Continued growth in ESG has clashed with growing criticism and the stark realisation that current solutions are not fit for purpose. What comes next for sustainable finance?
In 2021 the ICPP report showed the stark reality of the challenge facing the world. This has coincided with a discourse about ESG as ‘maturing’ and COP26 highlighting the transformative role of capital. Yet this may be the classic case of the teenager feeling older and wiser beyond their years. While 2021 has shown the promise of sustainable investing, it has also exposed the limitations and flaws of current approaches to ESG. 2022 will put these to the test, and show whether the promises of new regulation coming out of Glasgow in November will deliver or instead contribute to regulatory fragmentation. The new year’s resolutions for world leaders and asset managers should be tackling threats to biodiversity and properly integrating nature into sustainability assessments with the Kunming UN Biodiversity Conference in the spring offering an early indicator of progress. Key to facing these challenges will be better data to allow sustainable institutions to stand out and expose empty and shallow pledges.
More money, more problems
2021 continued the rapid growth spurt of ESG investing, with Morningstar reporting $3.9 trillion invested in sustainable funds in Q3. While 2020 and the impressive performance of ESG funds during the pandemic focused the debate on the rate of return of ESG, the space has changed in 2021. BNP Paribas Global ESG Survey reports that in 2019 52% of surveyed investors saw improved long-term returns as the main motivation for ESG investing. In 2021 this has dropped to 45%, with 59% saying brand and reputation is the main motivation, while External Stakeholder requirement has risen from 32% to 46%.
Yet 2021 was also the year where ESG came under unprecedented critique. Former BlackRock Executive Tariq Fancy, threw the first stone, calling ESG a ‘dangerous placebo’. As with all things ESG, the picture is complicated, messy, and full of contradictions.
Glasgow gone wrong
If the scale of the challenge ahead was not clear enough, the IPCC report in August offered a sobering reminder. World leaders arrived in Glasgow, knowing all-too-well that without urgent action, a 2°C scenario will be beyond reach. Hailed as the ‘Finance COP, the pressure was on for the financial sector to deliver. Mark Carney arrived in Scotland carrying $130 trillion pledged by banks, insurers, and fund managers all united in the Glasgow Financial Alliance for Net Zero.
While this number may be significantly overblown, the widespread commitment to Net Zero will put welcome pressure on financial institutions to publish specific plans on how they will meet their targets. This is a welcome step beyond voluntary commitments without interim goals - something which Matter has previously advocated for. This will be a drastic change for many companies. According to the CDP, 49% of financial institutions do not currently evaluate their portfolio’s effect on climate at all.
However, as we show in our recent white paper, minimising carbon footprint is not the same as driving the energy transition. By staying clear of energy and utilities in a portfolio, and thereby renewables, you stand a better change of achieving Net Zero. In 2022, as Net Zero becomes mainstream, expect sustainable investing to impose higher demands and focus on the energy transition.
Can’t see the forest for all the pledges
With Brazil facing the worst droughts in a century, COP26 saw widespread pledges to fight deforestation. Considering that a similar pledge was made in 2014, but abandoned due to lack of data, we are cautiously optimistic. These pledges mean little without granular data to follow through. The indirect exposure ESG funds face when they overweight financial institutions, explored in our white paper, has received little attention in regulatory discussions. 2022 will hopefully seek to amend this.
Biodiversity will see increasing attention in 2022. Already in January, the UK’s Green Finance Institute will publish plans for ‘high integrity nature markets’, and CDP will add six biodiversity questions to their corporate Climate Change questionnaire. Science-Based Targets Network will also have developed biodiversity science-based targets by the end of 2022. The second leg of the Kunming UN Biodiversity Conference in April will offer an early indication of progress made.
Regulation - too many chefs?
2022 will also see the realisation of the many regulatory efforts announced in late 2021. There is a real risk of regulatory fragmentation with the UK’s ambitious plans offering no mention of the EU’s SFDR. Investors may be increasingly confused by the alphabet soup of new regulations.
Much of the ambiguity surrounding plans for regulation will also be resolved- for better or for worse. The UK’s plans to be a Net Zero financial centre by 2023 illustrate this ambiguity. This means that all financial institutions and listed companies in the UK will have to publish specific Net Zero plans by 2023. These Net Zero plans will supposedly be measured against a ‘gold standard’ to be drawn up by members from industry, academia, regulators, and civil society. The ambition of the regulatory push very much stands or falls with this standard.
Efforts to harmonise regulation may risk reproducing the issues of ESG ratings. The International Sustainability Standards Board (ISSB) will begin working in 2022. Announced at the COP, it was tasked with creating a single set of standards to meet ‘investors information needs’. It will be a real question whether the ISSB ends up reproducing the problematic ESG Rating tendencies and undermining existing initiatives such as the SFDR, or if this is a real push towards sustainability and transparency.
To achieve adaptation, practice what you preach
COP27 will focus on climate finance and adaptation. In November 2022, the world leaders will gather in Sharm El-Sheikh, Egypt. The pressure is on to deliver necessary climate finance, as the UN estimates that annual spending on climate change adaptation needs to be five to ten times higher than current levels.
Where to find this cash? Look to green bonds. 2022 will see increasing issuance of green and sustainable bonds linked to adaptation. The EU Commission took an important first step in October 2021, when it issued its first green bond. The EU’s voluntary ‘gold standard’ for green bonds was still stalled at the time of issuance by member states over issues of nuclear energy and gas. In 2022 we expect the EU and other supranational institutions to practice what they preach and lead the way on sustainable standards for bonds.
A long way to go
While the industry may be maturing, there is a long way to go. As ESG becomes mainstream, regulation must not reproduce the issues of problematic ESG ratings, and accountability has to be based on solid data. While biodiversity, climate and Net Zero will continue to attract headlines in 2022, social issues must also not be forgotten. UNICEF recently reported that the progress on ending child labour has stalled for the first time in 20 years. While one should not be blind to the real progress that has been made in 2021, there is still a long way to go for sustainable investing in 2022.