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ESG Focus: Keeping The Bastards Honest

ESG Focus | Jul 15 2022

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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:

ESG Focus: Keeping The Bastards Honest

Big capital is shifting from the carrot to the stick as it prepares to wheel out ESG litigation, which is set to become a new investment opportunity – an asset class in its own right. 

-SEC to mandate on climate disclosure by year-end
-ESG litigation may be a route to profit and a market hedge
-Impact investors eye the litigation opportunity
-Auditors and lawyers prepare for the banquet
-Real estate and low-carbon markets come into focus

By Sarah Mills

The founder of the Australian Democrats, Don Chipp, coined the phrase “keep the bastards honest” in 1980 to describe the party’s mandate.

It was a pledge which would propel it to become Australia’s third major party and a cogent political force in the Australian Senate.

But in 2000, the party fell on its sword and dishonoured its core branding by passing the goods and services tax (GST) in clear contradiction to its mandate and the will of the people. The Australian Democrats evaporated into political history virtually overnight. 

The party had no mechanism to keep itself honest. 

It was a timeless and salutary lesson that applies equally to ESG.

Without a “keep the bastards honest” mechanism, the green transition too could crumble, but the founding fathers of ESG foresaw this and wrote one into the transition blueprint – litigation.

Litigation, once a David versus Goliath struggle between small interests and corporations, is about to become a battle of the Titans as global hedge funds and asset managers move to protect their assets and build new revenue sources. It's Greed versus Greed.

The stakes are high and rising.  

Bloomberg Intelligence says ESG investments are forecast to rise to US$50trn by 2025, compared with roughly US$40trn at the end of June 30, 2022.

Many are forecasting ESG litigation could be the next blow to strike markets as big capital shifts from the carrot (of rewarding compliance with capital), to the stick.

Many others are considering it a lucrative investment opportunity and market hedge.

A Friendly Heads Up

Calvert’s Executive Vice President Chief Responsible Investment John Wilson was visiting Australia recently.

He has the distinction of being a member of the US Sustainability Accounting Standards Board, which is establishing the ESG metrics that US companies will be mandated to report upon in their 10K annual filing reports.

Wilson says it isn’t quite time to nail down a universal international ESG standard yet, but he offered a friendly reminder that the US Securities Exchange Commission (SEC) is expected to mandate emissions reporting for US companies at the end of this year. 

The upshot, he says, will be litigation.

Nuts and bolts of the SEC legislation

Under the mandate, all US publicly-traded companies will be required to describe on the Form 10K their governance and strategy towards climate risk and their plan to achieve any target they have set.

They will be required to disclose Scope 1 (their own emissions) and Scope 2 (their energy emissions) targets and gain independent verification for carbon emissions estimates.

Reporting on Scope 3 emissions is a different kettle of fish.

Not all publicly-traded companies will have to report on Scope 3 emissions – only companies who have already set goals and are reporting on Scope 3 metrics will be held accountable.  Scope 3 disclosure will be phased in subject to safe harbor protections and will not be required of smaller companies.

Still, reporting on Scope 1 and Scope 2 emissions is a mammoth task in itself.

Wilson says the global auditing community is readying itself for the mandate, (more on that later).

And the lawyers are sharpening their knives.

ESG To Supercharge Litigation Funds

Litigation funds are designed to address the structural problems of capitalist systems.

“One way to deliver shareholder value is to cut corners and hide behind balance sheets and lawyers, which is an unfortunate consequence of business in the 21st century,” notes Edward Truant CEO of Slingshot Capital Inc. 

“This is particularly the case when the cost of litigation pales in comparison to its advantages and it can be highly inefficient.”

But as the “S” in ESG takes centre stage in investors' mandates, and as the world’s investment powerhouses face material losses from corporate ESG failures, investors are seeking new ways to protect their investments, hedge their exposures, and find new avenues of profit.

Litigation funds ticks all three boxes.

ESG Litigation – A Route To Profit

And the big guns are starting to mosy on up to the ESG OK Corral.

Investors everywhere, from asset managers to hedge funds are recognising the profitability and power of ESG litigation in the global transition.

With US$50trn at stake, the legal spoils are expected to be considerable.

The Hedge Fund Journal says hedge funds may approach ESG breaches in two ways:

-consider taking short positions in issuers they suspect of misstating ESG disclosures; or
-seek to recover through litigation monies lost in long positions through misstatements.

“Should funds wish to litigate on this basis, specialist third-party funders are likely to be keen to underwrite the claims,” notes the journal.

Listed litigation funds are already eyeing the lucrative market.

Burford is considered the world’s largest litigation fund, it is publicly listed with a market capitalisation of roughly $4bn according to Bloomberg Law.

Another big-hitter is Harbour Litigation Fund the world’s largest privately owned litigation funder, which gained $1.541bn through third-party capital raised and claims a 76% success rate on its website.

Closer to home, Omni Bridgeway ((OBL)) is a publicly listed company on the ASX and boasts a market-cap of roughly $1bn.

Investment in such companies offers a natural hedge, and it is likely more ESG litigation funds will list to attract the growing pool of capital.

ESG litigation encompasses human rights, environmental protection, climate change, equality, indigenous rights, and other critical causes.

Observers also see the litigation funding theme playing out in the tech sector and offering support for small providers against large customers who steal intellect property, in a bid to encourage innovation during the transition.

Already, specific subsets of ESG are attracting attention.

For example, Burford has established its “Equity Project” which has been “designed to close the gender gap in law by providing an economic incentive for change through a $50m capital pool earmarked for [litigation finance matters] led by women".

ESG Litigation and Impact Investment

Slingshot Capital’s Truant expects ESG litigation will become a new asset class.

While the Litigation Finance Journal notes the industry has yet to establish itself as such, it is definitely considered a key component to the emerging ESG asset class of impact investing, and is likely to position itself as such.

“Make no mistake, litigation finance is impact investing!” states the journal.

“Litigation finance is instrumental in driving societal, environmental and governance change.”

This is a key distinction, given experts expect impact investors may enjoy greater recourse in the courts, which we discuss further below, and attract greater capital.

When assessing a litigation fund, the Litigation Finance Journal suggests that investors look beyond returns generated by litigation to the social and environmental impact lens of the fund, as this will determine the amount of capital it attracts and its defensive characteristics.

The journal says ESG litigation funds (and many funds that include standard ESG issues) should be classified as impact investing for the purposes of portfolio allocation as discussed here.

Truant agrees.

“Every single wealth management firm, including Blackrock, Morgan Stanley and UBS … have recognised that making a difference is becoming increasingly important to the investor community,” says Truant.

“So for a nascent industry looking to ‘stand out from the crowd’ and given the demand for impact investing and the inherent societal benefits associated with its service offering, the industry is best served by ensuring litigation finance is included in the impact investing conversation.”

World’s First Listed ESG Litigation Fund Hits The Market

This month, Aristata Capital secured GBP40m of capital in its initial closing for its first impact litigation fund (impact-investing is an ESG asset class), Aristata Impact Litigation Fund (AILF 1).

The fund was anchored by The Soros Economic Development Fund; Capricorn Investment Group’s Sustainable Investors Fund; and several foundations and family offices.

Aristata Impact aims to have a hard cap of GBP100m.

Litigation Finance Insider notes the fund aims to deliver “above-market, uncorrelated returns from investments in commercial litigation”.

Impact Investors May Have The Advantage

Pundits believe that ESG litigation may be more successful in the impact-investing context.

According to the Global Investment Network, impact investments comprise $230bn in assets under management globally and JP Morgan expects this to rise to $1trn by the decade’s end.

The Hedge Fund Journal notes that traditionally “reliance has proved a difficult hurdle in courts but says it may prove simpler to evidence where an investor is bound by a mandate to invest only in a sustainable business.”

This is the market that the Aristata fund is targeting.

“Aristata is proving that investors don’t have to choose between achieving financial returns and driving social and environmental impact,” said Rob Ryan, CEO of Aristata Capital in a recent press release.

“Our impact focus is a powerful competitive advantage … (which) will drive attractive and competitive returns for our investors in a new market segment, while also enabling us to carry out our mission of closing the justice gap in commercial litigation where the system favours commercial strength and penalizes those without.”

According to Litigation Finance Insider, Aristata aims to “produce significant and measurable impact across a global portfolio of claims, including human rights, environmental protection, climate change, equality, indigenous rights, and a range of other critical causes while still providing investors with above market, uncorrelated returns from investments in commercial litigation.

Auditors Rubbing Their Hands And Watching Their Backs

Calvert’s Wilson notes that the global auditing community has been preparing for the introduction of the SEC rules.

On the one hand, new disclosure mandates offer a windfall of work via third-party verification. On the other, they pose legal risks.

The Big Four accounting firms are already separating their audit divisions out from their consulting divisions, to avoid accusations of conflict of interest, ahead of regulation.

In the UK, the Financial Reporting Council set a deadline of June 2024 for the Big Four accounting firms to separate their audit practices from the rest of their operations to avoid conflicts of interest, although reforms have supposedly been watered down or delayed.

The SEC has also initiated a review of potential consulting conflicts, and in Asia, the Securities and Futures Commissions and Hong Kong Monetary Authority have also been touting the need for more transparency on ESG.

The Wall Street Journal quotes SEC Enforcement Director Gurbir Grewal as saying:

“You will see that we will have a firm commitment moving forward to continue to target deficient auditing by auditors, auditor independence cases and earnings management.”

But analysts believe separation should be worth the Big 4’s while, freeing them to move into the independent verification market for banks and other financial institutions.

Supercharging Real-Estate And Low-Carbon Markets

Fortune Magazine argues in a recent article that the threat of disclosure and litigation is likely to supercharge real-estate decarbonisation and low-carbon markets.

“There are implications for the larger business community and real estate, one of the most significant contributors to greenhouse gas emissions,” says the article.

Real estate generates at least 40% of global emissions, with the United Nations Environment Programme estimating it is the world’s largest contributor to greenhouse gases. 

“The real-estate sector must quickly adopt new practices to create the impact at scale to fast-track decarbonisation efforts by 2030,” says Fortune.

The real-estate sector has largely been flying under the radar as investors have focused on utilities and energy production, but that is about to change.

In March, The SEC has called for real-estate investment trusts (REITs) to report on Scope 1, Scope 2, and Scope 3 emissions almost immediately.

In some good news for Australia, Australian REITs are leading world in decarbonisation, according to Credit Suisse. Now they just have to maintain the lead.

Meanwhile, pressure is on tenants to be transparent about their energy consumption, which should also lead to retrofits and the use of new materials.

Push back from US investors

The SEC’s plans to mandate disclosure by year end are not popular within many quarters of the US business fraternity, which are baulking at the cost. 

According to the SustainAbility Institute and ERM, companies that voluntarily report on the risks from climate change pay on average US$677,000 a year to gather the data.

Bloomberg says business groups backed by Republican legislators question the SEC’s foundation-stone assertion that carbon emissions is a “material” fact that should be declared in corporate financial statements.

Whether this will result in a legal stoush that tests the science surrounding climate change has yet to be seen.

A Case Of Diminishing Returns?

Many also question whether ESG litigation will be a viable long-term investment.

They argue that a few unsuccessful court cases will cause the corporate sector to pull its head in and toe the line, resulting in a big reduction in the current business opportunity.

Slingshot Capital’s Truant disagrees.

“[It is true] I can’t think of another asset class that is more impactful than litigation finance in terms of seeking justice and ensuring the companies and individuals that have been damaged at the expense of another’s actions are compensated,” says Truant.

“If litigation finance as an industry is successful, then taken to its logical conclusion, there is scenario where litigation finance is so effective that it changes the way in which corporations make decisions as they strive to ensure that their decisions are not adversely and illegally damaging other businesses and thereby diminishing the need for litigation finance altogether.”

But: “Call me a skeptic, but I don’t believe human behaviour, regardless of incentives, will ever change that significantly, and so I am going to continue to invest in litigation finance.”

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