Commitments made in 2021 must become reality soon, if end-of-decade targets are to be met.
If 2021 was the year of the net zero commitment, 2022 should witness early signs of delivery on pledges to halt and reverse man-made harm to the climate and environment.
Inspired by the COP26 agenda of ‘keeping 1.5°C alive’, last year saw countries, companies and investors outline plans to decarbonise economies and restore nature, potentially putting humanity on course to live sustainably within planetary boundaries.
These plans need to bear fruit quickly if near-term objectives are to be met and tipping points are to be avoided over the current decade. The US$130 trillion of private capital pledged in November by the Glasgow Financial Alliance for Net Zero (GFANZ) must be mobilised at pace to realise UN-sanctioned ambitions on greenhouse gas (GHG) emissions reductions by 2030, not to mention achieving Sustainable Development Goals in this UN-designated Decade of Ecosystem Restoration.
Accelerated allocation of private capital to sustainable investments at scale relies on actionable information, on both environmental risks and impacts. For this reason, 2022 is likely to be the year in which the debate on double materiality heats up.
“Embedding double materiality is essential to making responsible investment and climate integration fit for the 21st century. Looking at just one half of the equation feels very antiquated,” says Faith Ward, Chair of the Institutional Investors Group on Climate Change (IIGCC) and Chief Responsible Investment Officer at the Brunel Pension Partnership, which manages £35 billion on behalf of 10 UK local government pension schemes.
“We need to shift to a net-zero world, not just net-zero portfolios. This means understanding the impact of our portfolios on the world, particularly at a time when fossil fuel subsidies are still providing some very perverse financial incentives, which need addressing urgently.”
Making an impact
Corporate reporting of their sustainability impacts is increasingly seen as fundamental to meeting climate and nature-related objectives. The Impact Taskforce, an independent group of business, investment and public policy institutions from 40 countries, recently called on the Group of Seven (G7) nations to mandate impact accounting.
Impact measurement is being standardised, but data is a critical prerequisite. Historically, voluntary frameworks have been split on the scope of sustainability reporting. 2022 will shed light on whether mandatory reporting regimes will deliver the data sought by Ward and peers.
“We’re seeing a pretty significant discussion emerge over whether to view sustainability through a financial risk materiality lens or go beyond. Asset owners will need to formulate a consistent view because there are important repercussions in multiple areas of sustainability regulation, including company reporting, ESG ratings, transparency and the Sustainable Finance Disclosure Regulation (SFDR),” says Victor van Hoorn, Executive Director of Eurosif, the European Sustainable Investment Forum.
To date, Europe has made the boldest commitment to double materiality, which is explicitly embraced in the Corporate Sustainability Reporting Directive (CSRD) and its underlying European Sustainable Reporting Standards. Developed by the European Financial Reporting Advisory Group (EFRAG) and Global Reporting Initiative (GRI), a voluntary standards-setter which uses double materiality, the standards will be open to public consultation in Q1 2022.
CSRD negotiations between the European Commission, Parliament and Council, also scheduled for early 2022, will not be “smooth sailing”, according to US investment bank Jefferies, both due to challenges over double materiality and the directive’s wider scope than the Non-Financial Reporting Directive (NFRD) it replaces.
There may be an argument to postpone implementation for firms reporting for the first time, says Susanna Arus, EU Public Affairs Officer for law firm Frank Bold, but pushback from its planned introduction in 2023 would have serious ramifications.
Delaying CSRD adoption for those currently reporting under NFRD would be detrimental to firms and their investors alike, she says, given the new directive’s clarifications and improvements to existing requirements will result in “more meaningful, precise and relevant data on sustainability risks and impacts”.
Not only does CSRD give investors consistent and detailed inputs into their disclosure requirements, risk assessments and related climate exposure due diligence, it is seen as an essential foundation of Europe’s sustainable finance framework.
“A reporting system based on enterprise value will not allow countries to operate a taxonomy effectively, because it will not deliver the information investors need in order to apply the taxonomy,” says Eurosif’s van Hoorn.
This applies equally to the UK, which is due to come forward with details on its planned green taxonomy, having so far based climate reporting requirements on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
A recent update to the TCFD’s guidelines maintained its focus on reporting and managing climate risks relating to enterprise value. The newly-formed International Sustainability Standards Board (ISSB), which will roll out of its first draft standards in Q1 2022, is expected to pursue a similar path, under ex-Danone CEO Emmanuel Faber.
The UK has indicated a desire to go beyond its TCFD-led building blocks with new impact-focused Sustainability Disclosure Requirements (SDRs). Its Roadmap to Sustainable Investing says SDRs will require reporting on environmental impacts, but the extent is not yet clear, nor the transition from TCFD-based reporting. Feedback on a Financial Conduct Authority discussion paper on SDRs and green product labelling is due by 7 January and will be followed by policy proposals in Q2 2022.
The UK Sustainable Investment and Finance Forum (UKSIF) has welcomed SDRs as an opportunity to put all UK sustainability reporting requirements under one roof, but says more detail is needed.
“We want to see double materiality front and centre of the UK approach, but there are questions over its importance to the government, and whether the UK can provide a bridge between jurisdictions less keen on double materiality, such as the US, and those that are,” says UKSIF CEO James Alexander.
Outgoing GRI CEO Eric Hespenheide has played down differences between enterprise value and double materiality approaches, while van Hoorn fears they could represent a more fundamental schism, reflecting different perspectives across business cultures. The approach of the ISSB is considered particularly significant as endorsement by the International Organisation of Securities Commissions would pave the way for its standards to be adopted in member jurisdictions around the world.
But dual materiality is far from the only challenge facing regulators attempting to embed sustainability into financial and business decision-making.
Starting this month, corporates and financial institutions must begin to report on the alignment of their products and services with Europe’s Green Taxonomy. The publication of a helpful Q&A in December was somewhat overshadowed by EC plans to adopt a complementary Delegated Act (the first Climate Delegated Act was passed on 9 December), which effectively allow certain types of gas and nuclear energy generation to be included in the taxonomy, and thus regarded as sustainable. The DA is subject to approval by MEPs and member states, with Germany already indicating its opposition.
Much of the pressure to include gas and nuclear in the taxonomy ‘via the back door’ stems from fears that exclusion will widen the gap in funding costs versus green assets. Eurosif’s van Voorn suggests, however, that asset owners will continue to invest based on risk and impact assessments.
“By labelling something as green, you’re not going to alter how institutional investors look at the future. There would, however, be damage to Europe’s credibility in terms of its commitment to the rigorous adoption of required policy tools,” he says.
Less controversially, further DAs will be finalised this year which will help investors to identify products and activities that contribute to a wider range of environmental objectives, i.e., sustainable use and protection of water and marine resources; the transition to a circular economy; pollution prevention and control; and the protection and restoration of biodiversity and ecosystems. Progress will also be made on the development of a social taxonomy, after “internal agreement” was reached in Q4 2021 on recommendations from the Platform on Sustainable Finance.
Investors have been hoping for help from legislators to enhance insight into environmental and human rights risks along corporate supply chains, but draft proposals on sustainable corporate governance were twice rejected by the EC’s independent Regulatory Scrutiny Board in 2021. NGOs are concerned that business sector lobbying could delay the law until 2024 and have called on EC President Ursula von der Leyen to intervene.
Julia Otten, Policy Officer at think tank GermanWatch, expects proposals early this year, not least due to pressure from countries already in the process of implementing national legislation. “We’re urgently waiting for the Commission to come up with its proposal because we think there is need for a European standard. But it’s important that due diligence laws cohere with the broader picture of corporate regulation – such as CSRD and the taxonomy – to guide corporates toward a sustainable future,” she says.
“There is a risk of the debate getting polarised, but we need to establish connections between due diligence standards and board oversight of company strategy to achieve behavioural change.”
Valuing natural capital
Alongside such broad-based initiatives to help corporates and investors identify environmental risks and impacts along supply chains, sector-specific initiatives are also providing greater oversight, including UK and European measures to track the sourcing of commodities, which supports pledges made at COP26 to reverse deforestation.
The Glasgow summit may have highlighted the links between the dual crises of biodiversity loss and climate change, but the metrics and frameworks needed to quantify nature-related risks and impacts are far behind those developed to monitor GHG emissions.
2022 should begin to close the gap with the release of the beta version of the Taskforce on Nature-related Financial Disclosures (TNFD) framework in the first quarter, followed by the signing of a new Global Biodiversity Framework at Kunming in May, which will provide a 10-year map for protecting and regenerating nature, based on public and private sector commitments.
The TNFD framework is expected to follow the TCFD by focusing disclosure requirements on four pillars – governance, strategy, risk management, and metrics and targets – but it will deviate from its predecessor by focusing on double materiality from the outset, to provide “decision-useful information on nature-related dependencies, impacts and risks”.
With its final release due in 2023, the hope is that major jurisdictions will base domestic reporting requirements on TNFD, similar to the adoption of TCFD recommendations by the UK, New Zealand, Japan and others. EFRAG is due to issue a European biodiversity disclosure standard by June, while voluntary standards-setters have also been bolstering their reporting frameworks.
Ward says the lack of universally recognised nature-related disclosure standards is no excuse for inaction among investors. “We shouldn’t stop asking questions just because we don’t necessarily yet have a number to be able to quantify whether that’s good enough. Even asking the question starts to stimulate the right kind of outcomes,” she says.
Similar to how COP26 inspired a raft of new commitments, UKSIF’s Alexander argues that governments should use COP15 in Kunming to demonstrate their support for the TNFD and GBF. To this end, UKSIF recently called on UK Chancellor Rishi Sunak to encourage G20 support for TNFD, commit to exploring implementation of the Dasgupta Review’s findings into policy, and use the GBF to “provide a clear signal to investors on the urgency of biodiversity loss” as well as setting robust 2030 goals.
Making good on commitments
As 2022’s busy post-COP26 regulatory agenda unfolds, asset owners have little choice but to play the cards they have already been dealt. Very often that means assessing the environmental risks in their portfolios largely according to the TCFD-based disclosures of large corporates, or voluntary reporting via standards-setters.
Across 2021, net zero commitments and transition plans have unleashed a flood of information on how corporates are managing their climate risks and reducing their emissions. But Ward says these rarely tell the whole story, meaning asset owners can struggle to understand firms’ future climate trajectories.
“We’re still seeing disconnects between what we’re told in firms’ net zero commitments and what we read in their annual reports and statements. There are technical challenges to be overcome, but some firms are not yet recognising that we need to see these commitments hardwired into audited financial statements in order to have credibility,” she notes, adding that capex is a frequent area of dissonance.
Asset owners urgently need reliable inputs from corporates and asset managers to fulfil their own commitments. Now operating under the GFANZ umbrella, almost half (29) of the members of the UN-convened Net Zero Asset Owners Alliance have pledged to decarbonise their equity, bond and real estate portfolios by 16-29% by 2025.
And more than 50 asset owners, including Brunel, have signed up to the Paris Aligned Investment Initiative’s Net Zero Asset Owner Commitment. Signatories work toward net zero emissions by 2050 by adopting the Net Zero Investment Framework (NZIF), developed under the aegis of the IIGCC. This helps asset owners to develop net zero investment strategies with reference to governance and strategy, objectives and targets, strategic asset allocation, asset class alignment, and engagement.
New signatories must take ten specific actions within 12 months, including engaging with firms responsible for 70% of financed emissions, effectively requiring asset owners to turn commitments into reality this year. These ‘asks’ mean they can’t wait for regulations to drive greater transparency by corporates, instead using engagement tools to achieve their objectives, potentially fuelling robust dialogue at AGMs over the next sixth months.
NZIF will include methodologies around infrastructure and private equity from Q1 2022, asset classes that are both likely to become increasingly important as asset owners orientate toward emerging climate-positive technologies and solutions. Whether or not they have also signed up to the mirror version of NZIF, Ward says asset managers must keep pace with the needs of asset owners in 2022.
“Most asset owners need their managers to be their eyes and ears,” she says. “At Brunel, the level of specificity we need from companies in which we’re invested is far greater, including sector-specific decarbonisation pathways. We need sector analysts to be really ‘kicking the tyres’ at a granular level to make sure that companies are authentically doing what they said they would do, and that what they are doing is sufficient to address any specific risks.”
Transparency and transition
Sarah Peasey, Director of European ESG Investing at Neuberger Berman, an NZIF signatory, says the firm is setting interim goals with institutional clients to drive near-term change. This can include identifying firms and even sectors that have no place in a net zero mandate, but more often means examining investee companies’ transition plans, including their use of science-based targets.
In December, UK workplace pension scheme Nest demonstrated that asset owners are not prepared to wait forever for firms to engage on transition by divesting from ExxonMobil and a number of other “unresponsive” oil and gas firms. But the divestment debate remains nuanced, with many regarding it as a bargaining chip of last resort.
Peasey says progress toward peak emissions will not be linear over the next decade, with companies needing to invest significant capital to change the way they develop products and services. Over this period, emissions might plateau or even go up, requiring understanding rather than divestment.
“Our clients are going to need a holistic and transparent view of what companies are doing. We’re cognisant of the need to build more transparent reporting and be a lot a lot more transparent on engagement. Net zero is going to be complicated. We need to be able to give clients comfort that we’re holding companies for the right reasons,” she says.
Transparency is key to identifying opportunities, as well as managing risks and impacts. Investors know that allocations to renewable energy infrastructure in developing markets is one their most climate-positive options. But there are challenges sourcing assets, because many projects are only in the planning stages and new technologies are not yet scalable.
Renewed efforts are being made to encourage greater data sharing between the public and private sectors on such projects to support risk-return analysis. This is critical, says Peasey, noting that borrowing costs on projects are often high due to the low ratings on emerging market sovereign issuers.
World Bank research has found that 90% of the variation in ESG scores from seven providers across 133 countries is largely a function of differences in per-capita national income. “Systematically investing in accordance with standard ESG scores can be misleading or even harmful in the world of emerging sovereigns,” says Peasey.
The fiscal frontier
Improving the flow of information to help investors understand environmental risks and impacts is a critical issue for policymakers, encompassing corporate disclosures, financial product labelling and regulation of data providers, to name a few. But governments must also lead in many other areas, too.
IIGCC’s Ward says governments need to step up their efforts to provide certainty to industry and investors on the path to net zero. Before and during COP26, governments issued proposals which shed some light on sector-specific pathways, including the UK’s Net Zero Strategy, but in almost all cases more detail is required on how transition is expected to play out in key industries.
In a post-COP26 blog, Impax Asset Management CEO Ian Simm called for governments to issue sector-by-sector roadmaps ahead of COP27, also asserting the need for a price on carbon, and other measures “to ensure that price and other market signals incentivise investment”.
Often seen alongside measures to reduce fossil fuel subsidies, carbon pricing remains one of the biggest challenges for policymakers and priorities for investors, for its role in crystallising the true cost of CO2 pollution. An explicit tax on emissions is widely seen as too contentious, leading to Europe, China and the UK all operating ‘cap and trade’ emissions trading systems (ETSs).
All these ETSs face challenges in 2022, with China and the EC looking to extend the scope of their schemes, and the UK system in limbo awaiting the outcome of a government review, against a backdrop of energy price volatility. COP26 also provided a breakthrough of sorts on carbon trading, with the settlement of Article 6 of the Paris Agreement, but it is expected this will take time to filter through to private markets.
ETSs give governments a key role in setting the price of carbon emissions, even if they are not formally levying a tax. And in general, governments have been slow to use fiscal policy to achieve climate-related objectives. UKSIF’s Alexander believes a shift is necessary and suggests this could be one of the biggest challenges for policymakers in the next 12 months.
“We’ve got to look closely at the expense at which profits are made. Research increasingly shows most big firms are unprofitable if you factor in a realistic social and environmental harms at a reasonable cost,” he observes.
Alexander does not underestimate the scale of the challenge for policymakers, acknowledging that efforts to align fiscal policy with climate objectives must be socially just, globally coordinated and supportive of competition and innovation.
“But we can no longer use up finite resources as if they were infinite. Whether or not you call it a tax, one of the best ways to achieve this is use of market-based incentives to ensure firms pay a fair share of the pollution they cause, while also encouraging approaches that will reduce cost burdens and therefore prevent pollution.”