Week 24: ESG is something else

In this issue: ▸ The finance sector is disconnected ▸ Missing out on two big opportunities ▸ ESG Fraud ▸ Rationalising deception ▸ A post-global ESG ▸ And much more

Dear all,

Disruption. I kept repeating that word for myself, while sitting and listening to opening plenary session in one of the largest ESG investment conferences lately. Disruption. The conference went on. Sessions went on, panels were conducted in an ordinary fashion, people mostly agreeing with each other, friendly almost collegial atmosphere. We are all in this together. Business it is. At some point I hear someone say, “it’s better than 10 years ago, now we have targets, before it was all blur, now we have targets.”

I went in and out from sessions, searching for disruption. I could settle with resistance too. Although disruption is more what I like. Panic is not nice, but even that would have been completely ok. Nope. Elegant navel viewing in all sorts and shapes. We are good. We are doing fine. We have data, we have solutions, we have products. World is burning. Right now. Throughout the space where vendors and service providers compete for attention images of data streams, blue skies, and green pastures. Business it is.

Disruption. Resistance. In the beginning, now 20 years ago, the ESG movement had those qualities, had the ambition to disrupt what did not work and provide something better, had the courage to resist the inherently arrogant financial mainstream that typically used performance argument when participating in some panel and discussion. Now mainstream runs ESG. Controls the narrative, sets the boundaries, and slowly but surely transforms what ESG was intended to do into a tame pet. A plain vanilla thing.

The entire idea of integrating ESG was to change the underlying investment processes’ valuation models, not to adjust to unsustainable financial theories that dominate the valuation of assets. Right now ESG is no longer a disruptive force. And that is precisely what it needs to be. The core of the challenge with our unsustainable economic system is not resolved, the emissions generated by our investments and lending activities are still catastrophic, our investments are not creating tangible outcomes. We have a problem, a big one. In several of the sessions people addressed the need for more data and more reporting. What is the point if we really don’t want to change anything.

Maybe that would be a good conference topic for the next ESG event somewhere in the world: “Is the current ESG market really changing anything and has it what it takes to really change anything?” I would love to participate in that one. 

The finance sector is disconnected from reality

Towards the end of the second day, a person in audience asked the former consultant to Shell who went public on deceptions and lies by company in relation to climate change why it is so hard. Her answer: “When I listen to people from the finance sector talk about climate change, there is this disconnect with reality.”

Yes, that’s it. ESG financial executives don’t live in the Nigerian delta or in Bangladesh. They have a limited emotional relationship to pain caused by your house being flooded, blown away by storm or destroyed by landslide caused by melting ice. And when shit hits the fan, so to speak, we just buy a business ticket out. So, all in all, business it is and as usual it is.

I don’t know if people participating in the conference have missed this report or if findings where to “rude” for an such an eloquent audience. The Renewables 2022 Global Status Report says the share of wind and solar in the global energy mix has risen minimally in the last decade. While renewables boomed in the electricity sector last year, they didn't meet the overall rise in demand. In transport, which accounts for a third of energy, renewables provided less than 4% globally. 

And did they really take in the reality of the deadly heatwaves we see in Europe again this summer? The one right now is the earliest heatwave in 40 years, and the World Meteorological Organization warned Friday that this heat wave is a preview of the future, as heat waves are starting earlier in the year and are becoming more frequent and severe as a result of human-caused climate change.

Panic is the right mode for this. Pure and shear panic. From 2018 to 2020, ESG assets under management grew from $22.8 trillion to $35 trillion, with estimates that they will make up a third ($53 trillion) of all assets under management by 2025. And we have achieved. Nothing. 

ESG has become a punching bag for the far right, for disgruntled corporate executives and even industry insiders. But there’s one group whose growing disapproval might be the ultimate game changer. Retail investors are slowly starting to look under the hood of the $40 trillion ESG industry that’s increasingly steering their savings, and many aren’t liking what they see. What’s more, some of the biggest names in finance have been tainted by greenwashing allegations, with Goldman Sachs Asset Management and the investment arm of Deutsche Bank AG among the most prominent.

What are we going to tell retail investors? That we have the processes, we have the products, but we need more data? 

We have missed out on two big opportunities… 

George HW Bush infamously said: “The American way of life is not up for negotiation.” In terms of climate change, he was true to his vow. The most taboo word in US politics is “sacrifice”. This remains the case today come rain or shine, normal hurricane season or extreme, whether the west coast wildfires are out of control this year or not, and irrespective of the polar ice caps’ accelerating shrinkage. America is happy to discuss anything – carbon capture, solar blocking, hydrogen fuel cells, new nuclear plants – as long as we do not jeopardise our lifestyles. That is the real third rail of US politics.

Though 90 percent will never realise it, no American should be robbed of the dream of having their 20,000-square-foot home, five cars in the front, air conditioning or heating on full blast day and night, and the right to throw away more food every week than the annual consumption of the median Indian family. No politician seeking job security would question America’s providential right to limitless consumption. In this respect, Bush was merely expressing Washington’s most enduring bipartisan consensus.

The world has missed two big opportunities. The first was the pandemic, which unleashed roughly $20tn of spending worldwide. Covid-19, as David Wallace-Wells wrote this week in the New York Times, was a crisis-equals-opportunity moment. If governments had directed some of that largesse to speeding up the move to the new energy economy, rather than propping up old jobs, it could have been a paradigm shift. That chance was missed. Barely one percent of US coronavirus stimulus went to green initiatives, against a still modest 15 percent of European Union spending.

The second moment was Vladimir Putin’s invasion of Ukraine – the perfect chance to drive home the point that we have to stop funding autocratic petrostates. Joe Biden’s forthcoming trip to Saudi Arabia is all I need to say about that. I understand Biden’s domestic imperative. If petrol costs more than $5 a gallon in America, the party in power will lose.

At 15.5mn tonnes in annual per capita emissions, America’s carbon pollution levels are triple those of France and Britain and eight times that of India. They are also three times the global average. If India, where large swaths of the country still lack electricity, were to double emissions, it would still consume just a fifth per capita as the average American.

ESG Fraud

ESG fraud is an old thing but it is getting more and more, let me put it this way, limelight. Pressure is mounting on the C-suite to prove meaningful progress in setting and achieving ESG goals. This pressure has resulted in the creation of a business climate where the real risk is not adopting the principles of ESG. The development and implementation of ESG-friendly programs can be costly, both financially and logistically.

The pressure to adopt principles of ESG creates an environment ripe for fraud, and fraud thrives wherever the stakes are high. Internal ESG fraud is fraud committed by management or employees. It often involves intentional acts to deceive others by the reporting of false or misleading ESG information; by omitting material ESG facts; or by the improper disclosure of ESG initiatives, programs, and metrics.

External ESG fraud is fraud conducted by parties  outside an organization, such as vendors in an organization’s supply chain, contractors, customers, or other third parties. External ESG fraud often involves an intentional act to deceive an organization by omitting material facts or disclosing false or misleading information relating to ESG programs. As suppliers feel the pressure to adopt ESG policies consistent with their key customers, external fraud schemes may develop relating to the reporting of intentionally false and misleading representations about ESG policies and adoption. Alternatively, unscrupulous ESG-related vendors could take advantage of an organization by supplying inaccurate ESG information that results in the organization fraudulently reporting ESG-related data. 

One significant example of external ESG fraud is the sale of fraudulent “green” investments to supply desirable carbon emission credits to offset greenhouse gasses. The sale of these fraudulent investments represents fraud risk for companies and their investors. Companies that buy these credits may unknowingly misreport their carbon position and suffer reputational and regulatory consequences, while investors who buy stakes in either the companies selling or buying fraudulent credits may be subjecting themselves to traditional Ponzi or other investment schemes that exploit uninformed investors.

I wonder what people working in a financial industry feel when they read this? 

Rationalising deception 

Rationalization is a fraudulent actor’s ability to convince themself that the circumstances justified their illicit act. ESG represents many social virtues. Therefore, bad actors may rationalize that making progress on ESG promises is worthy of a reward, not punishment. For example, if an organization comes close – but still fails – to deliver on an ESG promise, the organization may rationalize a misstatement with the justification that “some progress is better than none.”

In other instances, individuals may justify their actions because the “ends justify the means.” If the choice is between providing honest and transparent reporting of poor ESG performance resulting in market losses and layoffs, or cooking the ESG books to show  a positive result, it becomes clear how some organizations might rationalize fraud.

Now onto a fresh example from the Nordics: The Norwegian Consumer Authority has found that the use of Higg Index data by Norrøna to support environmental claims is misleading to consumers and has warned H&M Group against using the same type of marketing.

The decision comes amid growing scrutiny of major fashion companies’ sustainability claims as greenwash concerns are gaining increased interest from regulators. It also hits the Higg Index, a widely used set of tools developed by the Sustainable Apparel Coalition trade group. 

When it comes to financial sector and rationalising, that is a tether piece perfected to its core. 

A post-global ESG… if you only knew what is waiting 

Complex global supply chains for low-margin and/or heavy goods won’t be feasible any more. Nor will Chinese mercantilism or, ultimately, the American overconsumption. Because the truth is that as things become more local they’ll also get more expensive, at least in the short term. And that’s a major challenge for the governments around the world right now. Green technology is ultimately going to be wildly deflationary. But in the short to midterm, as we get there, it will be just the opposite (changing old paradigms is costly at first, because you have to build the new ones). 

That’s going to mean that getting approval for more spending on climate is going to be impossible. Two weeks of climate talks in Germany have ended in acrimony between rich and poor countries over cash for climate damage. Developing countries say they are reeling from climate change caused by richer countries' emissions over hundreds of years. They hoped to get compensation onto the official agenda for discussions by world leaders in November. But in Bonn they couldn't get the US and the European Union to agree.

Developing nations say they need money to deal with the impacts of climate change, because they suffer the effects more than richer nations and have less financial capacity to cope. They argue that the climate change they are experiencing has been caused by carbon emitted by richer countries as they developed their economies. They say that Europe and the US have a responsibility now to compensate them for this. The US and Europe don't agree. They fear that if they pay for historic emissions it could put their countries on the hook for billions of dollars for decades or even centuries to come. 

Read more.

The rich countries still won’t pay for the damage done

At last year’s COP26 conference in Glasgow, island states and developing countries agreed to prioritise cuts to carbon emissions on the back of promises that richer nations would finally set up a compensation process this year.

It was a compromise they hoped would pay off. But despite two weeks of discussions in Bonn, they have been unable to get the issue of a funding facility on the agenda for the COP27 conference in Sharm El-Sheikh, Egypt in November. “The compromise was based on an understanding that countries would be willing to start talking and taking decisions on dealing with how to get that finance flowing for loss and damage.”

The EU consistently blocked discussions on finance for loss and damage in Bonn. The last two weeks exposed its hypocritical stance, with major countries like Germany sourcing new fossil fuels abroad while denying support to developing countries facing devastation from climate-induced superstorms and rising seas. And guess what? The question of a financial facility will now not be on the official discussions at COP27 in Egypt… Read more.

You can laugh or cry or scream, but that is the case. The EU and US will simply not pay. 

ESG undermines the development in poor countries

Post-globalised ESG carries another challenge too. This one is troublesome for any investor that “adheres to SDG’s”, reports on them and sell to clients that “this is how we contribute with our investments.” Simply put we have a rather colonial approach to emerging markets. We know what is right and why. Undermining the development in poor countries is not something any investor would want to achieve with an ESG strategy. But that is precisely what seems to be happening, according to a troubling report out this week.

The study – here it is – was carried out for the UK government by the consultancy Intellidex, aimed to identify the big impediments to capital flows into developing countries, through interviews with 52 market professionals. One of the biggest obstacles, it found, is the rise of ESG strategies. “It was a surprise to me, to what extent ESG – as it’s practised – is not aligned with the SDGs,” Intellidex co-founder Stuart Theobald said.

The key problem, according to the report, is the emphasis that many ESG strategies put on avoiding risk – especially of the reputational sort – rather than achieving positive impact. That very often leads investors to “downweight” developing markets, or avoid them altogether – either because of concerns about social and governance flaws, or a simple lack of data. If you want to make a big difference, you have to trade in harder, more difficult markets, and you’ve got to have a risk appetite for that. ESG investors’ nervous approach to frontier markets might be understandable. But if their strategies are impeding urgently needed capital flows, that looks like a pretty dire risk in itself.

A critical insight from the study is that the growing prominence of ESG considerations in top-down allocations may risk diverting capital away from emerging and frontier economies. Market participants are concerned that mainstreaming ESG considerations will drive capital away from developing countries, which has tended to score poorly on traditional ESG metrics or has lacked data altogether.

This is pointing in the direction I addressed some time ago: We need additional, new indicators that capture additionality in relation to ESG that will position emerging and frontier markets more favourably relative to developed markets, where marginal gains are more costly to achieve.

China gets its first ESG disclosure standard, and – surprise, surprise – human rights are not there 

The Guidance for Enterprise ESG Disclosure was first published last month by Beijing-based think-tank China Enterprise Reform and Development Society, with input from dozens of companies in China including insurer Ping An. It took effect on June 1. The guidance is specifically designed to match the operating conditions in China.

Ping An, which contributed its knowledge from developing its own proprietary ESG disclosure framework in the country, explained that the guidance “is based on relevant Chinese laws, regulations and standards.” For example, items such as corporate charity, resources contributed to corporate social responsibility activities such as poverty relief and the building of public infrastructure, and aid to the disabled and other vulnerable communities in terms of volunteer hours or donations are included in the guidelines, said the ESG office at Ping An. Adherence to the guidance is voluntary, but “it is a helpful starting point to have specific metrics of what companies should be considering to report on,” said Alexander Chan, head of ESG client strategy in Asia Pacific at Invesco.

Market stakeholders expect that official and mandatory requirements on ESG disclosure for listed companies are likely to be introduced by the end of the year, said Yuki Qian, head of policy at the Association of Chartered Certified Accountants China. Read more.

Developed by China’s biggest companies and government-backed think-tanks, the standards list more than 100 metrics that generally align with the global benchmark of draft rules issued by the International Sustainability Standards Board. The differences are they are more simplistic and add “Chinese characteristics” that measure things like corporate charity.

The guidance “encourages companies to consider their responsibility as a corporate citizen” rather than looking at ESG from a pure “compliance or risk management perspective,” said ESG analyst Jia Jingwei at Fitch Ratings. “It is a more comprehensive and holistic view of ESG.” The Guidance listed a total of 118 metrics, spanning 35 tertiary indicators and 10 secondary indicators under the 3 primary indicators of environmental, social, and governance. An overview of metrics in the Guidance is presented below.

And as you can guess, well, Human Rights, forced labour etc are not on the menu.

Relevant SDG targets related to forced labour were apparently missed by Chinese governmental bodies that drafted this voluntary disclosure regulation. Read more.

I would also recommend this piece with metrics for measurement of Human Rights in the investments.

Finally, let’s remind ourselves that investor appetite for sustainable products remains strong – and we should be grateful for this. Read more.

Have a great disruptive week!

Kind regards,
Sasja