COP26 priority #4: Measuring sustainability, addressing greenwashing

What gets measured gets managed: a truism that has particular resonance in sustainable investing. More than 3,500 financial institutions, representing USD120 trillion in capital globally, have signed the UN Principles for Responsible Investment. Yet there is no single agreed definition of how to invest sustainably, nor of what a sustainable financial product is. COP26 could make big steps forward in this area.

Traditional sustainable investment approaches, such as environmental, social and governance (ESG) criteria, tend to be based on historical data, and are backward looking in nature. They focus on companies’ business practices, rather than their business models. At Lombard Odier, we seek to go further: to assess the future alignment of companies’ business models to the net zero transition, and the climate-related exposure in our clients’ portfolios. This includes the physical risks their investments may face from more frequent extreme weather events, liability risks they may face from fossil fuel litigation, and transition risks they face as consumers switch to more sustainable products. To do so, we use metrics such as investments’ future implied temperature rise, benchmarked against industry standards and global goals such as those of the Paris Agreement. Our clients can use this to assess their portfolios’ climate risk, and mitigate their exposure.

Our approach builds on recommendations from the Taskforce on Climate-Related Financial Disclosures[1] (TCFD’s) Portfolio Alignment Team. These recommendations emphasise metrics of portfolio alignment including implied temperature rises.?Reporting on these measures is now mandatory for large UK-based pension schemes, and we would welcome moves at COP26 to hasten their adoption globally. Spurred by the TCFD’s recommendations, over 50% of companies now disclose their climate-related risks and opportunities, with a marked acceleration in uptake this year. The announcement of national reporting standards and moves by central banks have accelerated this trend. The European Central Bank has discussed how to revise its collateral frameworks and monetary policy operations to be consistent with climate objectives. The Banque de France led climate stress tests on banks and insurers in early 2021, and has strengthened its sustainable investment charter, including via measures to exclude fossil fuels.

Once companies disclose clear and consistent information on their climate risks, investors can make more informed decisions. Perhaps counterintuitively, we see attractive opportunities in today’s heavily carbon-dependent sectors such as energy, steel, cement and agriculture, where the transition need is critical, yet solutions are harder to find. In August, Swedish firm SSAB produced the world’s first fossil-free steel using hydrogen technology, years before many thought this would be possible.?

The adoption of standardised measures would also help address charges of “greenwashing” against investment firms. A company may have excellent business practices but still be on track for 3°C of global warming – a point many ESG metrics miss. For some investment managers, ESG criteria require them to categorise, or exclude, investments, without offering solutions. With 50% of all first-half 2021 flows into European exchange-traded funds going into ESG products, a lack of transparency and common standards leaves the door wide open to critique. COP26 is an opportunity for the investment industry to start making a real impact.

[1] TCFD: Measuring Portfolio Alignment: Assessing the position of companies and portfolios on the path to Net Zero