ESG Focus | Mar 30 2021
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Materiality And The Green Theme
In Parts 1 and 2 of this series, we examined First Sentier’s approach to materiality, focusing on the “S” in ESG, but this article focuses on green materiality – last but definitely not least.
– Beware the great global greenwash
– Biodiversity shaping up as key area of focus
– Climate disclosure right here and now
– The EU taxonomy is almost upon us
– Materiality in utilities, infrastructure and electrification
By Sarah Mills
Climate change and environmental themes are in the spotlight, and 2021 is being billed as the year of renewable energy and electrification.
Trillions of dollars will move over the next few years into these sectors – one of the largest funds transfers in market history.
This transfer began seriously several years ago and will accelerate, causing volatility in nearly every market sector, but particularly fossil fuels, as funds are transfused from old industries into new ones.
The European Union has earmarked E$1trn to the sector in its green deal; Biden has pledged US$5trn in his Build Back Better campaign (and his stimulus bills have just passed the Senate); Britain has announced a net zero target; and China has committed to net zero by 2060.
BetaShares CEO Alex Vynokur recently estimated that the additional investment required to achieve a global zero carbon-emissions economy by 2050 will be US$1trn-US$2trn a year in the decades to come.
Blackrock CEO Larry Fink recently advised that the climate transition presented a “historic investment opportunity”, describing it as “tectonic shift”; and that we were witnessing the beginning a long but rapidly accelerating shift.
All companies will be caught up in the transition and reorganising companies’ energy and water useage, supply chains, human capital and environmental impacts will come at a cost.
Those with the deepest pockets and most sustainable, circular strategies (which is likely to include some level of innovation) are pegged to be those with the best chance of surviving the next two decades.
Sharp-nosed sustainability innovators with access to big capital are also expected to succeed.
Companies in industries targeted for disruption are the most vulnerable.
Beware the great global greenwash
Institutions, financiers and advisers all around the world are jostling for pole position in the stimulus stakes; and the arena is expected to attract more than its fair share of shysters.
For investors, determining materiality will be crucial.
Green-washing is already commonplace, and investors everywhere are working hard to isolate the most material issues to long-term sustainability.
Or as Fink describes it: “the sustainability premium”.
Wrong decisions could prove costly. Many corporations will fail. The most sustainable (or fittest) will survive.
Legal suits are already on the rise for institutions accused of green-washing, and this is shaping up as a significant risk for investors.
German giant DekaBank was recently sued over a misleading fund impact calculator and that is just a warning shot across the industry bow.
A recent landslide European Parliament vote warns of stronger corporate liability rules on human rights and environmental issues.
Legal precedents are being established but most governments prefer to use the carrot rather than the stick and are working hard at building transparency and accountability around the issuance of green stimulus.
In this article, we check out these materiality benchmarks and frameworks, and the growing emphasis on judicious portfolio allocation as a way of boosting returns.
Recognising a delay in the arrival of reporting frameworks, we examine the available issues and metrics, such as the UN Sustainable Development Goals (SDGs) that First Sentier believes can prove a guide to environmental materiality.
Linking social and green materiality
Before continuing, just a quick reminder that green sustainability is about more than environmental issues.
In Parts 1 and 2 of this series (links below), we examined First Sentier’s approach to dealing with materiality in emerging economy supply chains, and the growing institutional focus on mental health, gender and modern slavery.
These social materiality issues will be very important for those investing in manufacturing industries and technologies supporting the green transition and other SDG goals.
This social filter may also prove a useful first-stage green-washing filter.
For example, founders of the ESG Olympics, Friends Provident Foundation; Joffe Trust and Blagrave Trust found that many ESG proposals from asset managers failed on social aspects in particular.
Responsible Investor also notes that some sustainability goals come at zero cost, so one assumes that any company that isn’t implementing them is probably not trying hard enough – another green-washing filter.
For example, on the environmental front, adoption of renewable energy sources and moving from paper to digital should reduce costs and improve efficiency within the short to medium term, and encourage energy providers to improve energy supply.
Areas of portfolio focus
It’s early days yet and the transition offers something of a smorgasbord for investors in terms of ESG metrics.
First Sentier suggests that isolating areas of focus can help investors simplify decision-making.
Another filter is to isolate the key threats to corporate sustainability during the transition, and apply these to investment decisions.
First Sentier is choosing specific United Nations Sustainable Development Goals (SDGs) as areas of focus – among other options; and then targets specific indicators that it believes it can both influence and obtain an outcome.
Biodiversity – one of the belles of the ball
On the environmental front, First Sentier has chosen biodiversity (which is considered to be mutually dependent with climate change) as one area of focus.
First Sentier’s approach to biodiversity at the moment is to map risks across its portfolios to identify companies that are most exposed to biodiversity-related risks; and many other institutions are doing the same.
Biodiversity is shaping up as a major ESG priority and is being considered one of the defining filters for a company’s “Social Licence to Operate”.
Chief Sustainability Officer & Global Head Sustainability Strategy, Advisory and Finance, Credit Suisse, Marisa Drew, notes that nature is critical to the global economy and is valued at US$125trn; and that biodiversity is critical to maintaining that value.
“An estimated investment of up to US$967bn is required each year if the decline in biodiversity is to be reversed by 2030,” says Drew, in the Unearthing investor action on biodiversity report; an excellent collaboration with Responsible Investor for those seeking more information on the topic.
“On the surface, this figure seems large, but it pales in comparison to global subsidies for high carbon-emitting activities that contribute to the biodiversity losses in the first place."
Drew’s statement is one of the first clear indications of a large impending switch from fossil fuel subsidies to sustainability initiatives.
The fossil fuel industry is one of the most heavily subsidised industries in the world and fossil fuel investors are likely to be keeping an eye peeled to the final decision of the post-2020 global biodiversity framework at the UN Biodiversity Conference COP 15 in May, together with decisions on related topics, such as capacity building and resource mobilization.
The biodiversity frameworks are also aimed at providing a market mechanism to arbitrate on increased competition between industries for a slice of the rapidly dwindling natural pie (nature represents nearly half of global GDP).
Bankable projects soon in the pipeline
Drew’s comments are also a fairly clear indication of the size of the investment prospect.
At nearly US$1trn a year, Drew notes the mobilisation of resources to protect biodiversity represents an opportunity for big capital globally, and says the task for leaders now is: “the creation of investible and structured opportunities for investors to deploy their capital. “
Investors have been shying away from biodiversity themes given the lack of bankable options, measurement standards, and internal expertise.
But it is estimated that in roughly two years, biodiversity standards will be established.
Enter the Task Force on Nature-Related Financial Disclosures (TNFD).
Like the Task Force on Climate Disclosure, the TNFD will contribute to the creation of a framework that will help financial institutions identify and mitigate the impact of their actions on nature and biodiversity.
Along with frameworks such as the UN SDGs and the sustainability accounting standards, these should go some way to helping investors measure materiality in the sector.
But many investors are attempting to position and educate themselves in the biodiversity space well beforehand.
Biodiversity is being prioritised by governments globally
More than 130 countries have been called upon to commit an initial US$500bn to support nature conservation worldwide.
The final decision of the post-2020 global biodiversity framework will be made at the UN Biodiversity Conference COP 15 in 2021, together with decisions on related topics, such as capacity building and resource mobilisation.
Just recently, the UK Treasury urged the private sector to take action on biodiversity in its Dasgupta Review.
To gain their social licence to operate, companies will be expected to price in nature-based externalities to their operations – a user-pays model.
Already, BHP Group ((BHP)) for example, has a section on its website dedicated to Biodiversity and Land, of which it owns or manages more than 8 million hectares of land and sea.
The biodiversity report surveyed 327 fund managers from more than 35 countries.
About 51% of fund managers believe biodiversity will be one of the most important topics facing the investor community by 2030.
The sectors institutional investors believe are most at risk from biodiversity loss are: food and beverages, 80%; healthcare, 39%; and consumer goods, 35%.
Respondents identified the top three causes of biodiversity loss that are most significant globally as: agriculture and aquaculture (66%); climate change and severe weather (60%); and pollution, such as domestic wastewater, agricultural effluents, solid waste, and airborne pollutants (51%).
They identified the main business risks associated with biodiversity loss as:
– reduced productivity of natural systems, 79%;
– supply chain risk, 58%;
– reduced quotas/reduced access to land and resources, 39%;
– reputational risk, 36%; risk of litigation/regulation 30%;
– changing consumer preferences, 20%;
– sustainability requirements and labels, 19%;
– financing risk, 13%;
– other, 6%; and don’t know, 1%.
Climate disclosure is right here, right now
Biodiversity impact investing may be a good two years off, but renewable energy is right here, right now.
Trillions of dollars of capital will be funnelled into the sector globally over the next few years.
Global carbon markets are progressing. There are 64 carbon pricing initiatives covering 46 national jurisdictions and 35 sub-national jurisdictions now operating.
The main risk for investors is that of disruption. What one invests in today could be gone tomorrow.
Determining the most sustainable companies throughout this period will be critical.
The obvious disruptee in the early stages of the transition is the fossil fuel industry; but more will follow.
FNArena will cover the area in more detail in our renewable energy series but this article centres on measuring materiality.
Recent news surrounding green materiality includes:
– the UK publication of draft TCDF reporting guidance for pension schemes;
– The introduction of the ESG bond framework for UK local authorities issuing ESG municipal bonds.
– warnings of sovereign credit downgrades linked to climate action, including Australia;
– a Fitch warning that sovereign credit ratings at risk from stranded assets;
– a massive downgrade of Exxon, Conoco and Chevron by S&P, exacerbating stranded-asset concerns;
– the Climate Law Initiative says Japanese company directors will be liable for climate decisions;
– the head of the French central bank urging the European Central Bank to “green” its collateral requirements and bond purchases;
– the introduction of the Carbon Border Adjustment Mechanism (CBAM) in Europe, which will tax imports that have not priced in carbon;
– The International Civil Aviation organisation has established a scheme requiring operators to purchase carbon offsets to cover their emissions above 2020 levels, starting from 2021; and
– ramping up of the operationalisation of the EU taxonomy to support the EU green deal.
A review of the EU emissions trading scheme is scheduled for 2021; clean legislation is anticipated in the US over the balance of 2021; and China plans to launch its national emissions trading scheme later this year.
The European Union Taxonomy could be upon us within a month
While SDGs offer an interim materiality screen, institutions are preparing for the rollout of various global reporting frameworks, the most imminent of which is the EU taxonomy.
Europe has linked the receipt of sustainable stimulus dollars to adherence to the EU taxonomy (EUT), a set of reporting standards to be included in non-financial statements. It is a matter of legal compliance.
Institutional investors and asset managers promoting their investment products as “sustainable” will need to explain exactly how the EUT criteria apply to their products, so as to marginalise green-washers.
Companies seeking funds will have to meet the same compliance standards as institutions.
The ambitious date for implementation of the taxonomy suggests it could be here within a month. It is hard to overstate the importance of this date to investors.
Once in place, trillions of dollars in impact and innovation funding will flood the globe. Its sole purpose: disruption.
The EUT framework earmarks the following six activities for funding largesse:
– climate change mitigation; climate change adaptation;
– sustainable use and protection of water and marine resources;
– transition to a circular economy; pollution prevention and control; and
– protection and restoration of biodiversity and ecosystems.
To be eligible for funding, a company or institution must:
– identify whether their products and services meet one of the above objectives;
– verify whether the eligible activities meet the technical screening criteria;
– perform due diligence to ensure “Do No Significant Harm” (to all other objectives) is honoured; and
– perform due diligence on whether the company or issuer has met the ILO Core Labour Practices (speaking again to social materiality).
Focusing on the green activities, Morgan Stanley has isolated 122 US companies with eligible revenue.
For example, it has just included 15 insurance companies under Objective 2: Climate Change Adaptation.
The analyst notes that this objective covers two types of activities: those that are adapted to material physical climate risks; and those that reduce that risk in other economic activities and/or address systemic barriers to adaptation.
It nominates 15 insurance companies that qualify based on their underwriting of climate-related hazards and thought leadership in modeling and pricing of climate change; including Warren Buffet’s Berkshire Hathaway.
“Do No Harm” is a big obstacle for amateurs weighing materiality.
Most investors can figure out whether products and services are aligned, but determining that they do no harm is another level of labour altogether.
The 18-page Morgan Stanley report on just one of the EU objectives gives some idea of the complexity of the task.
It also suggests a competitive advantage for larger companies with deeper pockets to ensure alignment when pitching for funds.
Global climate disclosure booms as Asia jumps in the ring
Meanwhile, the Asian Science-Based Targets initiative (SBTi) framework grew to 47% from 8% in one year and carbon foot-printing for listed equities grew to 79% in 2020 from 19% in 2019, according to the Asian Investor Group on Climate Change.
The group interviewed investors representing $1.9trn in assets in its Net Zero Investment in Asia survey and found decarbonisation strategies had been adopted by more than 40% of respondents.
Malaysia plans to launch a principles-based green taxonomy in 2021 based on the EU’s version, while the Taiwan financial regulator will finalise a sustainable finance taxonomy by year end.
Singapore is consulting on a green taxonomy and Japan is working on harmonizing its ESG disclosure with European taxonomies.
The survey found more than 70% of asset managers plan to launch a climate-related fund within two years.
US materiality frameworks on the way
US President Biden is also promising trillions but the links to materiality are still being established.
A founding member of the US Public Company Accounting Oversight Board, Daniel Golelzer has called on Congress to grant the body additional powers to establish audit standards for ESG.
Golelzer argues that the institution should be allowed to inspect audits on ESG and set standards on the topic given auditors are increasingly being asked to provide assurance for corporate ESG reporting; and given the proliferation in ESG funds and the importance of audits to investor capital allocation.
The PCOAB’s task is to conduct annual inspections of accounting firms that provide independent audits to more than 100 public company clients; and triennial inspections of those with few company clients.
Also in the United States, the Securities Exchange Commission has said international disclosure frameworks are key to supporting asset management companies in ESG decision-making.
And the US Sustainability Accounting Standards Board merged with the Global Reporting Initiative to form the Value Reporting Foundation, which will create a global set of accounting standards for sustainability.
These are still two years away.
Meanwhile, the Australian Prudential Regulation Authority (APRA) revealed it is developing a climate vulnerability assessment “to both uplift the scenario analysis capability and strengthen the understanding and management of climate-related risks within the financial sector".
Institutions relying heavily on portfolio allocation
In late 2020, the forum for Sustainable and Responsible Investment stated that US sustainable investment assets had $17trn – or $33% of all US professionally managed assets.
But it is widely acknowledged that only a minor percentage of these investments could genuinely be described sustainable.
Simple screens rarely translate to genuine outcomes benefiting people and planet.
And, as we have noted repeatedly, successful ESG investing is all about outcomes: we discussed the notion that impact (or genuine sustainability) is joining the old risk-and-reward paradigm at the hip in previous articles.
Successful ESG investing is also about portfolio allocation, according to Responsible Investor.
“Asset allocation is critical – the conscious choice of which asset classes to invest in – is said to provide upwards of 80% of a portfolio’s financial returns (the rest being instrument selection, such as stock picking),” says RI
“… So it is the most important choice an investor can when seeking to generate real-world investments.”
RI notes that at present, sustainability is being viewed as a trade-off with risk and reward – but argues that this is a fundamental misconception which is about to change.
“Sustainable factors often do not enter the asset allocation debate. When they do, they are typically considered at the end of the process and treated as a constraint.”
The solution to overstatement and under-delivery is dispensing with the trade-off paradigm and instead embedding sustainability in the asset allocation process – from future asset-price forecasts to the asset-class universe, says RI.
To do so, there are three pragmatic and return-maximising actions asset allocators can take.
1. Understanding where environmental and social themes meet inflation, productivity and economic growth and investing accordingly; and recognising that improved governance is also clearly linked to long-term performance.
2. Utilising attractive fixed-income use-of-proceeds investments, such as Multilateral Development Bank debt, which can fully replace conventional AAA-rated sovereign exposures in an asset allocation framework; and green bonds, which exclusively fund sustainable projects; and lobbying for new instruments such as waste-reduction bonds, which opens a broader range of sectors to use-of-proceeds bonds.
3. Focus on public market strategies over hedge funds; examine private markets in the impact space, which includes opportunities in microcredit, renewable energy, agricultural finance, sustainable infrastructure and impact growth, private equity.
For the smaller investor, these markets can be harder to access without an institutional vehicle; but at least understanding these asset allocations can help those directing their funds through institution to avoid green-washers.
"By addresing the source over 80% of portfolio returns, we can overcome our industry's challenge of overstatement and under-delivery," says RI.
And, for those who still prefer to go solo, knowledge is power.
RI also advises against recent strategies of relying on tax breaks and price-support mechanisms such as carbon credits, given subsidies can be removed.
We have seen this in the solar industry, when subsidies were withdrawn once the industry out-competed fossil fuels on price, leading to a collapse in share prices.
"We have witnessed how this support can quickly be taken away and the risks investors face if they relied upon subsidies to support underlying assets."
RI advises that the removable of renewable energy subsidies, or threat thereof, has changed the investment game.
Power Purchase Agreements and blindly chasing subsidy dollars are carrying higher risk; and investors need to focus on construction, says RI, harking back to our previously noted importance of asset allocation in sustainable investing.
“As the renewable energy sector continues its shift away from subsidies and the PPA space grows ever more crowded, investors should look for a third way to scout out strong opportunities offering stable, long–term returns".
So institutions have already switched their focus to integrating portfolio-wide decarbonisation goals.
Materiality in utilities and infrastructure
Given taxonomy and standards are still pending, we return to First Sentier to examine the available and simpler materiality assessment tool of SDG alignment, and influenceable indicators.
Utilities and infrastructure is one of First Sentier’s areas of focus.
To achieve its climate goals; the institution is focusing on the progression of listed infrastructure companies towards:
– decarbonisation and electrification;
– net zero emissions; and
– to a company’s ability to deliver on green energy and infrastructure.
In the listed infrastructure space, First Sentier is taking a long-term view and assessing companies’ actions now towards achieving these climate targets beyond the life of the current executive management team – out to the 2040s and 2050s.
It will also seek to more systematically measure impact and press boards for more comprehensive climate reporting.
As with its other areas of focus, the institution chooses SDG indicators that it can influence and which offer easily assessable milestones against which to hold corporations accountable.
The main SDGs for listed infrastructure are:
– 6: Clean water and sanitation;
– 7: Affordable and clean energy;
– 9: Industry innovation and infrastructure;
– 11: Sustainable cities and communities;
– 12: Responsible consumption and production:
– 13: Climate action
First Sentier’s Portfolio Manager, Global Listed Infrastructure, Rebecca Myatt, notes opportunities in the decarbonisation of power generation; electrification of transportation; and decarbonisation of industrial processes and heating.
“Net zero ambitions need to be translated into short and medium term targets.,” says Myatt.
“Management teams need to be fully aligned and we need to hold management teams accountable.
“We only invest where management operates the business effectively and in the interests of all stakeholders.
“Those that don’t look after their customers, employees, suppliers and larger community are unlikely to be rewarding long-term investments.”
First Sentier presents examples of corporations that have made good decisions in US states in which regulation has been enacted.
“Its significant investment in renewable energy with limited, if any, impact to customer bills aligns Xcel Energy with SDG7 (Affordable and Clean Energy: ensure access to affordable, reliable and sustainable and modern energy for all 7.2),” says Myatt.
Australia’s AGL Energy ((AGL)) would no doubt want to know how to achieve such a goal without destroying shareholder value.
Electrification – decarbonisation is the buzz word
First Sentier also nominated electrification as an area of focus.
The institution will be investing in environmentally friendly technologies, supporting innovation, and the rollout of cleaner, cheaper and healthier private and public transport, decarbonising the energy sector, ensuring buildings are more energy efficient, and working with international partners to improve global environmental standards.
This appears to fall under SDG 12: Responsible Consumption and Production, Target 12.6: Encourage companies, especially large and transnational companies, to adopt sustainable practices and to integrate sustainability information into their reporting cycle.
First Sentier’s chosen indicator here is 12.6.1: Number of companies publishing sustainability reports – a fairly easy hurdle for most companies.
A quick glance at the ASX300 shows many lodged sustainability reports in FY20. The quality of many of the reports may leave something to be desired, but it is the first step in ensuring corporate compliance.
Several Australian companies have already lodged green bonds, which meet the Responsible Consumption and Production Target.
Woolworths ((WOW)) raised $400m from institutional investors in 2019 in one of the country’s first green bond issues.
The company worked with the UK-based Climate Bonds Institute to create a benchmark for the carbon intensity of its supermarket sites, which provides a framework to assess Woolworths progress towards decarbonising.
Woolworths has earmarked the funding for solar panels, LED lighting, hybrid or HFC-free refrigerators and cutting down on plastic wrapping on fruit and vegetables.
Many may have noticed the amount of plastic on Woolworths fruit and vegetables has skyrocketed in the past two years, spiking possibly just before the green bond was issued – rather puzzling.
However, plastic on fruit and vegetables also has a carbon trade-off in that it preserves shelf life, reducing transportation costs.
Still, it is $400m in cash-cow Woolworths’ kitty, and a solid investment for institutional investors.
A final note on disruption
Australia’s media industry still stands as the gold standard in disruption for this country – yet it is a cautionary tale of what not to do, rather than how to innovate for survival.
A combination of: boys clubs, management dominated by political personalities with a strong focus on the present and on personal and longstanding power bases; as opposed to innovative, inclusive visionaries; contributed to one of the greatest losses of prestige and power witnessed in one decade.
The demise gradually accelerated in the first ten years, before snowballing in the final ten.
It was that first decade that was critical to ensuring masthead survival. By the time the second decade dawned, industry dominance was, for many, unsalvageable.
It is likely climate disruption will follow a similar trajectory.
Michael West conducted a brilliant interview at The Adelaide Writers’ Festival (now on youtube), titled The Land of Mates and Favours.
It is well worth watching from an ESG point of view, particularly given institutions are ramping up engagement with sovereign bond issuers over fossil fuels.
But it also talks to the cultural challenges Australia and Australian companies face in periods of disruption.
Unlike the United States and many nations, where innovation is welcomed, innovators are shouldered out by corporate politics in this country, given oligopolies have no need to take real risks, simply by virtue of belonging to the club.
Investors would do well to assess their portfolios with this in mind given the “clubby” nature of Australian business, which may even stymie corporate decarbonisation among the willing as the price to be paid for remaining in “the club”.
Materiality Matters Part 1 (https://www.fnarena.com/index.php/2021/03/16/esg-focus-materiality-matters-part-1/)
Materiality Matters Part 2 (https://www.fnarena.com/index.php/2021/03/22/esg-focus-materiality-matters-part-2/)
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
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