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As the world moves on from COP26, how might the asset management industry change its approach to ESG measurement?
When the UK hosted the UN climate change conference COP26 earlier this month, organisers and pundits called it “the world’s best last chance” to get the climate emergency under control by finalising the legally binding Paris Agreement.
Looking beyond the headlines, though, analysts are warning that the goal of limiting global warming to 1.5°C has been missed. Based on the pledges made at COP26, Climate Action Tracker calculates that these will still see temperatures rise by between 1.8°C and 2.1°C.
Additionally, according to S&P Global estimates, two thirds of major global companies hold “at least one asset at high risk” of physical climate change in a high-impact scenario.
A key sticking point in knowing how to address high risk has been the fact that no globally agreed regulation yet exists to verify the ESG practices of businesses and products. While COP26 saw the International Financial Reporting Standards (IFRS) Foundation announce the creation of the International Sustainability Standards Board (ISSB), the world will still have to wait for the substance.
And time is not in great abundance. As James Green, Client Portfolio Insight Lead at NatWest Trustee and Depositary Services (NatWest TDS), points out, frameworks for measuring financials have been refined over 100-plus years, to the point where data can easily be automated, but “we haven’t got 150 years for an ESG framework to evolve”.
Globally, the task at hand remains enormous.
Climate stress test: the CBES
In June 2021, the Bank of England conducted its first climate-related stress-testing exercise – the Climate Biennial Exploratory Scenario (CBES) – and is due to report in May 2022.
The CBES complements three aspects of COP26: to scale up finance and support; encourage ambition through carbon markets; and enable the transparent reporting of action and support. Ahead of the CBES launch in June, Sarah Breeden, BoE Executive Sponsor for Climate Change, explained that the exercise would be guided by three principles:
- incentivising companies to make an orderly transition to net zero emissions
- influencing the thinking of large investors
- making more demanding requirements on firms over time
CBES is running three scenarios – of taking early, late or no additional action against climate change – up to 2050. The scenarios look at risks arising from making structural changes to economic systems (transition risks) and the dangers associated with the rising global temperature (physical risks). The stress test involves various major financial stakeholders, including NatWest Group, speaking in depth with counterparties to extract information. As well as providing fixed balance sheet projections separately, they are considering management action that would be taken in each scenario to mitigate risk and approach new opportunities.
James Green hoped for a breadth of outcomes from COP26 that every nation and industry would support and put into action “If the agreements reached at COP26 are not executed upon then we may feel warm and fuzzy for a while but that will quickly give way to a feeling of fear as reality sinks in.”
“Ultimately,” he adds, “I want to see the convergence of standards and regulation. Everyone in line, every company reporting consistently and transparently on all aspects of their business so Capital can be allocated and monitored in a reasonable, auditable fashion.”
Further sticking points
David Marriage, UK ESG lead at PwC for asset and wealth management, says that the current way organisations investigate ESG, using sustainability reports compiled by a variety of analysts in the market, means there is “no independent view of accuracy in terms of the data”.
The likes of the Financial Stability Board’s globally focused Task Force on Climate-related Financial Disclosures (TCFD), the EU Taxonomy and the Value Reporting Foundation exist to guide finance professionals in the right direction. However, one anonymous source in asset management said that most calls with their clients were about ESG, asking what to do next. “There’s a gazillion different types of report they should be producing, all these different regulators coming out with new things; the EU Taxonomy, TCFD – the list goes on and on.”
Another sticking point, according to David, is that investigating climate data can lead to unintended consequences: “The more I look in my supply chain and find things and report them, I look worse than someone who hasn’t bothered. So we need to think about how we make sure transparency is rewarded in terms of the way we think about ESG.”
Regardless, “there’s been a massive shift in the market requirement,” adds Marriage. He points to “significant funds” now flowing through ESG mandates, in the range of £70trn to £100trn of assets. “We’ve seen investors and consumers start to take into account whether they’re really protecting the planet and society with their investments and purchases.”
“The more I look in my supply chain and find things and report them, I look worse than someone who hasn’t bothered. So we need to think about how we make sure transparency is rewarded”
David Marriage, UK ESG lead, asset and wealth management, PwC
Green observes that ESG investing “has to be checked just as carefully as any other type of investment”. He explains “If an investment manager says we’re not going to invest in companies that are involved in the oil and gas industry, it’d be up to us to find examples of portfolio investments that were.”
Deep exploration unearths information that requires someone senior to make a final call on a security’s suitability. He explains: “We had one example where a client’s portfolio had an investment in Alphabet, Google’s parent company, and it came up as having exposure to oil and gas. When we dug into it we found that Google had been producing artificial intelligence software for oil and gas companies. The big question is: is it really connected to oil and gas or is it to software?”
Tools to aid understanding
Greater knowledge of the factors that raise exceptions around securities can only be good for asset and fund managers. But as well as creating tools for them, some people believe there is scope to help the general public better assess the green credentials of everything they buy and use. Enter social enterprise and not-for-profit groups, such as Rewired.Earth, which is concerned that ordinary citizens might have difficulty finding and comparing ESG sources.
Rewired.Earth is on a mission to develop – and give to the markets – a digital ESG portal “where anybody can have a look at a company and say, ‘Yes, broadly, this one’s good for the planet”. Companies would generate visual red, amber or green ratings aligned to UN ESG priorities and regulations/standards. Those who wish to could explore the underlying data in more detail. “A lot of people are keen to use a framework that links the investor back into what’s actually going on in the market and the consumers, in such a way as you create a proper holistic storyline,” Rewired.Earth says.
It is little wonder, in their long wait for a standard regulatory framework, that financial services firms have developed their own analytics platforms and tools to help clients unpick ESG gaps and responsibilities.
For Green, the evolution of ESG investing has changed his role permanently, and soon enough, he says, it will be “almost impossible” for anyone to continue greenwashing: “If you have a climate impact fund, your natural inclination is to expect investments in it to be in things like wind and solar energy. If your prospectus says you can have oil and gas, we may say you can’t call it a climate impact fund.”
A big oil firm may put aside $10bn for environmental transition, but a better investment for ESG purposes would be 100% focused on renewables. Green says letting the big companies take the hit for a while would help to reset the cost of capital in favour of companies doing the right thing.
Doing the right thing
While it is the role of politicians to orchestrate overall action on climate change, financial markets could be doing a lot of the heavy lifting.
For Marriage, COP26 represented a chance to mobilise “the most powerful force in the world to make the difference – which is the financial markets and the capital markets more broadly.
“If you do the right thing, your share price goes up, and you can only do that by creating a level playing field in this space.”