Commentary

ESG in 2022: Impact Assessment to the Fore

Dierk Brandenburg, Head of Credit and ESG Research, Scope Ratings, says carbon pricing can help cut through climate-reporting complexity.

With net zero well beyond reach of current policies and technologies, investors are increasingly scrutinising the impact of their ESG strategies on the real economy and their contribution to decarbonisation or diversity.

As such, improved disclosure by companies is vital to help market participants assess ESG impact.

The problem is that expanded accounting and regulatory frameworks to simultaneously serve multiple stakeholders turn out to be lengthy, costly, and insufficiently orchestrated.

It is widely accepted that ESG assessments require better disclosure of non-financial information related to environmental and social factors. While this point is hardly controversial, better pricing of external effects such as carbon emissions may offer an alternative way of directly measuring impact in the financial accounts of a firm.

Pricing externalities

Strikingly, the widely acknowledged disclosure gap is neither due to lack of effort nor rhetoric. Numerous disclosure frameworks at global, regional, and national levels have been available for many years, and most listed companies maintain that they adhere to at least one of them.

Our non-exhaustive list identifies at least 10 frequently cited standards that cover various aspects of ESG-related financial and non-financial information. Yet, confusion reigns because disclosures are mainly qualitative and at times trivial, while quantitative disclosure remains voluntary and difficult to compare.

A complementary – if not more effective – approach is to ensure that negative externalities are directly reflected in financial statements through, in the case of greenhouse gas emissions, better and more transparent carbon pricing.

Direct pricing of many ESG impacts could yet prove the most effective way to evaluate the sustainability of complex companies and their value chains.

The planned expansion of the EU’s Emissions Trading System to transport and buildings will widen the reach of carbon pricing in the EU as will the Carbon Border Adjustment Mechanism which proposes a levy based on the carbon-content of selected imports to the EU.

Impact over risk

In the meantime, we see two main trends shaping the debate surrounding corporate sustainability during 2022: the regulatory and policy-making focus will remain on tackling climate-related issues; and ESG research will increasingly re-emphasise impact assessment over ESG-linked risks.

This is important from a credit perspective. Fixed-income investors typically neither take part in the financial upside involved with large-scale climate investments, nor are they in a position to bear the associated project and technology risks. However, bondholders require assurance that their funds refinance assets in line with ESG values.

ESG impact and ESG risk analysis are converging over the long term because one actor’s ESG impact drives another actor’s ESG risk and vice versa.

This applies especially for the systemic risks posed by global warming. Large corporates and regulators increasingly focus on indirect reporting of emissions accruing in the value chain (‘Scope 3’). Accounting for supplier footprints and emissions in final consumption aligns directly exposed industries (‘risk’) with their neighbouring sectors (‘impact’).

Binding targets

This ‘double materiality’ of ESG risk and ESG impact will shape the debate over disclosure and accounting materiality, but also influence discussion of how best to assess the ESG profile of an investment and its classification, for example, under a taxonomy such as the EU’s.

The big question for 2022 is therefore how quickly standard setters can agree on binding standards for non-financial disclosures, if at all. Progress in this area is vital, not at least because other flagship projects such as the implementation of the EU’s Sustainable Finance Disclosure Regulation and taxonomy depend on it.

 

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