From climate change to biodiversity: Beyond the ESG buzz words

As COP 26 draws to a close and in a week where the first sustainability initiative in the trading space was launched, we look at the role asset managers can play in the climate urgency along with the standards and data needed to support the journey.

With COP 26 coming to a close in Glasgow, and the climate urgency intensifying, the importance of the role financial services will have to play in supporting the transition to a more sustainable future is only now becoming apparent. But what impact will this new role have? Aviva recently announced it will stop investing in and insuring coal companies by 2022 unless they commit to science-based targets. With only two months to the deadline, such commitments raise once again the importance of access to accurate relevant data in environment, social and governance (ESG) in the decision-making process.

The data investors need is still patchy, inaccurate, often subject to interpretation and remains focused primarily on carbon emissions. However, carbon emissions are just the beginning of the ESG journey and as more areas come under scrutiny, the data currently available could soon become inadequate for financial services to meet tomorrow’s challenges. Increasingly, asset managers need to collect data from multiple sources to build a sufficiently adequate picture of a company’s future risks and opportunities. Just over half of asset managers are now electing to engage with companies directly, according to a report “Research – Changing the rules of engagement”, commissioned by Liquidnet, given the level of information that is now needed about a company. Rather than rely on external ESG rankings, this direct company data is then fed into internal models that enable portfolio managers to come up with their own ranking as to what represents a good ESG investment or not.

From climate change to biodiversity

The Paris Agreement focused on lowering global warming to below 2°C and channelling resources into mitigating the effects of climate change. Now biodiversity is emerging as the next area of focus for capital markets and will greatly expand the amount of data points asset managers need to collect, analyse and integrate into their investment decisions. The industry now needs to turn its attention to the Task Force on Nature-related Financial Disclosure (TNFD), which aims to build on the Task Force on Climate-Related Financial Disclosures (TCFD) framework to provide financial institutions and corporates with the means to measure and report nature-related risks and opportunities. With 21 targets to reach by 2050 and 10 milestones to achieve by 2030 including 30% of global land and sea areas conserved, halving the rate of species extinction and scaling up global financing to tackle biodiversity loss by $200 billion per year, the agenda is ambitious and far-reaching.

The shift from climate change to biodiversity will uncover a new range of risks investors need to factor into their decision-making process. According to a report from Moody’s Investors Service 12 sectors with a combined $2.1 trillion in debt and including extractive industries such as mining face high natural capital risks today. A further 16 sectors with a combined $8.3 trillion in debt and including retail and apparel have a moderate exposure. Alongside biodiversity, water stress is yet another area to address. Whether it is physical water risk such as flooding that could impact the future value of lands and properties or water scarcity that affect entire populations as well as business and agricultural operations, capital markets have yet to uncover what it really means for the companies they invest in and appropriately price these risks. According to a report from De Nederlandsche Bank, of the names held in equity portfolios by Dutch financial institutions at the end of 2017, over 20% have facilities that were located in extremely water-stressed regions.

The role of international standards

Initiatives are multiplying at the regional regulatory level to mandate what companies are required to disclose in order to avoid greenwashing. The EU announced the Corporate Sustainability Reporting Directive (CSRD), which under current proposals could mandate up to 50,000 companies operating in the EU to report non-financial data, up from the current 11,700[2] companies currently subject to the Non-Financial Reporting Directive (NFRD) today. The UK and the US respectively launched consultation papers in 2021 to build their own framework for climate-related disclosures. Yet, despite the push for greater transparency and accessibility of non-financial data, the proliferation of regional regulations will do little to help asset managers assess the ESG credibility of their investments given the global nature of portfolios. Data comparability is key, and the multiplication of conflicting standards will hamper progress at a time when more commitments are being asked of the financial industry.

Global ESG standards already exist but the development and updating of these standards requires greater collaboration, not only from regulators but also from the industry. The International Organisation for Standardization (ISO) has developed a range of standards that can assist with ESG investments; The Legal Entity Identifier (LEI) can be leveraged to identify parties for ESG activities and reporting. The International Securities Identification Number (ISIN) identifies financial instruments and can be used in connection with the reporting and identification of financial instruments linked to sustainable activities, such as green bonds. The Unique Product Identifier (UPI) could help an investor identify the company as Volkswagen, for example, and the financial product as capital raising for renewable energy.

The wider adoption of these existing global standards is particularly relevant as industry participants are calling for the implementation of a system to map companies’ information to the Security Master by means of LEIs or ISINs. These standards would help identify the underlying security and be able to transmit this information through automated workflows, which will provide for greater standardisation and comparability of the data.

The public and private sectors are multiplying their pledges to tackle climate change to achieve a zero-carbon economy in the decades to come. 33 financial institutions representing over $8.7 trillion in asset under management committed to focus on agricultural commodity-driven deforestation to create a more sustainable way to produce and consume. Yet, as an ever-increasing number of sectors get caught up in the race to greater sustainability, the next question the industry will need to consider is what this will mean in terms of liquidity. While a portfolio manager can have the best investment idea, the inability to enter or exit a strategy in a timely manner could have dire consequences on a portfolio return. As more sectors fall out of favour, market participants have yet to understand the ramification of the explosion of ESG investments on trading.

Despite the industry eagerness to jump on the ESG bandwagon, consumers, regulators, and some market participants are starting to question some of the green claims and the risk of greenwashing. The FCA highlighted their concerns when disclosing their ESG strategy; if the financial sector is to address the sustainability challenge in front of us, our current market structure needs to be re-thought to support that shift. There needs to be an appropriate regulatory foundation to ensure consumer confidence and adoption, and this means access to quality information, a robust ecosystem and clear standards to be adopted. The difference between public and private equity no longer matters; if corporates want to raise capital in the future to fund their projects, they will need to ensure their business model is viable on the long term and not only from a carbon emissions perspective but by considering all environmental and social variables.

Although experts have worked on these sustainability topics for decades, capital markets are only at the beginning of the necessary transition. We are just scratching the surface of what ESG actually means, the data needed to support it, whether and where it can be sourced and verified, and how this can be managed across an organisation with different funds and investment strategies. And yet, we will have to learn fast; the trend seems unmistakable; ESG Is here to stay.