Interlinking climate change with investments is critical today and it will become even more important in the future as climate change is one of the biggest issues facing humanity today.
Let’s face it. Climate change is one of the biggest issues facing humanity today. Everyone including governments, public and private sector industries, social organizations and individuals are doing their bit to combat emissions. Investors too, world over, have joined this battle against climate change. Why investors? Because investors can play a critical and a highly influential role in the way companies operate.
Sustainable and responsible investments also yield better returns. A 2015 survey on 3700 studies including 2200 unique primary cases explored the relation between environmental, social, and governance (ESG) criteria and corporate financial performance (CFP) and found evidence for the business case of ESG investing. The survey titled, ‘ESG and Financial Performance’ (Journal of Sustainable Finance and Investment) stated, ‘the orientation toward long-term responsible investing should be important for all kinds of rational investors in order to fulfill their fiduciary duties and better align investors’ interests with the broader objectives of society.’
Outi Helenius, Head of Sustainability at Evli says, “Interlinking climate change with investments is critical today and it will become even more important in the future. Investor can play huge role when deciding which companies to finance and own. Also, investors can drive change through engagement. There has been really positive development through several investor initiatives such as Climate Action 100+ and CDP’s Investor Letters.”
Big deal!
Currently, most large investors have made ESG a part of their investment processes. According to reports, managers of stocks, bonds and other assets worth USD 83 trillion have signed up for the United Nations’ Principles for Responsible Investment, promoting the inclusion of ESG factors in asset allocation. It is estimated that ESG funds around the world have risen from just 140 in 2012 to over 370 last year. During this period the assets under management of ESG mutual funds grew by nearly USD 400bn and crossed the USD 1trillion mark last year.
As ESG becomes central to investing, there is a need to overhaul and standardize reporting and assessment. Currently ESG reporting and assessment parameters vary across countries, jurisdictions, companies, rating agencies and investors. In addition, investors have different approaches for ESG. For instance, recently, Norway’s Sovereign Wealth Fund has reportedly chosen to exit its investments in coal and energy companies whereas Japan’s Government Pension Investment Fund has a totally different stance on the matter. It believes in ‘engaging with companies to improve ESG parameters rather than divesting altogether.
Smoke & mirrors
“There are challenges for both investors and companies. You can’t have the identical ESG reporting or rating parameters for companies operating in different sectors since material ESG issues differ by sector and even by company. E.g. one company might have production footprint in the area where water scarcity is real issue where as other company operating even in same sector might not be exposed to the same risks,” Helenius says.
“Similarly, reliability and collection of data is a big issue from the investors point of view. There are service providers who do the ESG ratings for investors. But it varies because different agencies have different approaches and methodologies. So we might end up in the situation where one ESG rating agency rates company with high grades and the other one with low grades,” she adds.
A report by the American Council for Capital Formation, points out that apart from geographical and subjective biases, there is an institutional bias with ESG ratings because separate agencies attempt to apply a one-size-fits-all approach in their ESG ratings, which ignores industry and company specific differences in risk profiles. The report, ‘Ratings That Don’t Rate: The Subjective World of ESG Rating Agencies’, elaborates that larger companies attract better ESG ratings because they can invest more in ESG measures. Small and mid-sized companies tend to lose out because of this bias. Add inconsistencies between different rating agencies to this list and what you have is ‘a possible failure to identify risks including ‘greenwashing’ (a practice that overstates ESG commitments) to display better ESG adherence.
Common ground
Experts believe many of these problems can be solved with standardization of ESG norms. The European Commission has recently made a significant move in this direction. It has published guidelines on corporate climate related information reporting as part of its Sustainable Finance Action Plan to ensure that the financial sector and private capital can play a critical role in transitioning to a climate neutral economy and funding investments in the scale required. These guidelines provide guidance to almost 6000 EU-listed companies including banks and insurance companies that are required to disclose non-financial information. EC has also released a proposal for a regulation for the establishment of a framework to facilitate sustainable investment (Taxonomy regulation).
“I think the EC has made a good and positive start to encourage companies to use the TCFD (Task force on Climate-related Financial Disclosures)-reporting framework to provide more transparent information to investors on climate change. Of course, since the regulation is not legally binding, it will be interesting to see how many companies will start using the new guidelines. Our mission at Evli is to ensure that climate change is taken into account in our investment processes. These guidelines will support our work by providing more reliable data,” says Helenius.
That’s a good stance to take considering that ESG-related investments are expected to soar in the coming years. A 2019 white paper by the World Economic Forum predicts that ‘the wave of ESG-related investment practice continues to grow and there are no indications that it will abate.’
Brace for change.
Interested in further reading? See Evli's recently launched Principles for Climate Change and read more about how Evli is putting more focus on climate change in its investments.
