Businesses and governments around the world are finally taking climate risk seriously and environmental, social and governance factors are driving an investment revolution.
We are witnessing a transformation of the investment world, from an industrial era-thinking mindset based on outdated risk measurements and pricing models to a future environmental, social and governance (ESG) era based on maximising benefits for both shareholders and stakeholders. This new model is being driven by decarbonisation, ecosystem boundaries, digitalisation, adaptative management and flexible, network-oriented connectivity. This transition is supported by a stakeholder outcry calling for a deep integration of ESG in all asset classes. ESG is at the heart of an investment revolution that must embrace long-term growth strategies. There is a growing demand from stakeholders for enhanced reporting and transparency on ESG issues, and as a response, organisations’ digital and ESG strategic investments are becoming inextricably linked.
Embedding ESG into the long-term core strategy is triggering a disruptive and transformative change. It is igniting appropriate transparency, materiality, reporting and accountability structures for ESG integration and building a purpose around ESG necessary to sustainably deliver superior society returns for shareholders and broader stakeholder groups.
It is promising that some CEOs are committing to science-based targets for emissions, confident that this will support long-term corporate value creation. The business case for action now is becoming stronger, with carbon prices likely to increase, and growth opportunities for investing in adaptation as well as renewable energy and energy efficiency becoming increasingly attractive.
Some foresighted business leaders are finally recognising that they must be the drivers for positive change and proactively address natural boundaries, social challenges, mobility and inclusive governance. Fiduciary duty is not just towards shareholders but to stakeholders. ESG is becoming the main driver in redefining materiality and internal capital allocation for all projects. However, many companies struggle to articulate a compelling ESG story, suggesting that there is both lack of knowledge and authenticity on ESG corporate purpose.
A new ESG investment revolution, mobilised by a more digital society, will bring disruptive and transformative change to the private sector. It is prompting more dynamic strategic scenario planning, a business transformation based on more rigorous scientific-based targets with reimagined measurement and reporting of ESG factors, and ESG-linked remuneration incentives.
Regulation, taxation and frameworks
Multiple policy-makers and regulators around the world are putting ESG at the top of their agendas. The EU is taking a leading position in this area, and US regulatory requirements for climate-related disclosures focus on providing investors with information to inform capital allocation decisions. New reporting standards such as the proposed International Sustainability Standards Board (ISSB) will focus on sustainability disclosure as an instrument of economic decision-making rather than on establishing thresholds for sustainability performance. These new sustainability standards are deliberately packed with conclusions about where capital should flow in a world where government stimulus is required to turbo charge climate investments.
The new ISSB standards will be focused on sustainability disclosures as instruments of economic decision-making, not on establishing thresholds for sustainability performance. Consistent, comparable and reliable information is the essence of investment analysis. Ultimately, there is a clear recognition that corporate valuations are increasingly driven by risks and opportunities that are not captured by traditional financial reporting. The ISSB’s proposed approach is based on the construct that when markets have access to comparable information about sustainability issues that affect financial performance and enterprise value, investors can better exercise their professional judgement in evaluating performance and markets can more efficiently price risk.
The need for science-based targets
Climate risk is finally being taken seriously by businesses and governments around the world after decades of vacillation and ample debate. The concept of a global carbon budget grounded on science-based targets is driving the debate. The generally accepted baseline used for the reckoning is the greenhouse gas (GHG) emissions into the atmosphere since the beginning of the industrial revolution. With that in mind, it is plausible to estimate the level of further emissions that can be added into the atmosphere and still have an acceptable scenario of keeping global warming levels below a 2°C increase. The most comprehensive methodology on the GHG budget is known as the Sectoral Decarbonization Approach, published by the Science Based Targets initiative.
This methodology allows companies to set a science-based target constructed on the required decarbonisation trajectory of the sectors in which they operate. The Intergovernmental Panel on Climate Change and the International Energy Agency provide robust climate change mitigation scenarios based on the best available science and analysis from around the world. The promising outcome of this is that several CEO at large corporates from various industries are now committing to science-based targets, confident that this will support long-term company value creation.
But there is still considerable political and market uncertainty, resulting in many businesses favouring a rather passive wait-and-see approach instead of taking a leadership position on sustainability issues, which may well affect direct costs and create a short-term risky competitive disadvantage.
The impending regulatory risk is creating a growing case for corporations bridging their fiduciary responsibilities and it is not inconceivable to think they could be ordered to respond retroactively to environmental damages caused by the corporate operations during past decades. In addition to that, empirical evidence suggests the window of opportunity to avoid additional dangerous climate change effects is becoming shorter and shorter. As a result, pressure is mounting on governments to increase their regulatory positions on GHG emissions.
Carbon pricing and new technologies
The movement towards carbon pricing is rapidly expanding and numerous projections suggest costs will continue to increase. Taking strong action to at least reduce emissions from energy use and broader resource use also drives direct operational cost savings. As the costs of low carbon technologies are swiftly decreasing thanks to innovation and a greater scale of deployment, the business case for investing in renewable energy and energy efficiency is becoming increasingly attractive.
At the Green Climate Fund (GCF), we are working to support the innovations – whether in policy, regulation, technology or finance – that will help us combat climate change. We are also using our resources to leverage private sector innovation in climate solutions. GCF has approved 190 projects to date, amounting to $10 billion in GCF funding for a total investment value of more than $37 billion. From those 190 projects, approximately 66 per cent have a technology component, although GCF’s technology portfolio falls short in fostering climate breakthrough technologies such as incubators and accelerators.
Setting ambitious targets can foster the potential for innovation within an organisation. Of the signatory countries to the Paris Agreement, 88 have revealed they are either using or intend to use carbon pricing to deliver on their national commitments, equivalent to pricing more than half of all global emissions.
The long-term nature of science-based targets provides a clear direction of travel of the low carbon transition. The emphasis of corporations towards the development of innovative solutions and new opportunities also creates reputational benefits for companies adopting science-based targets as part of their sustainability strategy.
There is now a trend for companies that have set science-based targets to urge their suppliers to do likewise, as they are keen to diminish their indirect impacts as much as possible. In addition, robust commitments on climate change are increasingly improving access to capital.
A number of financial institutions – particularly institutional investors such as pension funds – are putting in place specific reporting and investment criteria related to environmental performance for their portfolios, including some that are linked directly to a 2°C target, providing a clear signal to investors and regulators of their commitment to long-term sustainable growth.
Additionally, there is a good case for talent retention and human capital growth. Taking positive and proactive action on sustainability while embracing a sense of purpose at work for employees is deemed to boost morale and productivity, recruitment and the retention of quality staff. Being able to claim that a company is genuinely taking appropriate action in ESG factors is a very powerful internal message.
In setting science-based targets and aligning to the ambitions of the Paris Agreement, corporations can anticipate the impacts of regulatory changes. Compliance costs will very likely become higher with the addition of a carbon price, whether through taxes or cap-and-trade schemes. At the moment, carbon pricing is under implementation in 70 national and subnational jurisdictions throughout major economies in both developed and developing markets, accounting for approximately one-fifth of global emissions. The IFAC suggests a building blocks approach of multi-stakeholder-focused sustainability reporting, as well as investor-focused sustainability information material to enterprise values. It identifies sustainability factors to short-term, medium-term and long-term enterprise value, then establishes a baseline of information for investors and global capital markets. It includes qualitative information about governance, strategy and risk management and performance targets and quantitative metrics for material sustainability factors, both across industries and industry specific.
