The muddled universe of ESG calls for its own G

What is environmental, social and governance (ESG) investment? What is sustainability, or a sustainable asset, or a sustainable company? These questions, whilst at the heart of the modern business and investment world, continue to cause confusion even among the practitioners of the field. Can we trust the mushrooming sustainability pledges and claims of accomplishments by individual companies when, at the macro level, we see ongoing environmental destruction and exasperating social tensions on multiple fronts?

The application of ESG framework needs proper governance at global rather than national levels. The lack of standardised reporting, classifications, verification, and accountability mechanisms will keep on feeding into the widespread misconceptions. For example, ESG assets under management, which combine investments in funds that use ESG criteria, amounted to $37.8 trillion at the end of 2020. This is huge, making up nearly 40% of global assets under management. Many of the world’s leading representatives of the investor, media, academic and business communities often associate this or similar figures with sustainable investment.

The reality, however, is very different. Every fund manager has its own ESG investing criteria. These criteria range from very conservative, such as investment only in formally labelled sustainable bonds, and stocks of companies with the highest ESG ratings, to lax ones that exclude only arms, tobacco, gambling and other “sin” assets. The largest ESG funds are geared towards the big US tech companies, some of which are exposed to serious controversies on social and governance topics. Moreover, a number of these funds also hold shares of fossil fuel energy companies. Therefore, it is a big stretch to call these funds sustainable investments.

What should be done to advance harmonisation and transparency in sustainability reporting, evaluation, and investments across the world?

To begin with, it would be useful to set up an international task force for sustainable finance under the auspices of a leading international body such as the Financial Stability Board (FSB). Arguably, the most widely accepted and potent global framework related to sustainable finance is the Task Force on Climate-related Financial Disclosures (TCFD) created by the FSB. The Sustainable Finance Task Force could oversee and coordinate the work in developing key frameworks and regulations, including in the following areas.

First, a greater alignment of principles and standards of sustainability reporting. It appears that not much is being done in this regard. The International Financial Reporting Standards Foundation, or IFRS Foundation – the non-governmental body behind the IFRS standards, has joined the race to develop global sustainability reporting standards. Concurrently, the European Union (EU) is upgrading its own corporate sustainability reporting regulation. A more constructive course of action would be for the EU, other major governments, institutional investors and NGOs to throw their weights behind the IFRS Foundation and develop a single set of globally accepted sustainability reporting standards.

Second, standard classification or taxonomy of sustainable activities. Several jurisdictions, including the EU and China, have been developing their local taxonomies. In addition, under the umbrella of the International Platform on Sustainable Finance (IPSF), they are co-operating to develop a Common Ground Taxonomy (CGT). It is critical, that many other large economies, including the United States, endorse and implement a common taxonomy.

Third, investment products – bonds, shares, derivatives, mutual funds and exchange traded funds (ETF) should be classified based on their contribution to sustainability. An important step in this direction has been made by the EU through its Sustainable Finance Disclosure Regulation (SFDR), which was enacted in March 2021 and will be fully implemented by June 2023. Again, similar to sustainability taxonomies, global harmonisation of definitions for sustainable financial products is necessary to avoid confusion and greenwashing among international investors.

Fourth, mandatory independent assurance of sustainability reports for all public and large private companies to enhance the accuracy and completeness of these reports. The audit or review of sustainability reporting could be combined with the assurance of financial statements or done separately, at the choice of the reporting entity.

Finally, regulation of ESG and sustainability ratings providers in order to ensure they have robust and transparent methodologies, and adequate policies and internal control systems for the rating activities. The regulation should cover both sustainability ratings and ratings or opinions (second party opinions) on sustainable debt instruments, such as green, social, sustainability and sustainability-linked bonds and loans.

Through harmonised standards and mechanisms of verification of ESG-related information, we can minimise misallocation of capital, and tackle the dangerous illusion that sustainable development is getting the vast amounts of financing it needs.

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