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Tearsheet Briefing: ESG is at a crossroads

  • The role of finance and ESG in the battle against climate change is turning into a heated discussion across the political spectrum, with both parties aiming to encode their own agenda into law.
  • As the lines are being drawn, one thing is for sure - 2023 will bring a new wave of climate disclosures and regulation.

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Tearsheet Briefing: ESG is at a crossroads

The role of finance and ESG in the battle against climate change is turning into a heated discussion across the political spectrum, with banks and market participants increasingly getting caught in between.

One of the big underlying motifs of this ongoing conversation is a relatively new concept for white collar America – that there is a difference between actions motivated by financial returns and actions that take into account wider-ranging considerations.

Ultimately, the law dictates how to act on these differences. US legislators are actively looking to code ESG practices into law but accounting for the full breadth of impacts of an investment is not just difficult in practice, but also in theory. 

Investors and advisers are competing for the rising demand for “sustainable” investments, and the lack of disclosure requirements and standardization in this market segment led many players into freely manufacturing ESG-labeled financial instruments with little oversight.

ESG investing labels will be a key focus for The US Securities and Exchange Commission (SEC) this year, who wants to take a closer look at ESG-related advisory services and fund offerings in order to assess whether the funds are operating as described in their disclosures.

Last year, the SEC issued guidance on integrating ESG factors in the investment process to start getting a common framework in place, and the final version of the rules is expected this year. According to people close to the SEC, regulators are now considering easing climate disclosure rules following the pushback received on the initial proposed requirements.

However, Republicans are having none of it. They have been targeting ESG for a while, and they're not slowing down – they've introduced nearly 50 anti-ESG bills just this year, and it's only February. There are more anti-ESG bills in the pipeline, to be voted on by July.

The legislative initiatives targeted financial companies that engage in ESG investing, banning financial institutions from "discriminating against" fossil fuel companies, and banning asset managers from considering ESG investments. However, the banking community is fighting back, with a number of bankers associations across several states opposing this legislation

Whatever shape of form the rules will take, the main objective is to standardize metrics and reporting, which is a welcome development for market participants. The lack of disclosure requirements and standardization has given rise to greenwashing, a growing issue across finance. 

We've already seen that in Europe, more than $140 billion of so-called Article 9 funds – the EU's highest ESG designation – have been downgraded as they did not meet the criteria set by the ECB. This has driven investors to be more careful about how they classify their products, and it all started with regulation.

But perhaps more importantly, better disclosures will also allow companies to understand how their business will be affected by climate risks. Many carbon-exposed global companies are not considering the impacts of material climate-related events in their financials, nor are their auditors, according to Carbon Tracker.

And this political battle is not just about ESG, but also the wider connection between finance and climate change. 

For example, financial regulators are increasingly looking to understand how climate risks will affect banks and financial markets, pressed by the Democrats to make sure that financial institutions are addressing the issue. 

This led the Federal Reserve to require the nation's six biggest banks to take climate stress tests and implement scenario analysis exercises by the end of July, triggering accusations from the GOP for overstepping its authority.

Doing the right thing is… complicated

When it comes to the role of finance in climate change, we must not forget that the system that’s blamed is made of people, and many of them are fighting for change inside their institutions to address this issue. 

"Within the system, many people would like to do the right thing (i.e., finance more green projects) but they CAN'T -- they're legally prohibited from conceding returns to do 'good' not to mention they get paid on performance," said Tariq Fancy, the ex-head of sustainability at BlackRock.

The reality is that the current capitalist setup in the US needs additional regulation to implement incentives to take sustainability or environmental effects into account. 

Under the "sole interest rule" of trust fiduciary law, a trustee or fund manager must only consider the interests of the beneficiaries. A trustee would violate his duty if motivated by their own ethical judgment – they must only consider the “sole interest” or “exclusive benefit” of the beneficiary, according to an UNEP FI report.

Investors or asset managers need to be able to provide legally acceptable reasons for any course of action they take and their consequences on the potential impact on returns, and this is fuelling the actions taken by lawmakers. 

The argument of fiduciary responsibilities has been brought up a lot in this conversation. BlackRock CEO Larry Fink is constantly getting accused by investors of acting in conflict with his fiduciary responsibilities by acting on his own “woke” beliefs, but Fink argued that not taking climate change into consideration will hurt returns over the long term.  

As the lines are being drawn, one thing is certain – the SEC will announce a new set of rules this year around ESG, and the development will be welcomed by the investment community. The winds are already blowing in this direction, no matter what happens in Congress.

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