Europe

The ESG Interview: No More Fairy Tales

Eurosif Executive Director Victor van Hoorn calls for more transparency on corporates’ net zero transition plans.

On 1 January, France took over presidency of the Council of the European Union, coinciding with a consultation with Member States to decide on the inclusion of gas and nuclear energy activities in Europe’s Green Taxonomy via a Taxonomy Complementary Delegated Act.

France, which gets 70% of its energy from nuclear power, will be responsible for turning the consultation responses into draft legislation.

That a country with so much skin in the nuclear game is at the helm for such a controversial decision has caused some consternation. After all, the taxonomy is designed to drive capital to renewable sources of energy and other sustainable economic activities, as opposed to those which merely help in the transition from fossil fuels to greener alternatives.

Watered down policy

Draft proposals leaked at the start of January could well see gas and nuclear included in the EU’s taxonomy of environmentally sustainable economic activities, subject to certain conditions.

Robert Habeck, the Green MEP who was appointed as Germany’s Economy and Climate Action Minister in December, warned labelling nuclear as green under the EU taxonomy would “water down the good label of sustainability”, and is at odds with Germany’s announcement last month that it will phase out the energy source by the end of 2021.

Victor van Hoorn, Executive Director at Eurosif, the European Sustainable Investment Forum, agrees that inclusion detracts from the EU’s initial goal to create a “classification system, establishing a list of environmentally sustainable economic activities” which in turn would help meet the UN Sustainable Development Goals.

Van Hoorn says: “If it was up to us, we wouldn’t have put [gas and nuclear] in the Act because it deviates from the original policy intent.”

Echoing Habeck’s concerns, van Hoorn says there is a high chance that investors will lose faith in regulation that espouses the virtues of what he sees as unsustainable energy sources.

“The biggest risk we saw is that you don’t gain very much by putting [nuclear and gas] in the legislation, and you risk discrediting the system by doing so. Either policymakers think that investors are not very smart, or they think they are deeply cynical and that they will invest in anything labelled green.”

He adds: “The real risk is that investors say they don’t trust the taxonomy, but they have to use it even though it doesn’t inform their capital allocation, which was the initial policy intent.”

Design flaw

Van Hoorn’s critique of the EU’s sustainable investment legislation also extends to the Sustainable Finance Disclosure Regulation (SFDR) which as of 1 Jan 2022, requires asset managers to disclose the taxonomy alignment of their funds.

However, companies are not required to submit equivalent reports until the start of 2023, which suggests that in the lion’s share of cases, the requisite ESG data does not exist.

“Did we get the sequencing right? The answer is no. We should have companies report on their data before we impose obligations on financial institutions to disclose their alignment.”

Van Hoorn says this back-to-front sequencing has created uncertainty in the market, but says “the design flaw is not fatal” because data providers are able to generate solutions to “plug the gap”.

He also defends SFDR arguing that the regulation itself is a positive development which has raised market awareness of the importance of incorporating ESG into financial products and strategies.

“SFDR has been hugely positive for the amount of awareness and discussion it has triggered across the industry which wouldn’t have happened without it.”

While asset managers have expressed concern about a lack of data to inform their fund classifications under SFDR, Morningstar data shows 37% of total EU fund assets being categorised as Article 8 or 9 last year. As both new data flows and reporting requirements increase over time, regulators will be better placed to scrutinise any gaps between marketing and reality.

Light touch regulation

In the absence of mandatory company reporting to meet SFDR requirements, van Hoorn suggests it might be necessary to apply “light touch” regulation to the myriad ESG data providers that inform asset owners and their managers about the sustainability of the corporates in which they invest.

Last January, The European Securities and Markets Authority (ESMA) described the market for ESG ratings and other assessment tools as “unregulated and unsupervised”. It warned: “When combined with increasing regulatory demands for consideration of ESG information, there are increased risks of greenwashing, capital misallocation and products mis-selling.”

Van Hoorn expects the European Commission to announce a consultation on regulation of ESG data provision within the next few months.

He says: “The feeling is some relatively light touch regulatory intervention could be warranted. We would advocate for consistent transparency across data providers and the quality of data they use.”

Yet van Hoorn draws the line at forcing ESG data providers to harmonise methodologies, saying it is neither “desirable nor feasible”.

“We support the International Organisation of Securities Commission’s stance that ESG ratings should not be used for regulatory requirements, and they should in general be used with some caution. The problem is often ESG ratings are seen like credit ratings. ESG ratings measure so many different variables so who decides which is the right one to measure and how much weight to give it?”

Instead, he says asset owners should see ESG ratings in the same way they understand an equity analyst’s assessment; some will rate a stock buy, others sell and some hold.

“Asset owners should use the ESG ratings they are given to inform their investment decisions in the same they would an equity analyst’s view on a stock’s value,” he says.

Fairy tale land

Alongside regulation of data providers, van Hoorn calls for more rigorous evaluation of companies’ net zero commitments. According to PwC’s annual CEO survey, of the 22% of global companies that have pledged to reduce emission by 2050, only two-thirds have had those claims independently assessed and validated. That figure falls to 47% of UK companies.

“It is time to improve how companies report their net zero claims. They need to be subject to more granular and robust reporting regulations, and we have got member states and MEPs to table amendments [to the CSRD] to that affect.”

He continues: “Everyone is allowed to make net zero claims, but it is difficult to compare and to understand how the scenarios and pathways used are realistic or if they are in a fairy tale land. Investors need an explanation of what the scenarios are trying to portray and what the assumptions are. There will be a role for investors to discipline companies and say they don’t believe spurious net zero pledges and call out false green claims.”

A step in the right reporting direction, according to van Hoorn, lies in the Corporate Sustainability Reporting Directive (CSRD), which requires certain large companies to disclose information on the way they operate and manage social and environmental challenges.

This month, Eurosif signed an open letter to policymakers insisting the CSRD is implemented swiftly and with the appropriate funding, and maintains its double materiality objective.

“Overall, we are pleased with CSRD for several reasons. It tries to address the problem with the SFDR sequencing as fast as possible. It also preserves the objective of reporting double materiality which is essential if you want investors to have the right information to apply the taxonomy properly,” van Hoorn adds.

France has just six months at the head of the EU table, which van Hoorn notes is not long to push through any items it has on its own sustainability agenda. However, he is optimistic that a country that was an early adopter of climate reporting regulations will be well placed to drive the bloc in the right direction.

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