investors.
The aim is to blend information about sustainability into investment, as well as integrating sustainability, using ESG factors, firmly into the governance of financial institutions. But without appropriate, rigorous standards and labels for financial managers, that goal will not be achieved.
Activists draw attention to gaps in current intelligence caused either by non-disclosure or unreliable metrics and criteria. More knowledge, they argue, is required because ESG factors are material risks. At the same time, better knowledge would allow investors to match their investments with environmental requirements embedded in policy by funding the most appropriate energy installations, for example. “Financial markets work on the basis of information; the more information there is, the better they work. This is about establishing a market for a two-degree world”, explains Mark Lewis, an energy equity specialist as well as member of the Task Force on Climate-related Financial Disclosures (TCFD), whose recommendations in 2017 on climate risk and disclosure have informed the HLEG. These are likely to be incorporated into existing EU reporting legislation.
If business-as-usual prevails, however, most current investment will contribute to more than three degree increase in global temperatures by 2050. That is well above the two degree maximum above pre-industrial levels agreed at the Paris Agreement on climate change in 2015, on which European climate policy is now based. Three degrees would create severe penalties to ecosystems, substantial species extinction and climate turmoil. This would have major economic impacts on supply chains and infrastructure, for example.
Hence, after years of controversy over carbon footprints and offsets with diverging definitions, vague ESG criteria, and shaming pollution incidents created by well-regarded corporations, a new threshold has been reached. It is a moment many of these activists have dreamed of: a solid framework of ESG definitions and standards impressed into all investment. This, they suggest, would create a much more reliable hierarchy separating the ESG leaders from laggards.
Until such uncertainties are resolved through clear classifications, the environmental benefit of much investment in energy and environmental technologies through, for example, the evolving market of green bonds, will remain in doubt. A new performance bar based on disclosure would improve investor understanding and encourage participation. “Once it’s competitive to declare, you’ll probably find more and more investors will put their money with asset managers that provide more information” comments Lewis.
Political leadership driving the project already emerged a couple of years ago. In France, a pilot for European reform is already under way through an innovative regulation known as article 173 in force since 2016. Embedded into France’s 2015 green growth (LTECV) law, passed during the tenure of President Francois Hollande, the rule requires asset managers and institutional investors to describe how they are incorporating ESG factors into their investment strategy. Companies with assets valued at more than EUR 500 million also have to report on how they are incorporating climate risk into fund management and contributing to financing the energy and environmental transition described in the law. All asset classes are included.
So far, it has met with mixed success since reporting started in 2017. Early investigations of disclosures by insurance companies and pensions funds, for instance, found much of the data obscure, hard for the consumer to follow, irrelevant or non-existent. According to Indefi, a financial market research company, out of the 51 institutions publishing information about ESG considerations, 49% practised exclusion and 59% practised ESG integration. In addition, 71% published a carbon footprint, which in most cases related to their equity holdings alone. Only one quarter published a description of a trajectory minimising their impacts to below two degrees Celsius, and 41% analysed climate risk – although both these activities are a requirement of the law.
It is an uncomfortable and time-consuming requirement to comply with, and investors are still feeling their way on the law. However, opposition has been considerable, as one executive observes. “I wonder whether a reporting requirement would bring us further than we are already. From talking to managers dealing with this in France, I understand it is very difficult to report properly”, states chief investment officer Jelle van der Giessen of Dutch insurer and asset manager the NN Group, a minor player in the French market but lobbying on the potential replication of the regulation in the Netherlands and across the EU.
As he indicates, other options for driving change could work better and are less costly, such as the more direct channel of shareholder pressure. “If I had to spend one euro on engagement or on reporting, I’d choose engagement and going beyond a policy of divestment. It’s not clear what is being added by obtaining reports or whether that is helping us,” he says.
Any similar law proposed at the EU level might thus go one step further than demanding more non-financial disclosure, which is already required of corporations but not investors in the 2014 Non-Financial Reporting Directive. This obliges companies to include non-financial statements in their annual reports from 2018 onwards. The high-level group’s endeavour suggests authorities would exact precise and uniform disclosure of ESG criteria, and more specifically by investors, by upgrading current legislation. Only this would improve asset performance comparisons.
Where it once led with the 2006 Companies Act, which required quoted companies to disclose annual greenhouse gas emissions in their directors’ report, Britain is now a step behind. However, a similar investigation was launched by Defra in September 2017, and parliamentarians are now conducting an inquiry on green finance. Initiatives similar to the European Union may come through thereafter. “I’d expect legislation [on ESG reporting by investors] to come through in the next three to five years”, suggests Jon Williams, sustainable finance partner at PwC.