January 2020 will be remembered as a historic milestone for sustainability: many experts consider the open letter of global investment manager BlackRock, informing clients of the firm’s commitment to sustainable investing, as the ultimate ‘marriage’ of money and sustainability. It confirmed that mainstream investors increasingly believe that environmental, social and governance (ESG) metrics have a direct impact on risk and return. Since then, the COVID-19 pandemic has shaped our global economic and financial order at an unprecedented magnitude. Yet sustainable finance appears to be accelerating. During this pulse check with one of Schneider Electric’s global sustainability experts, we look at the different catalysts that are driving the sustainable investment movement.
Maureen Bray, International Consultancy Director
Maureen is an International Consultancy Director working for Schneider Electric’s Energy & Sustainability Services helping organizations strategically set, plan and achieve energy and sustainability goals.
Sustainable Finance – going mainstream
“I believe we are on the edge of a fundamental reshaping of finance”
~ Larry Fink, BlackRock CEO
When Larry Fink wrote his letter in January 2020, it was just another, very clear indication of a shift in the way money is invested. Sustainability finance has entered the mainstream: According to KPMG’s 2020 Sustainable Investing report, 85% of institutional investors today demand ESG-oriented hedge funds.
Sustainable financing includes a mix of strategies that investors use to factor in ESG aspects for their investments:
- Positive screening to select companies with strong sustainability performance, eventually based on 3rd-party disclosures and ratings, such as CDP, GRI, and DJSI.
- Exclusionary screening to eliminate companies in industries or countries deemed objectionable, or that violate some set of norms, such as the Ten Principles of the UN Global Compact.
- Integration of ESG factors in fundamental analysis, risk and portfolio strategies.
- Sustainability-themed investing such as in a fund focused on access to clean water or renewable energy.
- Proactive ownership engaging deeply with portfolio companies to enhance their sustainability .
The main pre-COVID driver for sustainable investing was climate change risk. Climate change is a system-wide risk that is global, long-term and only growing. Large investment firms ideally want to limit volatility and maximize returns in their portfolio by combining investments from asset classes with varying levels of risk – but climate risk is too large; you simply can’t hedge against the failure of the planet. Consequently, large pension funds have been early adopters of sustainable finance. Take the Norwegian pension funds, for example: Forced to take a long-term view because they have long-term liabilities (they must plan to pay out retirements for the next 100 years) these companies have pioneered implementing a strict sustainability focus in their investment strategy.
Another strong driver is financial return: Sustainable corporate performance is linked with financial performance. Corporate Knights annual ranking of the world's 100 most sustainable corporations released in January 2020 was one of many analyses demonstrating strong evidence that sustainable performance is consistent with equal or better returns for investors.
COVID-19 Pandemic – an accelerator?
It’s clear that sustainable investing was not brand new by the time COVID-19 took center stage. After addressing immediate health issues, as well as the most urgent impact from shut downs, many companies are turning their focus to prepare to rebuild when the crisis fades. However, there is strong evidence that many economies will not simply return back to “normal”, but rather use the opportunity to rethink their transition to a more resilient, low-carbon future. The pandemic has proven the systemic relevance and immediacy of sustainability risks. The root causes of the pandemic – the outbreak itself (biodiversity loss and nature destruction), as well as the practices leading to the economic disaster (weak social protection, inadequate investment in disaster response, etc.) – are heavily interlinked with ESG factors.
And again, there is financial rational backing up the trend: a recent Morningstar survey found evidence that ESG-related investments (both funds and indexes) have outperformed benchmarks in the crisis. Consequently, a growing number of investors say they are taking environmental, social, and governance considerations into account in all or part of their portfolios, especially social impacts, as a result of the COVID-19 crisis.
Sustainability reporting – even more critical in the era of sustainable investing
The growing appetite for sustainable investment generates a corresponding need for sustainable reporting. However, many investors say they cannot readily use companies’ sustainability disclosures to inform investment decisions, as most corporate sustainability reporting is not aimed at investors and instead has a marketing focus. NGO’s and other institutions have established standards & indices, such as the Global Reporting Initiative (GRI), Sustainability Accounting Standards Board (SASB), Dow Jones Sustainability Indices (DJSI) or the Global Real Estate Sustainability Benchmark (GRESB), that have substantially improved the quality and availability of sustainability information. On climate risk specifically, the Task Force on Climate-related Financial Disclosures (TCFD) developed voluntary, consistent climate-related financial risk disclosures for use by companies in providing information to investors, lenders, insurers, and other stakeholders. As of February 2020, support for the TCFD had grown to over 1,027 organizations, representing a market capitalization of over $12 trillion. And recently, global environmental non-profit group CDP created a temperature ratings system that will allow investors to track carbon emissions across the value chain of more than 4,000 companies.
Regulation sets the pace – or does it?
The catalysts for sustainable investment differ dramatically from one region of the world to the next. The role of regulatory oversight to incentivize ESG reporting and sustainable investment is no exception.
In the EU, policy drivers have concluded that the fragmentation of the current ecosystem is problematic for the objective to channel investment towards sustainable activities. They assert that only a single set of harmonized EU ESG regulatory standards will be sufficient to protect investors, overcome greenwashing and achieve ambitious sustainability goals. Only a few governments so far are mandating the use of standards, with France being a forerunner. Article 173 of the French Law on Energy Transition and Green Growth contains a comply-or-explain requirement for investors to report on their portfolios’ ESG integration, greenhouse gas emissions risks and contribution to a low-carbon economy.
The EU’s Sustainable Finance Action Plan, a complex mix of legislative measures including Taxonomy Regulation, Sustainability Disclosure Regulation, Climate Benchmarks Regulation and a proposed Green Bond Standard, will complete this regulation for the rest of the EU. As one of many measures, the European Commission published new, non-binding, guidelines for company reporting on climate-related information under the Non-Financial Reporting Directive 2014/95/EU. The guidance applies to large listed companies, banks and insurance companies with more than 500 employees. The guidance proposes ways of assessing climate change impacts on the financial performance of companies and incorporates the recommended disclosures of the TCFD. Stay tuned for future updates, where we will look into these packages with greater depth.
The UK follows a very similar approach to greening financial systems and mobilizing finance for clean and resilient growth. Its Green Finance Strategy contains recommendations (rather than strong legislative intervention) to encourage the cooperation of the government, regulators and the private sector.
On a global scale, ESG-related legislation is on the rise: New Zealand and Canada switched from voluntary guidance on climate disclosure in favor of mandatory regimes. Japan’s Financial Services Agency (FSA) finalized and published the second revised version of Japan’s Stewardship Code that, for the first time, addresses issues of sustainability including ESG factors. Interestingly the U.S., where a comprehensive regulatory regime for sustainable finance is not in place, is one of the most active markets for sustainable finance: a huge dedicated sustainability investment market infrastructure is taking shape with Blackrock’s, Microsoft’s, Delta’s and Amazon’s multi-billion dollar sustainability and climate investment commitments.
How to attract the sustainable investors?
As climate risk becomes more severe and investors bring even more sustainability into their investment decisions, ESG reporting will only grow in relevance. Companies that integrate ESG factors into their core strategy and provide meaningful sustainability reporting will be the most attractive to investors. Here are some recommendations for corporates:
- Conduct a materiality analysis to find out which ESG factors drive the most value for your organization.
- Align ESG reporting with your company’s financial reporting (consider an integrated report) and address the direct impact of ESG activities on improving financial performance.
- Discuss how ESG is connected with the organization’s risk management and define the role of the board in overseeing the company’s ESG activities
- Report against at least one recognized ESG framework, if not multiple frameworks, and address the Task Force on Climate-related Financial Disclosures (TCFD) recommendations.
- Track regulatory changes and adapt your reporting accordingly.
- Ensure the accuracy of ESG information, automate data streams and share how the information is validated.
COVID-19 has fueled the sustainable financing trend, while at the same time one of the largest wealth transfers in modern times is underway, putting more than $68 trillion into the hands of the most ESG-conscious generation by 2030. Companies that wish to remain relevant must consider how they ingrain ESG into their DNA and answer the calls from these consumers.
What can companies do to get ahead of 2030? Watch the recording of our recent webinar to get our experts’ advice, and leave with action steps to bring sustainability – and therefore resilience – into your organization.