“The financial industry is a key catalyst for the real economy to combat climate change.”
This was our conviction in 2010 when we started one of the first companies enabling investors to measure the climate risk and outcomes of their investments. Not many shared this view. 10 years later, there is hardly any regulator and investor who is not thinking about climate change and the role of financial markets.
In 2021 the ISS ESG Climate Solutions team published a series of 10 lessons over the course of what was our 10th year of helping investors to tackle climate change.
Three main challenges require careful, yet immediate attention: the regulatory beast; methodological mayhem; and investor climate action.
Regulation
While it is uplifting to see an increase in climate action statements, the corporate leaders adopting more ambitious strategies are largely the same companies that were leaders in reporting five years ago. Yesterday’s climate leaders are becoming increasingly sophisticated, while yesterday’s climate laggards are still laggards. The time for voluntary industry commitments has passed, and it is now up to climate regulation to foster change in the real economy.
Regulation should still be applied judiciously to avoid missteps. One area where this is relevant is the regulation of investors, where there is a mismatch between regulatory expectations and the finance industry’s challenges. Another potential regulatory pitfall arises with regulating how ESG data and service providers construct ratings. Regulators should focus on creating a level playing field to enable competition – standardization risks killing much-needed innovation.
Climate Change needs regulation, and needs it fast. Regulation is a powerful force for change, but it is essential that current approaches avoid the risk of missing the target.
Methodology
While daring to simplify might be a virtue, the outcome should not be simplistic. Approaches that look at sectors without a granular understanding of the underlying companies can lead to ‘fossil-free’ claims that are false. Sometimes, the soft drink producer in your portfolio might sit on fossil reserves without you knowing it.
While ‘fossil-free’ approaches look at the supply side, it is a carbon footprint that measures the demand side: fossil fuels combusted and greenhouse gas emissions. Consequently, most investors start their climate analysis with an investment carbon footprint. Guilty of co-inventing the logic of portfolio carbon footprinting in 2010, we think a carbon footprint’s primary role is helping to evaluate the decarbonization strategy’s success, rather than a strategy itself.
The latest and greatest approach and challenge, the Net Zero label, is an example of a well-intended pledge where the methodological backing is lagging. It does not simply mean reducing and potentially offsetting greenhouse gas emissions: carbon must be removed from the atmosphere at large scale. Investor Net Zero pledges are not yet embracing that part of the equation adequately.
Many investors remain puzzled and use whatever climate impact and risk measurement tool or methodology is within reach, resulting in a lack of clear understanding of what is being measured; why it makes sense in the given context; and how to act upon the output. A prudent approach should choose the opposite sequence: know what you would like to find out; survey the market for the best approach; and apply it.
Investor action
If good climate reporting was the aim, we are almost done with our homework. There are over 60 investor-focused climate reporting regimes, new ones are popping up almost monthly, and the ISS ESG Climate team’s automated reports cater to almost all of them. Reporting, however, is only a means to an end.
The end must be to change investment practices. Despite the remarkable reporting efforts going on, less than 3% of all ETFs globally follow an ESG logic.[1] This number was below 1% before 2018, so there is some growth, but too little, too late for 2021.
Lack of data is often cited as the main reason for investor inaction. In times of ESG data overload and machine learning, the emergence of Artificial Intelligence (AI) is potentially accelerating information availability – with increased noise in the results. While there is room for AI in the ESG data collection process, we are a long way from being able to rely on AI for ESG ratings, and humans must remain a key part of the analysis process.
Depending on the asset class, tilting investment strategies might not yield much real world impact anyway. For listed equities, for example, it is not divesting but engaging that may deliver the strongest outcomes. Voting on climate resolutions at company Annual General Meetings (AGMs) is becoming an extension of unsatisfactory engagement outcomes, and investor groups such as Climate Action 100+ and the Net Zero initiatives are making increased use of the climate vote.
When it comes to real world impact, debt financing might offer stronger climate-related leverage than equity investing. If access to capital comes with strings attached, this can ensure company climate transformation in exchange for less costly capital. Green lending and sustainability linked bonds have the potential to become this much-needed catalyst.
Outlook
Prudent regulation, smart methodologies, and investor action - these are the three areas that will decide if the financial world will get its act together and deliver a decade that will see the needed change and transition by countries, companies and people. Only then will our mantra from 2010 become reality - that the financial industry is a key catalyst for the real economy to combat climate change.
This is a sponsored post by ISS Market Intelligence, you can read the full paper here >>
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[1] Source: ISS ESG calculation based on ETFGI: https://etfgi.com/news/press-releases/2021/03/etfgi-reports-assets-invested-etfs-and-etps-listed-around-world-reach