Is the invisible hand of the market no longer green?

The transformation needed to allow for humanity to live well within the planetary boundaries is the challenge of our time. It requires capital, innovation, regulation and participation of all to pull in the same direction. And we need to pull much harder. That’s why we can’t afford a backlash against responsible ESG investing.

In what has become a yearly ritual, Larry Fink published his annual letter to BlackRock’s investors in mid-March. In contrast to previous years’ editions, the Chairman of the world's largest asset manager with more than $ 9 trillion under management barely mentions ethical investment according to environmental, social and governance (ESG) principles in his nearly 10,000-word piece, leading to reactions ranging between glee and solemnity . Mr. Fink, once considered a pioneer of ESG investing who claimed to use his heft to reconcile the greater good with financial returns, now talks much less about responsible capitalism. One sentence in his letter stands out: “it is for governments to make policy and enact legislation, and not for companies, including asset managers, to be the environmental police”.

Unlike in previous years, BlackRock is facing a backlash in the US against their perceived outspokenness about ESG issues. Powerful societal forces, seeking to delay efforts to decarbonize, have given up doubting the science amid the overwhelming evidence presented. After succeeding slowing down climate action denying what even the fossil fuel industry knew to be true, a new strategy is at force now. They are no longer merchants of doubt. The new formula: stoke fear about the workplace retirement plan 401k and argue that alignment of capital with climate action would melt returns, most notably pensions.

The sixth IPCC report includes a graphic depicting how inaction will affect current and coming generations.?

Should the opposition against broad transformation succeed in discrediting ESG as politically motivated ‘wokeness’, the ensuing slow-down of capital’s pull will have a massive effect.

It will not safe the pensions of the baby boomer generation, amid the very real physical climate risks deprecating the underlying assets. The World Economic Forum has identified environment-related risks in six out of their top ten risks for this decade .?

Apart from pointing towards the short-term shareholder gains made possible from windfalls within the fossil fuel industry and banking on humanity’s built-in weakness of being incapable to deal with long-term risks, the attack on ESG is made easier because of the self-inflicted weakness:

Those three letters are meaningless unless they operate alongside robust regulation, a stronger focus on investing in assets that bring the necessary innovations, and?efficient financial markets that create the framework for companies across all industries.

The increasingly fractious debate about ESG standards worries me, as it poses numerous challenges for companies like Bayer that are putting their sustainability strategies into an evolving investable framework.

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Sustainability needs to be embedded into business strategy

In recent years, we have been embedding environmental, social and governance metrics across Bayer’s operations and reporting processes. And I use the word “embedding” deliberately: as my colleague Klaus Kunz wrote last summer , at Bayer we have made ESG a priority from the top levels of our company, permeating its goals across operations, processes and divisions, implementing ongoing evaluation and oversight mechanisms, and aiming for ever more transparency. At Bayer, we focus our sustainability commitments on areas where we have most impact, including access commitments for health and nutrition in low- and middle-income countries as well as reduction targets for environmental impact of crop protection in agriculture from up- to downstream.

In doing so, we are harnessing the oft-neglected “G” (governance) part of the triad to progress towards our ESG goals – and I believe that structurally at Bayer, we are doing the right things. Embedding sustainability into a business requires significant governance adoptions which start at the top. This is why the CEO at Bayer has also taken the role of the Chief Sustainability Officer. The compensation of the Board of Management is linked to the achievement of the sustainability commitments. In 2024, our shareholders will have an opportunity to confirm a strong sustainability component in the remuneration framework.

All these ESG goals are subject to scrutiny by investors and ESG ratings providers. We engage with them pro-actively and address controversial topics in a transparent way. For example, Bayer has provided comprehensive reports on how we mitigate risks related to our agricultural business, e.g., neonicotinoid insecticides and genetically modified crops. Subsequently, ESG rating agencies ISS and MSCI have lifted red flags for Bayer.?

The challenge with ESG ratings ?

ESG metrics are a key driver of business for financial services providers as more investors seek strategies that can deliver returns from doing good. A common challenge with ESG ratings, however, is that a company with a high ESG rating is not necessarily one that is doing good in our world. While this can be true, it is not a given – because some ESG ratings measure a company’s exposure to the material risk posed by environmental, social and governance factors, not the company’s impact on our environment and society. Some ESG ratings ask not what a company can do for the planet – they ask what the planet can do for (or to) the company. Water consumption, for instance, is then considered from the perspective of available resources for the company, not the company’s impact on local water quality or supply.

Other rating providers do use performance KPIs related to impact. This so-called impact materiality versus financial materiality is a very debated topic. Standard setters, the EU and the US have different stances. Today, one could split the different approaches and target audiences of rating providers broadly into two key categories: investor-focused ratings award low ESG-related risks and high opportunities (e.g. Sustainalytics), while ratings with a broader stakeholder focus award good performance (e.g. Carbon Disclosure Project).

In addition, ESG ratings adopt sector-specific methodologies, ranking companies against their industry peers, not against universal standards. Up to a point, this is understandable:

ESG ratings need to be sector-specific and geography-specific to account for the relative importance of some issues versus others.

For example: topics of diversity versus soil contamination contribute differently to the sustainability score of a mining company in Australia versus a retailer in Europe. However, as pointed out by an in-depth Bloomberg investigation in 2021, this approach leads to poor comparability among firms of different industries, with many agencies awarding “acceptable” ratings by default to companies from some of the highest emitting and controversial industries. The Harvard Business Review has pointed out that under this system, “fossil fuel companies can have better ESG ratings than makers of electric vehicles”.?

And some even argue that the ESG industry is a placebo, a mass greenwashing exercise: it fools investors and wider society into believing that they are doing good with their investment portfolio, thus potentially leading them to become “more complacent about doing things that actually create change […] careful choices about what they buy and who they vote for, for example”, as the FT’s Robert Armstrong put it. I do not subscribe to this view, as I genuinely see action from our investors linking their investment in Bayer to ESG-driven transformation. But I acknowledge there is a debate. It’s an important part of self-regulation, to address the challenge and to achieve a closer alignment of rating frameworks because, ultimately, they all seek to address the same planetary conditions and challenges. Inconsistencies are jet-fuel for those who seek to undermine ESG in an effort to slow down the transformation.

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Change is coming: rating standards are being tightened?

There are other criticisms of ESG investment, of course, and the brouhaha ultimately boils down to the fact that, despite the clever marketing, ESG investing is not so very different from conventional investing: its ultimate goal is to maximise profits for the investor (Larry Fink’s letter also makes this clear); it just happens to use different metrics in doing so. But as matters currently stand, these metrics vary wildly and often are a black box, and thus a big part of the sector’s image problem.

Change is coming: ESG rating providers, aware of increasing scrutiny from regulators concerned about false claims, are tightening the criteria used for the ESG assessment of funds, while regulators in the EU and UK are beginning to make critical noises about the data and methodologies used by providers, and even considering regulatory fixes. Fund managers, in turn, are demanding more disclosure from companies, especially on environmental data. They also have a point. For example, reporting on biodiversity and nature-related risks is now at the point where reporting on climate change risks was five to ten years ago. Reporting standards are currently being developed by the Task Force for Nature-Related Financial Disclosures (TNFD) and Bayer is committed to providing the data as required.

In the EU, a host of policies born of the European Green Deal have come into force since the EU Taxonomy Regulation in 2020, most recently the Corporate Sustainability Reporting Directive (effective since January 2023), which binds listed SMEs and all large companies to detailed reporting requirements, including the requirement to confirm how their business strategy is compatible with the Paris Agreement and EU Climate Law. Meanwhile in the US, the Securities and Exchange Commission (SEC) is fighting hard to implement its proposed rules on mandating disclosure of Scope 3 emissions, carbon offsets, and climate-related risks for listed companies. Beyond the “E” in ESG, the SEC will also soon propose disclosure rules on human capital management, on ESG fund disclosure for asset managers, final rules on fund names, and corporate board diversity.

All these efforts by the EU and the US enhance disclosure, but don’t yet regulate ESG ratings in the way that credit rating agencies were regulated after the financial crisis in 2008. ESG rating providers have developed proprietary methodologies, interpretations and use cases for ESG metrics. This is why some stakeholders call for regulatory intervention , and I tend to agree there is a need to improve market confidence in such ratings.

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Bayer has committed to generating impact

Of course, ESG investment is just part of the bigger corporate ESG puzzle – which, if done properly and effectively, is an exercise in fact-finding, in rigour.

Commitment to ESG means gathering, sharing and using data transparently and in a way that looks at the company’s impact as a whole.

A crucial point for me is that we are adhering to science-based targets that are aligned with the Paris Agreement objective of limiting global warming to 1.5°C relative to the pre-industrial levels, and the same will be true for actions to reverse the loss of nature under the UN governance framework on biodiversity. I cannot emphasize enough the importance of “science-based targets”: in this zero-sum game for the future of our planet, there is no margin for error in calculating to what extent companies must transform their operations.

ESG commitments go beyond climate change mitigation. We are playing a key role in adaptation. As we are leading the sector in terms of the goals we have set ourselves and the technologies we are pioneering. Our principal decarbonization goal, for instance, is to become climate-neutral by 2030, reducing greenhouse gas emissions from our highest-emitting crops by 30% in our sales regions by 2030, becoming more energy-efficient in our own operations, and in the upstream and downstream value chain and by offsetting emissions; and to achieve net-zero carbon emissions by 2050. These are all outcome-based goals with a significant impact on value chains.

We will continue to work hard to transform Bayer further. Framework regulations and policies need to be bold and stay the course to be predictable and reliable for business. Because we are struggling with the same challenges Larry Fink outlined in his shareholder letter: as a public company, we must answer to our shareholders. Sure, there will always be activist investors calling for stronger commitments to ESG – but at the same time, they ultimately are investing in Bayer to make a profit, not as a gesture of charity.

We have to be able to justify to them the high upfront costs of decarbonization, for instance – and doing so is a no-brainer if legislation is in place that obliges us to invest in sustainability. At last week’s Bayer’s AGM, Ingo Speich, representing Deka Investment, one of our major investors, has asked Bayer for a vote on climate. This is also suggested by the Climate Action 100+ network . We will explore this. It might be a good way to contract with our shareholders on Bayer’s contributions to mitigation and adaptation amidst the need for accelerated transformation.

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Regulatory interventions are justified

This “hard stick” approach to regulation would not just have a direct impact in terms of carbon emissions reduction or reducing impact on the environment and the ecosystems– it would constitute the necessary “risk exposure” that would harm a company’s ESG rating should it fail to take the appropriate mitigation measures, thus ensuring that its rating truly reflects its impact on the planet and on societies. Policies should take the form of:

• Mandatory, industry-specific and outcome-based corporate targets for decarbonization, habitat restoration and pollution reduction, which will spur investment in green technologies and the energy transition;
• Ambitious, transparent and standardized requirements for reporting, like the SEC proposal for carbon emissions or future standards on nature-related risks, which will increase scrutiny of companies’ environmental impact and allow progress to be tracked;
• Implementing carbon trading systems based on the polluter-pays principle (or increasing the ambition of existing ones, like the EU Emissions Trading System), and closing loopholes to ensure that polluters cannot “import” their way around paying for their emissions (as is the goal of the EU Carbon Border Adjustment Mechanism);
• Redirecting subsidies on fossil fuels into clean energy technologies and infrastructure;
• Nudge initiatives and actor coalitions to address “high-leverage” areas of consumer behaviour (meat consumption, travel, purchasing fashion, tech and white goods).

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Decisive action is needed for every highly emitting industry

No single policy or corporate initiative is the silver bullet in making our economies and societies truly sustainable. Achieving transformation on this level requires deep change across sectors and operations (the “whole-system approach” advocated by the UN). This demand is what many people see as the fatal flaw of ESG, in fact: they argue that in trying to be everything, it achieves nothing; that it is too ambitious to demand that companies perform across the full spectrum of E, S and G. I beg to disagree: we are increasingly seeing how ambitious and previously unthinkable climate and societal goals can align with business objectives. Because companies can thrive in the face of the most extraordinary and challenging of circumstances. We adapt, we pivot, we diversify.

We need decisive action from companies and regulators in every single highly emitting industry – from agriculture, to construction, to mining, to fast fashion.

With adequate warning, and governmental support in the necessary infrastructure, companies can adapt and flourish in a climate of ambitious ESG requirements. There is simply no other option; companies that ignore their ESG obligations should find themselves on the wrong side of the law and will find themselves on the wrong side of history. Because, while incorporating ESG into corporate strategy and investment decisions is not a panacea in achieving net-zero carbon or eliminating poverty, it remains a vital part of our journey to transformational sustainability.

Indeed, as Larry Fink put it, it is for governments to make policy and enact legislation. But then companies, and asset managers, need to put their weight behind such policies. Public and private sectors must mutually reinforce decisive actions to combat climate change, halt biodiversity loss and build an economy that benefits more people. To ensure global participation and progress, it is essential for at least Europe and the U.S. to align their efforts.