ESG refers to the Environmental, Social and Governance risks embedded in a business, while ESG investing is about taking these risks into account in investment decisions. Put another way, ESG is everything not on a company’s balance sheet or earnings; and that is precisely its Achilles’ heel.
ESG investing has become a huge business. From about a zero market share of assets under management 10 years ago, ESG-labelled funds in the United States today are $16 trillion, one out of three professionally managed dollars.
ESG has a long history but only took off five years ago. The game changer was the Paris Agreement, signed in 2015, as well as the United Nations’ Sustainable Development Goals, adopted in the same year.
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There are no universal rules to analyse ESG risks in most companies, or clear frameworks to police ESG-labelled investment products.
For example, deforestation is a major driver of climate change. You would think it’s being used as a filter to ensure companies in ESG-labelled funds are not turning a blind eye to deforestation, but you would be wrong. Carbon Tracker, a thinktank, found that 78 per cent of mutual fund providers offered ESG investments but none specifically excluded deforestation risk. Not a single one actively priced climate risk either.
Inconsistencies and abuse are rife. BNP Paribas, the largest bank in the Eurozone, never wastes an opportunity to boast of its green credentials. It’s also the world’s top banker of offshore oil and gas over the last five years and managed to increase fossil fuels lending since the Paris agreement. Here’s the same BNP on sustainable investing: “Why sustainable investing? Quite simply, it is worth it”. BNP peddles ESG products to its clients with one hand, while its other hand fuels the climate crisis.
Investment managers and banks are taking advantage of our collective willingness to help fight climate change because the ESG space is, to put it mildly, a zoo. Epic greenwashing is everywhere: Out of 253 funds that switched to an ESG focus in 2020 in the US, 87 per cent of them rebranded by adding words such as “sustainable” or “ESG” or “green” or “climate” to their names. None changed their stock or bond holdings at that point.
The good news
All is not bad news, however.
First, leading ESG standards organisations - voluntary NGOs that have issued ESG standards - are collaborating to provide consistent approaches. That’s good because we need one ESG framework, not hundreds that people can use for ESG arbitrage.
Second, the IFRS Foundation is developing ESG standards. This Pope of the accountancy profession develops the globally accepted accounting standards that accountants apply when they review and sign-off on financial statements. Because 120 countries use IFRS standards, adding ESG standards through the equivalent, for that profession, of a Papal edict, will probably have a global audience. That is a very good thing, even if it’s thirty years late.
Third, Europe introduced in March rules that will police investment products. In time, these rules are intended to force asset managers, banks, insurance companies and pension funds marketing ESG products to go through tough disclosure requirements.
Fourth, the UK is working on introducing new ESG disclosure requirements for investment managers.
Fifth, the US Securities and Exchange Commission (SEC) is now on the case. Earlier this year, it laid out an ambitious agenda promising to make environmental, social and governance issues central to its mission. That’s extremely important because these should be part of almost every financial transaction. The US SEC, the supervisor of the largest securities markets in the world, can make it happen.
Yet, regulators have made it difficult for us to be optimistic. The same US SEC, for example, issued guidelines in 2010 on climate disclosure which were promptly ignored by companies as well as the SEC.
We need to price the ‘E’ in ESG
The problem we face, however, is deeper than the absence of a set of consistent and universal ESG criteria. ESG is about disclosure and reporting: Information that companies have to put together and disclose. That won’t effect real change. Regulators need to recognise that the “E” in ESG, i.e. environmental factors, is quite different from the “S” and the “G.”
“G” is about leadership and the integrity and quality of corporate actions. “S” is about how companies use and manage human capital.
“E,” however, must be priced: Environmental impact should flow through income statements and affect earnings. Destroying the environment and polluting, free of charge, cannot be just a disclosure issue.
Climate change for example impacts companies’ bottom line directly but these risks are not priced-in. Take AT&T, the US telecom company. Natural disasters cost it a billion dollars since 2016. Where were these in its financial statements before 2016? Nowhere. As a result, there were material omissions from its earlier financial statements because it never bothered to assess the climate risk its operations faced and take financial provisions accordingly.
Research firms should start issuing restated earnings that show pollution costs. For example, a carbon price of $100 would be ascribed to the greenhouse gas emissions of the largest 1,000 companies in the world, then flow this cost through their profit and loss accounts. Similar methodologies would be used to price deforestation impact and many other environmental factors. That would then show that most, if not all companies are publishing wrong numbers: balance sheets and income statements with material misstatements and omissions.
Fighting climate change decisively is not about whether we are using plastic straws. We already show, for plastic straw manufacturers, what they collect selling them and what they pay to manufacture them. Most importantly however, we need to show a currently invisible expense: what it costs to ensure plastic straws are collected and returned to the manufacturer, or safely disposed of, together with the cost of the pollution from their key ingredient, oil and gas. Plastic straws would then be exposed for what they are: poison, and loss-making at that, and companies would stop manufacturing them.
If corporate earnings change, everything can change. Meanwhile, every company today – no exceptions – is capitalising profits and socialising its impact on the environment.
Assaad Razzouk, host of The Angry Clean Energy Guy podcast, is a Lebanese-British clean energy entrepreneur, author, and commentator based in Singapore