A little history
In 2015, 196 countries and the European Union signed the Paris Climate Agreement[1], pledging to limit global warming to 1.5° above pre-industrial levels. Although the method for achieving this is not very precise, the commitment is strong, and finance has not been forgotten. Article 2c[2] of the Paris Agreement stipulates that "financial flows must be consistent with a greenhouse gas (GHG) reduction trajectory and resilience to climate change". Clearly, finance must be involved in efforts to mitigate climate change and adapt infrastructures and lifestyles.
Mitigation means using less fossil fuels. Adaptation means protecting populations and ecosystems from climate change that is already here. These are the two main thrusts of climate action.
This agreement gave a major boost to the world of finance. Institutional investors began to direct their investments towards climate and sustainability issues. It's no longer a question of practicing responsible investment on the margins, or a few exclusions. This new investment strategy is developing at full speed, and is known as ESG investment, for Environment, Social and Governance, 3 different factors grouped under the same banner.
In just a few years, ESG investments have skyrocketed to $35,000 billion by 2020, representing over a third of the world's financial assets (Assets under management). In some countries, such as Canada, the proportion of ESG investments exceeds 60% [3]. A considerable figure, which raises questions. One wonders whether the real economy, which underpins these financial assets, has been transformed to such an extent in such a short space of time.
Skeptics be damned, even Larry Fink, the high-profile boss of asset management behemoth BlackRock, is getting in on the act in 2018. In his annual letter to CEOs, he advocates the era of responsible capitalism[4]. Gone is the liberalism of Milton Friedmann and the priority given to shareholders; what counts now is the prosperity and security of citizens. Companies must take all their stakeholders into consideration, in an approach that integrates social and environmental concerns, and which John Elkington has called the "Triple Bottom Line" for People, Profit, Planet.
Lack of international standards and a jungle of labels
But there's a big problem. There is no universally accepted, standardized reference framework that defines what is truly ESG. So everyone will put their own preferences and priorities. For some it will be the environment, but not necessarily the climate, perhaps just reducing waste and water consumption. For others, it will be social issues, such as safety and training. Finally, in terms of corporate governance, an area which has already been strengthened over the last ten years, we will be ensuring, for example, the appointment of independent directors and the transparency of executive remuneration.
Clearly, the ingredients of "ESG mayonnaise" are highly variable, with fluctuating proportions of E, S and G. A mayonnaise that will have different flavors depending on the company's priorities. Will it be tasty? As Aswath Damodaran, eminent Professor of Finance at Stern and highly critical of ESG, so rightly says, "goodness is in the eyes of the beholders." [5]
Yet green, ESG, responsible and sustainable labels are flourishing, and rating agencies are getting into the extra-financial business. With no qualms about it, this little world evaluates objects that are not at all comparable, with data of heterogeneous quality.
When it comes to CO2 emissions, for example, companies often limit their information to scopes 1 and 2, without taking scope 3[6] into account. For example, some airports claim to be carbon-neutral because the airport fleet is electric, but forget to take air traffic into account. A fine example of greenwashing. Sometimes, companies don't even give any information on their physical emissions (tonnes of CO2), contenting themselves with mentioning, in a qualitative approach, the actions taken to decarbonize their business, or the governance set up to steer a trajectory that aims for Net Zero[7] by 2050.
Rating agencies, on the other hand, want to cover as many companies as possible in order to sell non-financial information to asset managers. It's their business. So, rather than waste time making in-depth assessments and talking to management, they send companies lengthy questionnaires to fill in every year. What I call ESG "tick the box". Underneath all these forms and indicators is a serious problem of lack of transparency in the financial markets, as in 2008 with the subprime crisis.
Standardization on the horizon?
This cannot continue. Stakeholders are putting on the pressure. NGOs, young activists like Greta Thunberg, future employees, consumers, are getting angry on social networks and in the sphere of political ecology.
So governments and regulators are finally realizing that they cannot delegate the sustainable transformation of the economy and businesses to the financial markets. They have to get involved, and play their sovereign role.
And so regulations are being put in place, particularly at European level with the new taxonomy that now classifies activities according to their sustainability. According to this taxonomy, sustainability does not stop at climate, but also includes the protection of water and oceans, the transition to a circular economy, pollution prevention and the protection of biodiversity and ecosystems. A total of 6 environmental objectives[8].
To be aligned with the European taxonomy, an activity must meet the following conditions:
- make a significant contribution to one of the 6 environmental objectives
- do no harm to the other 5 objectives ("Do notharm" principle)
- comply with minimum social standards (OECD, UN and ILO principles, International Bill of Human Rights)
- comply with the technical standards of the implementing decrees published via the delegated act.
For once, it's not a directive that will take years for each country to transpose into local law, but a regulation that has just come into force. What no European national government could have managed to legislate on - because they are all prisoners of a "tragedy of horizons"[9], the contradiction between their 3-5 year political horizon, and the timeframe of climate change, which is more than 10 years - Europe has done.
And so, from 2023, companies with more than 500 employees will have to declare the proportion of their activity that is sustainable in the sense of the European taxonomy, now known as "green ratios". Their performance will henceforth be assessed according to these green ratios. The obligation applies not only to their sales, but also to their investments, since it is indeed industrial investments that are the real vectors of long-term transformation. This means, for example, that the major oil companies will have to report very precisely on the proportion of their investments in renewable energies. At last, we'll be able to find out whether those who run communication campaigns about their transformation are translating their fine words into deeds.
The European taxonomy will be complemented by an overhaul of the Non-Financial Reporting Directive, now called CSRD, which will apply to all companies with more than 250 employees (50,000 in Europe). As for banks and financial institutions, under the SFRD they will have to publish their "green asset ratio", i.e. the proportion of their loans earmarked for financing sustainable activities.
It's a new paradigm, almost a Copernican revolution , which puts sustainability at the center rather than the periphery. Or are these green ratios just another indicator to be added to the traditional financial performance indicators? Drowned in too much information, will we still be able to identify the most sustainable companies?
Be that as it may, these laws will apply throughout the European Union, as well as to the non-European subsidiaries of European companies: their influence will therefore be worldwide, as was that of the American Foreign Corrupt Practices Act (FCPA), whose extraterritorial nature caused major companies on every continent to tremble.
The new legislation will also steer financing, whether public or private, debt or equity, towards sustainable activities. The ambition is to transform the European economy as part of the Green Deal[10 ] and achieve carbon neutrality at European level by 2050 to limit global warming.
Greenwashing, the noose is tightening
Greenwashing, which flourished in a context lacking in standards and norms, is beginning to be the subject of legal action and even condemnation.
Here are a few notable examples from the energy sector:
- In 2020, Italian oil company ENI was fined 5 million euros for misleading advertising for its Green Diesel,[11] and the company was also ordered to pay a fine of 1 million euros.
- Total Energies was sued in 2022 by 3 NGOs (Greenpeace, Amis de la Terre, Notre affaire à tous) for false environmental claims, in other words, contradiction between the communication campaign and the reality of the actions[12].
Subpoenas of this type against behavior that can be described as deceptive commercial practices will be issued more and more frequently. And they can lead to criminal sanctions.
Advice to companies
In this context, which is becoming clearer and tougher, companies must mobilize now to :
1/ Understand the new laws and regulations that come into force, and even maintain a constant dialogue with the various regulators to anticipate their recommendations.
2/ Learn to calculate their "green ratios" and have a robust methodology for justifying their ESG performance, by applying internationally recognized standards.
3/ Communicate responsibly and with integrity, avoiding greenwashing.
4/ Given the scale of the work to be carried out, we also need to train our employees in the new skills required (technical, legal, etc.), so that they understand what is at stake, and share the ambition to make the company more sustainable. This calls for a wide-ranging training plan, from board members right through to operational staff in the field.
Last but not least, companies need to transform their strategies and operating models to become more sustainable, otherwise they risk not only being unable to finance themselves, but also not attracting the talent they need.
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Anne Frisch - 08/29/2022
[1]https://unfccc.int/fr/processus-et-reunions/l-accord-de-paris/l-accord-de-paris
[2] French text of the Paris Agreement https://unfccc.int/sites/default/files/french_paris_agreement.pdf
[3] 2020 Report http://www.gsi-alliance.org/
[4 ] In English: https: //www.blackrock.com/corporate/investor-relations/2018-larry-fink-ceo-letter,
In French: http: //www.sefior.fr/wp-content/uploads/2018/06/Lettre_de_Larry_Fink_aux_dirigeants_des_grandes_entreprises_2018_FR.pdf
[5]https://aswathdamodaran.blogspot.com/2021/09/the-esg-movement-goodness-gravy-train.html
[6] Scope 3: indirect emissions up and down the value chain https://bilans-ges.ademe.fr/fr/accueil/contenu/index/page/categorie/siGras/0
[7] Defined by the United Nations as the reduction of emissions "to a level as close as possible to zero, with the remaining emissions in the atmosphere being reabsorbed, for example by the oceans and forests" https://www.un.org/fr/climatechange/net-zero-coalition
[8]https://finance.ec.europa.eu/sustainable-finance/tools-and-standards/eu-taxonomy-sustainable-activities_en
[9] Expression coined by Marc Carney, Governor of the Bank of England, in a speech at Lloyd's in 2015 https://www.bankofengland.co.uk/-/media/boe/files/speech/2015/breaking-the-tragedy-of-the-horizon-climate-change-and-financial-stability.pdf?la=en&hash=7C67E785651862457D99511147C7424FF5EA0C1A
[10]https://ec.europa.eu/info/strategy/priorities-2019-2024/european-green-deal_fr
[11] This biodiesel is made from palm oil, a crop that contributes to deforestation https://www.europeaninterest.eu/article/eni-fined-e5m-deceiving-consumers-green-diesel-italian-watchdog-rules/
[12]https://www.carbone4.com/article-total-neutralite; https://www.business-humanrights.org/fr/derni%C3%A8res-actualit%C3%A9s/totalenergies-assign%C3%A9e-en-justice-pour-pratiques-commerciales-trompeuses/
