Climate change is the topic du jour and, along with other ESG issues, is not high up on global governments' agendas only... According to the TCDF Status Report 2019, we are seeing an increasing demand from investors for "better information on how companies – across a wide range of sectors – have prepared or are preparing for a lower-carbon economy". In fact, 2018 saw the incorporation of ESG factors into investment decision-making processes double to almost 43%.
Strong ESG performance = strong company performance
At least 85% of FTSE 100 companies do not have adequate carbon-reduction strategies in place, and over a third of the world's 200 largest companies do not fully disclose their GHG emissions. The planet is certainly in danger, but what about business? In 2017, the OECD reported a growing consensus that ESG factors are critical to the health of any company. Companies with strong ESG performance enjoy better brand image, a more loyal and stable customer and employee base, lower cost of capital, better access to finance and, ultimately, a greater focus on long-term value creation.
It's all in the data
While demand for ESG data is high, the data itself is often insufficiently detailed and not comparable within industries due to the lack of standardized disclosures and metrics. Some companies may choose to ignore requests for ESG information from shareholders and investors since they can be time-consuming and expensive, but at what price? To name but one negative consequence, S&P changed its rating on more than 100 companies between 2015 and 2017 for ESG-related reasons.
Some requirements focus on climate change, others cover the full spectrum of ESG factors. Some home in on disclosures, others enforce business change. Financial services companies are required to integrate ESG into their business models resulting in a significant second-order effect on entities they invest in.
Global ESG action
Various countries are certainly waking up to the reality of ESG. France currently leads the way in legislative requirements with institutional investors and fund management companies required to report on ESG factors in their annual reports since 2017. Luxembourg published its Sustainable Finance Roadmap last year, in response to the 2030 Agenda for Sustainable Development as well as the objectives of the Paris Agreement. The Grand Duchy also created a legal framework for green covered bonds linked to renewable energy projects. More recently, the Chamber of Deputies introduced the draft of law 7433 modifying the UCITS Law to reduce the annual subscription tax rate to 0.01% for funds with a sustainability certification and an ESG, green or social purpose in their investment strategies. Compliance with these conditions might need to be certified by an independent auditor. The Ministry of Finance highlighted their commitment to giving "an extra boost to a booming sector in Luxembourg and to be a precursor in terms of more favorable taxation to be reserved for sustainable finance."
EU regulation set to transform the ESG landscape
The EU Sustainable Finance Regulation is expected to have far-reaching effects within the EU and beyond. So, what is actually required?
- Environmental focus
Harmonized criteria (taxonomy) to define whether an activity is environmentally sustainable.
- Sustainability risk incorporation
Portfolio managers must disclose the integration of sustainability risks (SR) in their investment decision-making process, as well as publish due diligence policies and action taken (if they consider investments decisions to have an adverse impact). Fund prospectus must include descriptions outlining the way SRs are integrated into investment decisions and assessment of the likely impact of SRs on the returns of financial products. By 2022, every financial product will have to disclose if (and how) it considers adverse impacts on sustainability factors.
- Suitability tests
Intermediaries must identify clients' sustainability preferences. Asset managers, therefore, will have to set up new controls to incorporate SRs into their internal procedures and investments processes, review all policies and documentation, and adapt pre-contractual and periodic disclosures to investors.
The business implications of climate change
The investment needed to meet the Paris Agreement is estimated at an additional (astronomical) EUR 180 billion annually. Many sustainable and innovative businesses will be successful and have green bonds available to finance themselves.
The TCFD reports that while climate-related financial disclosures are improving, there is still a long way to go to achieve sustainable operating models that meet the Paris Agreement goals. Involvement of risk management and finance functions is critical to mainstream climate-related issues.
Risks of misselling
It is crucial to integrate ESG into the existing data governance framework. The lack of consistent and reliable data associated with poor ESG governance creates a multitude of risks across the business, in areas such as investment, marketing, investors and regulatory reporting, and compliance.
Times are certainly changing...More than two-fifths of largest companies have opted for external assurance of their sustainability reports...a figure that will most likely increase in the future.
The time is clearly now.
ESG in Numbers
16 percentage of companies worldwide that opt for external assurance (a figure likely to increase as stakeholders put greater demand on the quality & reliability of non-financial data)
49 per cent. Proportion of sustainable investing in Europe relative to total managed assets. This compares with 25.7% in the US, 63.2% in Australia/New Zealand, and 18.3% in Japan
91 percentage of investment firms that say governance has the greatest impact on investment decisions
50 percentage of surveyed CFA Institute members who believe independent verification of ESG information should be similar to an audit
123 companies in the S&P 500 with a board-level sustainability or responsibility committee
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