SUSTAINABLE FINANCE, REGULATION
Journey to green in ESG transformation
21 May 2021
As capital pours into ESG investing strategies and sustainability linked debt becomes mainstream, how are regulatory frameworks developing to support this growth and prevent greenwashing? flow’s Clarissa Dann brings together key points from dbSustainability Research analysis
In our earlier article, Building ESG investor frameworks, flow reported on how the EU is driving sustainability focussed regulation that will ultimately require European fund managers claiming to be sustainable to reveal the portion of sustainability-aligned investments in their portfolios using the EU Taxonomy framework (an investment classification system). This update provides further detail on progress towards a globally accepted benchmarking tool, and how investors are seizing the opportunity to support transformation.
EU Taxonomy Framework update
As a reminder, from 2022 European corporates with more than 500 employees will need to disclose their revenue/turnover and capex that is aligned with the EU Taxonomy (i.e. sustainable), while European investment funds will need to disclose what percentage of assets held are aligned by 31 December 2022.
Debbie Jones, Global Head of ESG, Company Research adds in the #dbSustainabilityTracker (21 April), that “Conceivably, US companies will need to as well, if they wanted to be owned by funds in the region (Europe) claiming to have a sustainable objective or borrow for green projects in Europe”. The tracker explains that business activities are considered to be green under the taxonomy if they substantially support one (or more) of six objectives:
- climate change mitigation,
- climate change adaptation,
- sustainable use and protection of water and marine resources,
- circular economy,
- pollution prevention and control, and
The purpose of the taxonomy, which creates a sustainable investment classification system, is to help drive capital towards sustainable activities and investment, as well as support a green bond framework.
Entered into force on 12 July 2020, the EU's Taxonomy regulation, is, explains the EU in its Press Corner, “a living document and will continue to evolve over time, with more activities being added to its scope by means of amendment”. Agriculture and certain energy sectors not yet included are expected to be rolled out during the course of 2021.
On 21 April, the EU provided an update, explaining it needed more time to make decisions regarding nuclear energy and natural gas (anticipated to be both a scientific and political issue debate). In addition, it held off a decision on agriculture and chose to wait until the Common Agricultural Policy is updated. The EU also extended the deadline for making a decision around bioenergy and forestry, although it did relax biomass criteria. Other points to note in this update were, “Commentary and positioning on hydrogen remains favourable, as expected” and “Carbon sequestration does not appear to be considered a sustainable activity”.
In his panel session at the 1 March dbSustainability ESG conference, Global Trends in Sustainability Regulation,1 Nathan Fabian, Chief Responsible Investment Officer at investor network Principles for Responsible Investment (PRI) and Chairperson of the European Platform for Sustainable Finance indicated that because the “negative impact of the financial crisis was very largely felt in Europe” the region’s policy leaders “thought we needed more direction on our financial market development as a bloc.
“We know sustainability is going to be an important part of that,” he added. Fabian pointed out that around 100 economic activities are covered by the taxonomy in preparation for “final detailed law” covering 90% of Europe’s emissions for climate mitigation and representing activities within sectors touching around half of the economic activity of European listed companies.
“When we look in our portfolios, very small proportions of the companies we invest in already meet green criteria,” said Fabian. He pointed out that in a typical equities portfolio when diversified only around 5% to 12% of it will be derived from investee company activities that meet the criteria. While an understandable reaction is “I don’t look very green,” “everyone is in the same boat,” he says.
Alignment with other frameworks
The EU’s 21 April press release made the point that “Very few countries outside the EU have developed taxonomy frameworks, such as China, while others are in the process of developing them. Consequently, the International Platform on Sustainable Finance (IPSF) has started a working group on taxonomies, co-chaired by China and the EU to undertake a comprehensive assessment of existing taxonomies developed by public authorities of its member countries. This work will result in a Common Ground Taxonomy to display the common features of existing taxonomies, starting with China and the EU. The Common Ground Taxonomy will be a solid basis to develop common standards.”
It added, “The EU will continue to actively contribute to the global effort to align frameworks defining sustainable activities (i.e. taxonomies), through the IPSF and in other forums such as the G7, G20 and Financial Stability Board.”
In October 2020, the OECD published a helpful overview of the taxonomies in place at the time in the report, Developing sustainable finance definitions and taxonomies.2 This said that the EU regulation “stands out in its combined approach of several environmental objectives, with a substantial contribution to one objective such as climate mitigation joined with a no significant harm requirement for other environmental objectives such as adaptation and other natural capital objectives”.
Along with sustainable finance definitions in Japan, France and the Netherlands, the OECD report sets out the broad framework of the “Chinese taxonomy”, pointing it that it is mainly regulation concerning green bonds.
China’s green credit and green bonds
China has created separate definitions of green credit and green bonds. The following is an extract from the report of China’s green credit regulatory guidelines and green bonds that amount to its “taxonomy”:
“The China Banking and Insurance Regulatory Commission issued green lending guidelines in 2012, Green Credit Statistics Forms in 2013, and Key Performance Indicators (KPIs) for implementing the guidelines in 2014. There are no environmental criteria or thresholds mentioned in the English translation of these documents. Further research would be necessary to identify environmental criteria and metrics if they exist. Banks are required to report every six months the loan balance of credits identified as green, and report the impacts of these credits on energy savings and emissions reductions, as well as water savings. Green credit sectors are agriculture and forestry, energy and water saving, nature protection, ecological restoration and disaster prevention projects, waste disposal, recycling and pollution prevention, clean energy, rural clean water projects, green buildings and green transportation. Green loans meeting eligibility requirements and having at least a double-A (AA) credit rating can obtain preferred central bank refinancing.”
“Under the supervision of the People’s Bank of China (PBOC), a China Green Bond Endorsed Project catalogue was issued in 2015 (Green Finance Committee, 2015). The catalogue applies to green bonds issued by financial institutions. Green bonds may be used as collateral for low-interest central bank loans, which gives financial institutions an incentive to issue them. The six categories of eligible green bonds are energy savings, pollution prevention and control, resource conservation and recycling, clean transportation, clean energy and ecological prevention and climate change adaptation. The catalogue provides detailed criteria and thresholds, in the form of references to domestic industrial standards and regulations. The PBOC also issued guidelines for listed and non-listed domestic corporate bond issuances, which are aligned with this taxonomy. Large banks such as Bank of China, the Industry and Construction Bank of China, and the Development Bank of China, have tapped global markets with green bonds, using international standards (more specifically, the Climate Bonds Standard issued by CBI).”
US green policy
In their ESG chartbook: Growth, performance, Biden (February 2021), Deutsche Bank Research strategists Jim Reid and Luke Templeman together with Debbie Jones ask “The US has lagged on ESG for years... could Biden be the catalyst that means it rapidly catches up?” On 8 April the tracker noted how President Biden’s US$2.3trn “infrastructure plan crystalised a number of “E” and “S” objectives, including provision of internet access to those underserved, delivering clean water, creating affordable/green construction, and support research efforts to create a low carbon economy. “Only US$621bn of the plan is targeted towards typical transportation development of which US$174m is earmarked for furthering electric vehicle (EV) infrastructure, an area where the US is behind,” they add.
As for shaping investor behaviour the Securities and Exchange Commission (SEC) has made a decisive start. Having announced its Climate and ESG Task Force in its Division of Enforcement on 4 March to identify misstatements or gaps in climate risk disclosures,3 the staff of the SEC’s Division of Examinations issued a risk alert on 9 April, which while having no legal force, nevertheless provides some insights into what could contribute to future regulatory framework development.4
The alert points out that the rapid growth in demand and increasing number of ESG products and services, coupled with a lack of standardised and precise ESG definitions, “present certain risks”. It adds, “The variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors. Actual portfolio management practices of investment advisers and funds should be consistent with their disclosed ESG investing processes or investment goals.”
The big focus on the SEC, however, is whether or not they will push for climate disclosure for corporates, although they seem to be working towards this – on 15 March the SEC called for public input in light of the demand.5 The SEC and the Biden administration appear to be signalling that they are open to participating in discussions to advance a global framework, but that is likely to take time.
“I believe the TCFD framework can set the global standard for climate related disclosure”
Task Force on Climate-related Financial Disclosures
In April 2015, the Group of 20 (G20) Finance Ministers and Central Bank Governors asked the Financial Stability Board to convene public- and private-sector participants to review how the financial sector can take account of climate-related issues. As part of its review, the FSB identified the need for better corporate disclosure information to support informed investment, lending, and insurance underwriting decisions and improve understanding of climate-related risks.
To help identify the information needed to assess and price climate-related risks, the FSB established an industry-led Task Force on Climate-related Financial Disclosures — the TCFD. The FSB asked the TCFD to develop voluntary climate-related financial disclosures that would be useful to investors and others in understanding material risks.
In its 2020 report, the TCFD said that “Companies supporting the TCFD represent a broad range of sectors with a combined market capitalisation of US$12.6trn. This includes just over 700 financial firms, responsible for assets of US$150trn. In addition, nearly 60% of the 100 largest public companies support the TCFD, report in line with the TCFD recommendations, or both.”6
The TCFD recommendations can be viewed on their website here. “I believe the TCFD framework can set the global standard for climate related disclosure. It focuses on financially relevant information and encourages scenario analysis that arguably will give investors comfort that a company has examined its climate impact, including the potential risks and opportunities,” says Deutsche Bank’s Jones.
Greenhouse gases and Scope 3 emissions
The Greenhouse Gas Protocol (GHGP), first published in 2001, is the most widely used corporate accounting standards for emissions. At present many companies disclose Scope 1 and 2 emissions, but not Scope 3.
In the #dbSustainability tracker report, What are Scope 3 emissions and why are they important? (26 April), analysts Debbie Jones, Liam Fitzpatrick and Luke Templeman say that “more requirements and incentives will no doubt be needed to be introduced if governments intend to make good on their stated environmental commitments”. They observe that while 127 countries have committed to or are considering committing to net zero emissions, “most have not explained how they will achieve this”.
The trio believes that regulation will be needed to require companies to evaluate their Scope 3 emissions to effect real change and approach carbon neutrality. As a reminder, Scope 1 direct GHG emissions are from sources that are owned or controlled by the company, Scope 2 are indirect GHG emissions from the generation of purchased or acquired electricity, steam, heat, and cooling, but Scope 3 are other indirect emissions from sources that are not owned and not directly controlled by the reporting company.
“Scope 3 is often referred to as the company’s value chain. It is an optional reporting category for the GHG protocol, but various stakeholders (e.g. governments, customers and investors) ask for this disclosure,” notes the report. It goes on to explain how in general terms, Scope 3 emissions include a corporate’s upstream and downstream value chain (e.g. suppliers and distributors), as well as business travel, leased assets, and even bank lending exposure. “It is typically the most difficult to calculate and frankly involves a lot of estimate,” the report’s authors add.
When it comes to lending and investment, alignment with Scope 3 is becoming increasingly important. The TCFD recommends that Scope 3 emissions should be measured and reported if appropriate. Deutsche Bank’s Jones, Fitzpatrick and Templeman note “This is important when considering BlackRock endorses this framework and has asked all public companies held to align their reporting with the TCFD. Considering that Scope 3 is a large portion of the emissions for many companies, it would seem that reporting them is, in fact, appropriate.”
They add that the UK’s Financial Conduct Authority will be requiring corporate disclosures consistent with the TCFD in annual financial reports published in 2022. “We would not be surprised to see the SEC look to elements of the TCFD when determining relevant and material financial disclosures,” they explain.
“Investors are interested in who can transition, how fast they can transition and can they provide clear evidence about progress”
Undeterred by Covid-19, retail investor appetite for sustainable exchange traded funds (ETFs) has accelerated. In Flow Tracker: US Industry Mutual Fund & ETFs (12 May), Deutsche Bank analysts Brian Bedell and Jacob Henry note, “2020 saw significant growth for sustainable ETFs in and outside of the US while flows YTD through April are currently on pace to easily surpass 2020 levels especially outside of the US.” See Figures 1 and 2.
Figure 1: US Sustainable ETF Flows (US$bn)
Source : Morningstar Direct, Deutsche Bank Note: includes both active and passive ETFs Data through 4/30/2021
Figure 2: Global ex-US Sustainable ETF Flows (US$bn)
Source : Morningstar Direct, Deutsche Bank Note: includes both active and passive ETFs Data through 4/30/2021
On a global basis, negative/exclusionary screening is the most used sustainable investing strategy (ranking first in Europe and second in the US), explain Jones and Brian Bedell in their paper, What are exclusionary trends in sustainable investing? This references the 2018 Global Sustainable Investment Alliance estimate that US$19.8trn in assets under management (AUM) employed this type of strategy (up 31% from 2016).7 “The 2020 report has not been published, and while ESG integration is the fastest growing strategy (+69% from 2016- 2018), we would expect an absolute increase in exclusionary screening given the significant flows into sustainable investing since 2018,” they explain.8
Their report points out that more utilised exclusions include what are often referred to as "SIN" stocks: adult entertainment, alcohol, gambling, tobacco, small arms and weapons, although “climate and energy base exclusions for thermal coal and nuclear energy have grown meaningfully in Europe” and other focuses include palm oil production, GMOs, animal testing, fur and leather, and military contracting.
Returning to the point made by PRI’s Nathan Fabian that “everyone is in the same boat” in that revenues from companies meeting ESG criteria only make up a small proportion of portfolios, the question is more of “where do we go from here?”
Fabian predicts that somewhere over the next 15 to 25 years, this low level aligned investments needs to rise to around 50% to 60% − “a big shift”. Nobody expects all capital to move into those sectors overnight, so, explains Fabian, “we have a transition discussion”. Investors are interested in “who can transition, how fast they can transition and, can they provide clear evidence about progress”.
While the EU Taxonomy is “just one tool” it is still an important benchmark that helps investors support companies with good transition plans, says Fabian. In a later session at the same dbSustainability virtual conference, Henrik Pontzen, Head of ESG at the Union Investment arm of Germany’s DZ Bank with around EUR368.2bn assets under management (AUM) and a deep history of sustainability investing going back several decades explained how this is already underway as an investment strategy. While of course the fund will “invest if the traffic lights show two-times green from a fundamentals and sustainability point of view”, it also targets ESG “transformers”.9
“We see sustainability as typically coming together with a high valuation”
“We don’t only want to invest in companies already green but also want to be able to identify continuously and systematically the companies showing the best indicators of becoming so. If a lousy company becomes better, the overall effect is greater than if someone who is almost perfect becomes a little bit better,” explains Pontzen.
This is actually a huge opportunity. “We see sustainability as typically coming together with a high valuation. By finding and identifying companies not yet but becoming green the opportunity is there to buy them cheaper,” he concludes.
Deutsche Bank Research reports referenced
#dbSustainabilityTracker: EU taxonomy update, exclusionary trends in ESG, and research highlights (21 April) by Debbie Jones, Brian Bedell, Liam Fitzpatrick and Luke Templeman
What are exclusionary trends in sustainable investing? (3 May) by Debbie Jones and Brian Bedell
#dbSustainability tracker, ESG: Growth, performance, Biden (February 2021) by Jim Reid, Luke Templeman and Debbie Jones
Flow Tracker: US Industry Mutual Fund & ETFs (12 May) by Brian Bedell and Jacob Henry
1 See https://bit.ly/3hMb2sp at dbresearch.com
2 See https://bit.ly/3fRBiQK at oecd-ilibrary.org
3 See https://bit.ly/3u2o47h at sec.gov
4 See https://bit.ly/3uZQsIF at sec.gov
5 See https://bit.ly/3wkRWgP at sec.gov
6 See https://bit.ly/3yqX05m at bbhub.io
7 See https://bit.ly/3bGmwty at gsi-alliance.org
8 See https://bit.ly/3fBu9Cq at dbresearch.com
9 See https://bit.ly/3owXxxO at dbresearch.com
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