Environmental and financial worlds meet in the “E” of ESG
Developments in the environmental and financial worlds may appear to be at first sight completely separate from each other. In this blog post, we will explain why this no longer applies in 2021 and why developments in the financial sector are relevant for companies operating in the environmental sector.
Introduction: ESG factors
In recent years, there has been an increasing focus on sustainability, including in the financial sector. The financial sector can contribute to the realisation of national and international sustainability objectives by, for example, financing sustainable initiatives or providing insights into the sustainability objectives of financial products. Additionally, (private) investors find sustainable investments increasingly important. In early 2018, the European Commission published the Action Plan: Financing Sustainable Growth (“Action Plan”), which lays the foundation for the first sustainability regulations for the financial sector.
According to the European Commission, “sustainable financing” generally refers to the process of properly taking into account environmental and social considerations in investment decision-making, leading to increasing investments in longer-term and more sustainable activities. One of the ways of engaging in financial services in a sustainable way is to integrate Environmental, Social & Governance (“ESG”) factors.
ESG is increasingly enshrined in law, requiring the financial sector to consider ESG factors in their decision-making. Examples include the following European regulations that follow from the Action Plan:
a. Sustainable Finance Disclosure Regulation (aka SFDR) (Regulation (EU) 2019/2088).
The SFDR requires financial institutions to disclose information about sustainability risks. A sustainability risk is an ESG event or circumstance that, if it occurred, could cause an adverse effect on the value of the investment. In addition, financial institutions should report on the degree of sustainability of their products and on how they integrate sustainability into their policies.
b. Regulation on the Establishment of a Framework to Facilitate Sustainable Investment (also: Taxonomy Regulation) (Regulation (EU) 2020/852).
The Taxonomy Regulation establishes criteria to determine whether an economic activity qualifies as environmentally sustainable. This allows determination of the extent to which a particular investment is environmentally sustainable. In addition, investors use ESG factors to assess investments and other economic activities. Companies also use ESG factors in non-financial reporting (also called sustainability reporting). It is therefore of great importance for companies and financial institutions to understand how entrepreneurs give substance to these ESG factors within their business operations.
The Taxonomy Regulation has a broad scope. Certain large non-financial institutions will also be required to report according to the standards of the Taxonomy Regulation.
In this blog post, we address the “E” in ESG. We will explain what this factor entails, whether material standards apply to this factor, and we will explain which material standards are applicable. Finally, we will explain the importance for practice.
Note: Social factors (such as working conditions (throughout the supply chain) and governance factors (such as diversity and remuneration policies) will not be covered in this blog post.
What is covered by the “E” in ESG?
The “E” in ESG stands for Environmental; also referred to as the ecological or environmental factor. It is a broad, and not especially well-defined, concept. When considering this factor, one can think of environmental criteria, such as the extent to which the company contributes to climate change, the use of fossil fuels, energy transition, environmental pollution, circular economy, emissions, energy-saving measures and environmental opportunities. In addition, the aforementioned Taxonomy Regulation creates a framework to give substance to the ecological factor. In the Taxonomy Regulation, an economic activity is considered ecologically sustainable if that economic activity:
- Substantially contributes to the six environmental objectives listed in the Taxonomy Regulation;
- Does not seriously detract from the environmental objectives stated in the Taxonomy Regulation;
- Is conducted in compliance with the minimum safeguards set forth in the Taxonomy Regulation; and
- Meets the technical screening criteria that the European Commission has established.
Giving substance to the ESG standards
If companies rate themselves on ESG in their reporting or their financial products (known as an “ESG score”), it is important for these companies to understand how the ESG score is established. Companies need to know when and to what extent an investment or investment product has an impact on the environment.
The interpretation of ESG standards, and more specifically the ecological factor (“E-factor”), is not exhaustively regulated by any government or at the international or European level. Consequently, there are as yet no concrete material standards against which the E-factor can be assessed in order to establish an ESG score. Due to the lack of concrete standards, companies and financial institutions can indicate how they give substance to the E-factor through various descriptions, often uncertain or unmeasurable.
It is intended that the Taxonomy Regulation will give more substance to the E-factor by introducing technical screening criteria, as mentioned above.
On April 21, 2021, the European Commission adopted a delegated act (also called the EU Taxonomy Climate Delegated Act (preliminary text)). This contains the first set of technical screening criteria. These should contribute to two objectives of the Taxonomy Regulation: (i) climate change mitigation and (ii) climate change adaptation.
The EU Taxonomy Climate Delegated Act covers the economic activities of about 40% of listed companies, in sectors that are responsible for almost 80% of direct greenhouse gas emissions in Europe. These include sectors such as energy, forestry, industrial production, transport and construction. More activities will be covered in the future. The EU Taxonomy Climate Delegated Act should support sustainable investments by clarifying which economic activities contribute most to the achievement of the European Union’s environmental goals. The delegated act will be formally adopted in late May once translations are available in all EU languages. The delegated act will enter into force on January 1, 2022. Similar standards will follow in the future for the ‘S’ and possibly the ‘G’ in ESG.
In addition, there are private initiatives that offer an ESG label or certificate (for a fee). Companies are responding to the lack of concrete and measurable ESG standards by developing various ESG standards and benchmarks. Investors often use benchmarks as a pricing tool for financial instruments, because it tracks and measures the performance of investments. These benchmarks are now also being developed to measure financial instruments against ESG factors and are termed ESG benchmarks. In addition to these ESG benchmarks, there are ESG ratings issued by ESG rating agencies. The ESG rating is being seen as the non-financial equivalent of the credit ratings issued by credit rating agencies.
Financial regulators and governments have raised criticism about the above-mentioned private initiatives. For example, the sustainability data is not always consistent, comparable and reliable. Rating agencies do not always agree on the degree of sustainability of a company or an investment product. Thus, the valuation method can differ: different rating agencies are taking into account different aspects when determining their rating; there are differences in the factors used and the weight assigned to them. ESG rating agencies are also not regulated. The Financial Markets Authority has expressed concerns about this and has proposed that rating agencies and specialised data companies should be regulated and supervised.[1]
One of the reasons that ratings and benchmarks differ in valuation methodology and final ESG score is the lack of material standards. Substantial amounts of data is used and compared to arrive at a particular ESG score, but there are no substantive material standards against which to measure. In practice, it is therefore common to get a better E-score if it can be shown that certain industries are excluded by a company or in an investment product.
Importance for practice
It is clear that the transition to a climate-neutral Europe will demand a lot from companies. It is therefore of great importance for companies to know whether and how they can meet the applicable ESG standards. This is currently not sufficiently clear for companies and financial institutions. The EU Taxonomy Climate Delegated Act is a first step in the right direction, but more tools for companies would be very welcome.
For more information, visit our website: Energy Transition and Climate.
