Promoting and facilitating ESG investments: some recent developments and trends

ESG investing has come a long way.??

In fact, the first ever sustainable mutual fund, Pax World Funds started 50 years ago when it was founded by two anti-Vietnam War United Methodist ministers with just over US$100,000. The fund still exists today and now manages over US$4 billion of assets globally.

Early ESG investment focused more on social responsibility and was based on screening (excluding industries like tobacco, gambling, weapons manufacturers) and was also based on shareholders activism to exert influence over corporate conduct.?

ESG investment attracted broader attention when the UN published its Global Compact report in 2004 called “Who Cares Wins”. This report set out the views of a coalition of leading financial institutions that companies that considered ESG issues are more equipped to manage their risks and deliver shareholder value.?

An even bigger impact was made a year later by a report prepared for?the Asset Management Working Group of United Nations Environment Programme Finance Initiative (UNEP FI) called “A legal framework for the integration of environmental, social and governance issues into institutional investment”. ?

The report (prepared by Freshfields – I have to mention this) was groundbreaking as it concluded that integrating ESG considerations into investment analysis to more reliably predict financial performance was clearly permissible and was arguably required in all the 8 jurisdictions that the report covered, including the US, UK, and Japan.??

ESG soon began to gain traction as a strategy – an increasing number of institutional investors started to integrate ESG considerations into their pursuit of financial returns.??

20 years on, we all know that ESG investment is no longer a niche approach and we have seen a proliferation of different labels being used to describe this type of investing from: ethical investment, responsible investment, socially responsible investment, sustainable investment, ESG integration investment and of course the increasingly attractive sounding impact investment as well.??

From only 60 socially responsible mutual funds in the mid-90s in the US, the value of professionally managed assets with ESG mandates has grown in recent years at a staggering pace - from US$22 trillion in 2016, US$30 trillion in 2018, US$35 trillion in 2020, US$46 trillion in 2021 and is expected to grow to US$53 trillion by 2025, according to analysis by Bloomberg. It is expected by then to account for more than a third of all global investments.

So Isn’t this a great trend -?what is the problem??

The problem is that we have seen an alphabet soup of voluntary frameworks and standards for sustainability reporting. Apart from those which many will know, such as TCFD, CDSB, VRF (which integrated IIRC and SASB last year) and GRI, there are at last count no fewer than 600 other frameworks, scorecards and matrices which create complexity, add to the ever-increasing cost for preparers and do not provide globally consistent, comparable and reliable information for investors.?

Recent developments?

Let me now update you all with some recent developments.?

Some of you will know that last November on the third day of COP26, the IFRS Foundation made a very important announcement. The IFRS Foundation was set up 20 years ago as a public interest organisation to help converge national and regional accounting standards with the IFRS standards that it develops.?A job well done if I may say so as currently over 144 jurisdictions mandate the use of IFRS standards.?

The exciting announcement was the establishment of?a new International Sustainability Standards Boards (ISSB) under the IFRS Foundation as a sister board to IASB which sets the IFRS accounting standards. ?

ISSB’s objective is to develop standards that result?in more consistent, complete, comparable and verifiable sustainability-related?financial?information?- so investors and other capital market participants have the necessary information to allow them to make an assessment?of a company’s enterprise value.????

These will not be just any standards. The ISSB’s mission is to deliver a comprehensive global baseline of sustainability disclosure standard for the capital markets. It also aims to develop a taxonomy to facilitate digital reporting and tagging?of sustainably disclosure.??

What is so exciting is that the announcement last November also included a plan to simplify sustainability reporting by consolidating CDSB (which has happened) and VRF (which is on track to complete by June this year) into the IFRS Foundation. This will be a win-win situation for both preparers as well as investors as we hope this will reduce duplication and cost and improve efficiencies. ?

Two further points to make. The ISSB standards are being designed to be used as a building block and to be interoperable with jurisdictions which have their own requirements or standards which address a broader stakeholder information needs.??

The ISSB will also pay special attention to the needs of emerging and developing economies, as well as smaller and medium-sized companies and others within global supply chains, recognising the additional challenges faced by such companies in applying sustainability disclosure requirements.

Significant progress has been made since last November and on 31 March this year, two proposed exposure drafts for IFRS sustainability standards - a climate standard and a general requirement standard were published by the ISSB for a 120-day consultation period ending on 29 July. Let me mention a few highlights:??

• the climate standard proposes disclosure of scope 1, 2 and 3 using GHG protocol and the use of climate-related scenario analysis to test?businesses’ climate resilience?
• the climate standard did not start from scratch but was?built on the recommendations of the TCFD and benefited from the work of the combined technical staff of CSB and VRF, including from Integrated Reporting and SASB. It also incorporated industry-based disclosure requirements based on the SASB standards
• the IFRS sustainability standards are designed to work with any generally accepted accounting practice and policies – in other words, those using US GAAP can also use the IFRS Disclosure Standards?
• the climate standards also require asset managers, commercial banks, insurers and investment banks specifically to disclose their “financed” and “facilitated” emissions – in other words, scope 3 GHGs emitted by investees and counterparties to these four types of financial institutions as a result of their lending, investments and financing have to be disclosed?

IFRS Foundation is not the only organisation which has put out a proposal on climate related disclosure.?

Ten days before we published our exposure drafts, the US SEC put out proposed changes requiring US-listed companies to include climate related financial disclosures in their legal disclosure documents.

I’m pleased to report that there is a lot of symmetry between the SEC proposal and the ISSB exposure draft: both are investors focused, based on TCFD’s recommendations and require scope 1, 2 and 3 disclosures. All this is encouraging as there is alignment towards a global baseline of investor focused climate disclosure standards.?

As if two consultations are not enough for our markets – just before the end of May, the European Financial Reporting Advisory Group (EFRAG) also published a consultation on the European Sustainability Reporting Standards exposure drafts. As we all know, the EU focuses on double materiality, namely looking at how business activities impact the environment as well as how companies could be affected by sustainability issues. ?

EFRAG has put out a total of 13 exposure drafts covering not only general principles, strategy, governance and materiality assessment which apply to all topics, but topical standards for each of E, S and G and subtopics underneath each topic. So to illustrate, under environment, there is a climate standard and other environmental standards on pollution, water and marine resources, biodiversity and ecosystem and circular economy.?

Further updates?

Against what may seem to be a lot to do just to cope with consultation papers, we at the IFRS Foundation are very determined to make a global baseline of sustainability standards a reality.?

To that end, we have set up a working group of jurisdictional representatives to facilitate dialogue for enhanced compatibility between the ISSB’s exposure drafts and SEC and EFRAG’s initiatives on sustainability disclosures.?

Members of the working group come from the Chinese Ministry of Finance (MOF), the European Commission (EC), the European Financial Reporting Advisory Group (EFRAG), the Japanese Financial Services Authority (JFSA), the UK Financial Conduct Authority (FCA) and the US Securities and Exchange Commission (SEC).?

We really want to be inclusive and collaborative to bring about a sophisticated and globally compatible baseline standard.?

More encouragement and momentum came on 20 May, when G7 Finance Ministers (from UK, USA, Canada, Japan, Germany, France and Italy, plus the EU) and Central Bank Governors issued a Communique (press release) in which they welcomed the inauguration of the ISSB and its progress of work on the global baseline of sustainability reporting standards.?

They urged the ISSB and national and regional standard-setters as well as other reporting initiatives to actively cooperate in the process of elaborating the baseline so that it can be implemented globally.?

They stated that this baseline should be practical, flexible and proportionate and ultimately suitable for SMEs.?

And encouraged countries to prepare for adoption of the global baseline to minimise fragmentation, reduce reporting burdens and make consistent sustainability information available. ?

They see the global baseline as having a vital role in building trust and transparency to foster economic stability and contribute to the transformation of sustainable economic, social and environmental systems and a just transition for a better future. The press release hit the right notes and sheer music to my ears.

I should mention that the IFRS Foundation also entered on 24 March into a cooperation agreement with the Global Reporting Initiative (GRI), which focuses on broader stakeholder’s needs. This demonstrates the desire for an interconnected approach for sustainability disclosures, again to help reduce the reporting burden and to further harmonise the sustainability reporting landscape at an international level. I couldn’t be happier with this development.

The ambition of the ISSB is to issue final requirements by the end of this year, depending on feedback received. ?

ISSB will also consult the market later this year to determine its future agenda and standard-setting priorities.

?A few trends and some personal reflections?

1. The first trend is obvious - we all know that climate change is getting more and more urgent. ?

We can no longer hide from the impact of flooding, storms, hurricanes and freak weather events on people, businesses and communities around the world.?

Scientists have told us in the latest IPCC report that we may have less than 8 years to limit global warming to preindustrial levels of 1.5?C and if collective action is not taken by then, even limiting global warming to 2?C will be beyond reach.??

And what happens if global temperatures rises beyond 2 degrees? Well, in addition to increasing heat waves, longer warm seasons and shorter cold seasons, heat extremes would more often reach critical tolerance thresholds for agriculture and health. ?

It’s pretty grim stuff - but it puts the urgent need for a global baseline climate standard into context. ?

2. My second trend and reflection is that sustainability reporting needs to be integrated with financial reporting. Educational materials from the IASB website requires preparers to consider the impact of climate change and disclose them in financial statements, whether in cash flow, impairment losses, or capex if material. CFOs and accountants need to start thinking more about this.?

In any event, the IFRS Foundation now has a unique opportunity to integrate financial reporting with sustainability reporting to give investors a holistic understanding of the enterprise value of an entity. Enterprise value is defined as the total value of an entity i.e. the value of the entity’s equity (market cap/share price) and net debt. ?

This value needs to reflect an entity’s business model, future cash flows and the effects of sustainability-related risks and opportunities arising directly or indirectly through its value chain or investments in other companies and the impacts of a company on people and the planet.?

The market will have to start thinking in those terms and the IFRS Foundation also encourages adoption of the Integrated Reporting Framework and the IASB Management Commentary to drive connectivity between different strands of disclosure. The aim is to communicate a concise and comprehensive understanding of how a business creates value over the short, medium and long term.?

We also expect closer cooperation between ISSB and IASB under the umbrella of the IFRS Foundation to ensure that the work of the two boards is coordinated and supports joint initiatives to develop synergies between IASB and ISSB.?

3. Another reflection I have is that, ESG needs to be embedded within every aspect of the operations of a business to enable progress in the transition to net zero. It’s no longer acceptable to just make claims about sustainability without taking real action –especially as we see the rise in climate lawsuits and actions by activist groups on corporations.?

ESG reporting can no longer be treated as a tick the box exercise that is left to lawyers, accountants and compliance functions within organisations. Given the groundswell of support and media attention all around every business, it requires compassionate senior management and every single person within each board. That’s the goal anyway. ?

4. Our world needs to eliminate greenwashing. ?

Disclosure is not just paperwork. It is the bedrock for all investment decisions. ?

One of the problems that we have seen as a result of the lack of any global standard is cherry picking and rampant and serious greenwashing. ?

The sooner we have a set of high quality, comprehensive globally consistently, comparable, verifiable, decision-useful sustainability disclosure information being made available by all listed companies, including SMEs, in emerging as well as developed markets, the earlier we will see an end to greenwashing if jurisdictions can require mandatory adoption of the climate standards around the world. ?

One of the most famous quotes about disclosure made after the turmoil of the Great Depression in the 1920s was “sunlight is said to be the best of disinfectants.” ?

One hundred years on, we need sunlight again to stop greenwashing to not only protect investors but also not to impede the proper allocation of capital to transition the world towards net zero.?

5. My last reflection is this, in recent years, there is a trend toward greater attention to a corporation’s role in society, a role that often goes beyond economic interests.?

Covid has given everybody an opportunity to step back and rethink the purpose of business and what drives the business. ?

What is obvious is that “business as usual” is no longer acceptable as we see businesses struggle, survive, thrive, evolve or even die, through the disruption of covid, digital transformation, climate change, geopolitical tension and social movements around our world.

It’s been four years since Larry Fink’s famous letter to CEOs asking public companies “to make a valuable contribution to society”, for companies to “benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate” and advocating long-term value creation. And three years since 181 CEOs of America’s largest corporations from the Business Roundtable, overturned a 22-year-old policy statement that defined a corporation’s principal purpose as maximising shareholder return.?

The model of capitalism in the 21 Century is also being redefined. We are seeing it described with adjectives such as Creative capitalism, Conscious capitalism, Woke capitalism, Compassion capitalism and Tomorrow’s capitalism. ?

It is perhaps time we all retune our mindset. Please all help also to eliminate a tick-the-box culture. ?

We have a once-in-a-generation-opportunity to work together to bring about a global baseline of climate related financial disclosure. ?

The ISSB’s consultation is open until 29 July, so please encourage everyone to pass on the message to relevant stakeholders to respond or respond yourself to our exposure drafts and also to the SEC and EFRAG public consultations. ?

We hope there will be widespread support for the alignment of requirements and ideally the adoption of the ISSB requirements as a global baseline.?