For the better part of the past decade, the responsible investment industry has known but one god: HARMONISATION. Whether it’s the Task Force on Climate-Related Financial Disclosures, ISSB, or any other range of initiatives, the goal has been clear: harmonise, harmonise, harmonise.
ESG ratings? Divergence is bad. Carbon footprinting? PCAF to the rescue! Climate scenarios? NGFS, tell us what we should use!
The idea that harmonisation is a good thing stood as an uncontested idol on panels, in think tank reports and in the hallowed halls of regulation. Harmonisation supporters have at times exhibited a religious zeal that would make the apostles blush.
And there are obvious merits to harmonisation. But not always and everywhere.
Climate scenarios are perhaps the most notable example.
Harmonisation obviously makes sense from the perspective of financial regulators looking for consistency.
But then, in the words American essayist Ralph Waldo Emerson: “A foolish consistency is the hobgoblin of little minds.”
For one, this harmonisation remains as elusive as the holy grail. As many in the industry busying themselves with the task of sustainability reporting will tell you, even elemental reporting metrics like financed emissions are still hobbled by a flexibility in application.
Not to mention scenario analysis where the tweaking of any number of parameters can yield dramatically different results.
Search any number of PCAF signatories’ emissions reports and you will in many cases notice a carve-out here or a flexible application there. In fact, when my think tank analysed PCAF disclosures a few years ago, we could not find a single case of a signatory applying the standard 100 percent.
There is no shame in that. “Trust thyself! Every heart vibrates to that iron string.” Obviously investors (and banks) have chosen to do what makes the most sense for them.
But where does that leave harmonisation? Well, not in much of a better place than we found it 10 years ago, I would argue.
For all intents and purposes, the overwhelming majority of sustainability disclosures are still not systematically comparable.
But then perhaps harmonisation was always – at least to a degree – fool’s gold. Is it so bad, then, to be misunderstood?
The drive towards harmonisation has always stood in tension with the goal of “ownership” of sustainability indicators within an organisation. The more an organisation follows a universal standard, the more it tends to conflict with the internal change management necessary to turn metrics into action.
Nowhere was this lesson taught to me more clearly than when we worked with the California Department of Insurance under Dave Jones’ leadership in 2018. We had designed a centralised project analysing the cohort of insurance companies active in California – 100 percent comparable, 100 percent harmonised analysis.
But when insurance companies received their results, they did not feel any “ownership”. For many, as much as it pains me to admit this, the results were thus not useful. When an institution adheres to a standard in reporting or uses a scenario they do not believe in, why would they action the results?
Harmonisation has obvious merits. It reduces transaction costs and creates regulatory certainty. Incredibly valuable – but a far cry from opening two sustainability reports and truly being able to compare apples to apples.
Interestingly, it seems regulators are waking up to this new reality. The UK Prudential Regulation Authority in its recent consultation paper (CP10/25) describes its expectation that firms are “able to justify the selection and conceptual soundness of scenarios they rely on”. The European Banking Authority similarly in its guidance on ESG risk management released in January expects institutions to “justify their choice of scenarios”.
Long gone are the days and dreams of those that sought one scenario to rule them all, one to bind them. Regulators understand that there is a value in being a nonconformist, even at the expense of harmonisation.
In a sense, this new insight liberates financial institutions to be more focused on sustainability risk assessments that make sense for them.
But it also will pose new challenges.
Follow the guidelines and use NGFS scenarios was a mantra that may have worked one or two years ago. Not so much anymore. There is now a clear expectation of being able to justify choices within an institution, to undergo an internal process of truth-finding.
Put differently, to actually have a view about how much transition alpha (or any other ESG alpha) an institution expects there to be, and the extent to which they intend to capture it.
RI professionals should see this as an incredible opportunity to reframe the relationship around climate scenario analysis within an organisation. If an organisation needs to justify its scenario choice, it needs to build internal conviction.
Rather than simply forcing scenarios onto the risk or portfolio management teams, only to see them ignored, either because the ambition level was seen as unrealistic or the design implausible (note the recent NGFS short-term scenarios that see the US as one of the top five decarbonising economies until 2030), this new approach can create joint purpose. A regulatory mandate to co-create scenarios and convictions, rather than another era of box-ticking.
Perhaps a measure of progress in this dynamic is not the degree of harmonisation, but the conscious adaptation and wielding of standards to serve internal objectives.
In this new world, harmonisation still plays a role. For some primary metrics like emissions or assets reporting, ownership is both less important and harmonisation more realistic. For others, harmonised standards can reduce search and transaction costs. But when it comes to scenario analysis and the goal of comparability, understanding what investors actually believe and what risks they price may be more important than a one-size-fits-all mentality.
Perhaps it is time for another god in the world of disclosures, next to that of harmonisation: Emerson’s self-reliance. It seems that at least regulators increasingly think so.
