Growing concerns around sustainability and climate change amongst all stakeholders, coupled with stakeholder demand for material information to appropriately identify, understand and mitigate ESG risks have led to the proliferation of ESG disclosures and reporting frameworks. International regulations including the Task Force on Climate-related Finance Disclosures (TCFD), or the International Integrated Reporting (IR) and global initiatives such as the EU Taxonomy, have emerged in the past few years. Increasing pressure on companies and investors to adopt these frameworks has accelerated non-financial reporting and disclosures globally, with reportedly 90% of S&P 500’s companies reporting on ESG or climate. These developments represent a global ESG ecosystem with, not only non-financial reporting and disclosure best practices and voluntary reporting frameworks, but also competition on ESG performance and metrics leading to ESG ratings and rankings on global indices, such as the ones by MSCI, S&P, Dow Jones and more.
“The uncoordinated evolution of different voluntary frameworks challenges companies’ ability to meaningfully demonstrate value creation and progress on ESG factors.”
While this indicates a promising start, progress remains uneven, with the level and quality of disclosure varying significantly across sectors and geographies. Considering the plethora of reporting frameworks, ratings and rankings investors and companies often grapple with subjectivity and disparity in ESG standards, definitions, metrics due to which the capacity to compare organisations’ performance is lost, or the very least, reduced. Frameworks also have overlapping focus, and yet, diverge in their parameters and metrics, resulting in similar but incomparable systems of measurement. The uncoordinated evolution of different voluntary frameworks challenges companies’ ability to meaningfully demonstrate value creation and progress on ESG factors. However, the more serious threat is that such lack of uniformity can increase the risk of greenwashing. These challenges have increased the desire for a harmonized global framework for ESG disclosures across many financial institutions, companies, and regulatory authorities.
A number of correct initiatives that are working towards cohesion and objectivity within the ESG reporting and non-financial reporting discourse, are rapidly emerging. Most famously, the European Commission’s climate action initiatives, including the European Green Deal and the Sustainable Finance, which involve a set of measures to improve capital flows to sustainability activities across the EU region, demonstrate attempts to consolidate disparate ESG standards, definitions and metrics for the region.
Regulators need to focus on standardising ESG Risk Assessment in order to help mitigate ESG risks and create a level-playing field for investors.
The Basel Framework, for example, includes guidance on capital adequacy, market liquidity risk and stress testing to ensure a functional financial system which is resilient to uncertainties. While these broad categories of risks collectively cover the range of uncertainties, there is no structured approach to mitigate ESG risks. While most Basel members agree that climate change poses a serious threat to financial stability, in order to strengthen governance and risk management, regulators can mandate the creation of Board-level committees. Such committees’ function would be to oversee all activities related to ESG, including the company’s performance against set targets, ESG risk assessment and management, reporting and disclosures, among others. This would help mitigate a number of future non-financial risks that could shock the global financial system.
Therefore, what we need at an aggregate level is comprehensive policy guidelines on ESG-related factors.
“Greater cohesion in reporting practices would not only help investors differentiate between market leaders and laggards from an ESG perspective, but also accelerate investments in sustainable businesses, while contributing to the overall global net-zero and transition targets.”
This guidance may include;
- A taxonomy on green and/or sustainable finance,
- Appropriate ESG metrics, including how they are measured and reported,
- Enabling asset tagging to SDGs or ESG factors,
- Providing clarity on setting targets for diversifying portfolios to include a larger mix of green and/or sustainable finance in portfolios, and more
Inclusion of ESG risk assessment under regulators’ risk-based supervision is also essential. In doing so, financial institutions and banks will be able to better assess ESG and climate-related financial risks, thereby maintaining asset quality, futureproofing, planning for the long-term for future credit portfolio, loan pricing among others, each of which would guarantee effective risk mitigation.
This would help achieve the much-needed cohesion and objectivity in global markets and would create a level-playing field for market participants. Consistent measurement of ESG metrics would lead to effective comparison between businesses on ESG performance, encouraging the proliferation of accurate ESG ratings and rankings of global ESG indices. This would also bring in enhanced transparency to entities and gain fiscal discipline. A deeper understanding and better preparedness for mitigating and/or adapting to ESG and climate risks is an additional benefit. Greater cohesion in reporting practices would not only help investors differentiate between market leaders and laggards from an ESG perspective, but also accelerate investments in sustainable businesses, while contributing to the overall global net-zero and transition targets.
Such developments, which are fully aligned to the global sustainable finance agenda would minimise instances of greenwashing, through the creation of a cohesive, standardised and uniform ESG ecosystem, supported and promoted by financial regulators.
Bibliography
https://ec.europa.eu/clima/policies/eu-climate-action_en
https://ec.europa.eu/info/publications/210421-sustainable-finance-communication_en