Richard Mattison: Greater transparency on ESG will unlock capital for sustainable development

Members of HLEG share their thoughts on key topics under discussion

This article is one in a series of thought leadership pieces written for Responsible Investor by members of the European Commission’s High Level Expert Group on Sustainable Finance. To see other HLEG coverage, see here, or to comment, visit our discussion page.

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Data is the key to scaling sustainable finance. Uncovering it is the challenge. EU policymakers should be bold in implementing the recommendations of the Task Force on Climate-related Financial Disclosure (TCFD) as this will drive the availability of relevant, comparable and consistent data for investment decisions. Without meaningful disclosure data, markets will remain blind to the financial implications of climate risks. Without this data investors may fail to identify this century’s major growth opportunities.
The EU High-Level Expert Group (HLEG) on Sustainable Finance’s interim report has outlined the systemic change needed to make financial markets more sustainable. As a member of HLEG, let me list the main problems we have encountered:

Asset owners have locked up significant capital in unsustainable, carbon-intensive investments. They are seeking investments that deliver long term enhanced returns while at the same time helping to fund the transition towards a greener and more sustainable economy. There is limited information available today on how assets are performing on ESG issues and the link to financial return over the longer term. This is impeding capital allocation to sustainable investments.

Asset managers are usually only provided with a relatively short-term mandate by the majority of institutional asset owners and are monitored on a quarterly basis with limited or no requirement to report on the ESG performance of their portfolios. This drives short-term and often unsustainable behaviour.

Companies across many sectors will need to invest significantly in order to avoid material ESG risks and take advantage of the transition to a more sustainable economy. Issuers, however, complain that there is not enough capital available for the projects they need to invest in to drive the shift to a more sustainable business model at scale. This is often due to a lack of clarity about the financial and ESG benefits of these projects over both the short and long term.

Governments have made ambitious commitments, such as the Paris Agreement on climate change and the Sustainable Development Goals, but lack the capital required to achieve their goals.Capital markets will have to help fund the transition required if these international and national commitments are to be met.

Development banks can initially drive uptake of green/sustainable projects but often lack private sector partners to match their contributions and continue to fund these projects to scale.

The common problem that underpins the systemic challenge is a general lack of disclosure and analysis of the financial opportunities and risks, both short and long term, associated with ESG. Sustainable development requires significant capital but this can only be provided if there is enough information flowing along the investment chain. Markets can only be efficient if there is a timely and relevant flow of information. Trucost has analysed the disclosure of 6,300 firms in its Environmental Register database and only 46% provide standardised quantitative information on carbon emissions; only 36% on air emissions; and only 21% on water dependency. Data is often insufficiently robust, financially relevant or forward-looking, meaning that investors cannot incorporate this information into the investment process.

The EU should strengthen corporate disclosure requirements, proactively monitor compliance and ensure organisations that do not meet the new disclosure standards are held to account

The market is therefore calling for much greater standardisation of disclosure to require companies and investors to publish the data needed to inform decision making. The EU should strengthen corporate disclosure requirements, proactively monitor compliance and ensure organisations that do not meet the new disclosure standards are held to account. The TCFD implementation guidance for financial and non-financial sectors provides an excellent starting point on what these new data disclosure requirements should look like. The HLEG interim report supports this by recommending that “the recent TCFD recommendations should be integrated in a way that advances EU leadership… providing legal certainty and maintaining a level playing field globally”. The review of the EU Non-Financial Reporting Directive is a timely opportunity to achieve this.
There are several elements of the TCFD recommendations that can be implemented in Europe and I will outline two examples.
As a first step, the EU can encourage or mandate companies to conduct scenario analysis to assess the resilience of an organization’s strategy to climate risks, taking into consideration a 2°C scenario. The tools to do this exist already. For example, Trucost just launched a carbon pricing tool that quantifies the impact of carbon pricing and taxation on operating margin for companies at the entity and asset level. This type of assessment is critical as it will allow decision makers to define financially material risk over various timeframes and highlight opportunities to create more resilient business models. As the TCFD points out, disclosure of the results of scenario analysis will allow investors to assess:

  • The degree of robustness of the organisation’s strategy and financial plans under different plausible future states of the world;
  • How the organisation may be positioning itself to take advantage of opportunities and plans to mitigate or adapt to climate-related risks; and
  • How the organisation is challenging itself to think strategically about longer term climate- related risks and opportunities.
    Disclosure of company-level climate risks and opportunities will allow investment managers to make better decisions. However, it will be important for asset owners to understand how each portfolio, across different asset classes, is performing overall, as this will guide capital allocation. It is therefore critical that asset managers also report on metrics used to assess climate-related risks and opportunities in each fund or investment strategy.As a second step, the EU could make it mandatory for asset managers to disclose the weighted average carbon intensity for each fund and strategy, and consider other useful carbon exposure metrics, such as how aligned the portfolio is with a 2°C scenario.
    These two examples highlight how the TCFD recommendations can be specifically applied in a European policy context.

The EU could make it mandatory for asset managers to disclose the weighted average carbon intensity for each fund and strategy

Note that these approaches do not need to be focused just on carbon risks but can address other environmental impacts, such as water, and more broadly ESG issues and SDG-alignment too. Although most listed companies do not disclose water-related financial risks, Trucost estimates the total unpriced water risk at US$439 billion, factoring water scarcity and water quality issues. Social metrics must also be disclosed if the EU’s goals of creating good quality jobs, tackling inequality and delivering inclusive growth are to be achieved.
Better disclosure of ESG risks, alongside other much needed reforms, such as a clearer definition of the relation of ESG to fiduciary duty, will allow investors to more accurately price risks and allocate capital towards sustainable development. The EU can lead on sustainable finance and now is the time for EU policymakers to be bold by advancing and integrating the TCFD recommendations for corporate disclosure into our capital markets.

Dr Richard Mattison is the CEO of Trucost, an environmental data house that was acquired by S&P Dow Jones Indices last year.

To give feedback on the group’s interim report, published in July, see here.