Green Finance Advisor of Friends of the Earth (HK)

Year to date 2021 has been a banner year for ESG investing where many would argue the coronavirus kicked off a sustained shift of flows and invest interest into ESG themed investments. Flows into ESG themed investment products has reached historic highs and performance of ESG related investments have also proven to outperform traditional investments, busting one of the biggest refrains investors had regarding ESG investing in which many believed ESG investing is only in name and does not produce material benefits in performance for investors. As of August 31, 2021, the MSCI World ESG Leaders index registered 19.8% in return versus the MSCI World index at 18.3%, an outperformance of 1.5% in absolute terms and 8.2% in relative terms. The P/E of the ESG Leaders index stands at 24.82 versus 23.87 for the traditional index, which is a 4% premium over the traditional index. Last but not least, the Sharpe ratio since Sep 28, 2007 is 0.48 for the ESG Leaders index versus 0.47 for the traditional index. These data point to the arrival of ESG investing in the public markets as a mainstream and no longer a wished for but seemingly unattainable reform of the capital markets. This should ensure those public companies who have a demonstrated better ESG implementation and compliance cheaper access to capital and in turn help them to grow more competitively compared to those with a poorer ESG record, which cumulatively should have an incremental impact in achieving ESG goals such as mitigating global warming (MSCI, 2021).

However, it is not enough if public companies are complying with the ESG requirements whilst private companies are not impacted, in fact as the trend in the past decade has been for companies to stay private for longer, enjoying a highly active private equity market and multiple rounds of fundraising, regulators would be amiss if they fail to encourage ESG compliance for private companies. Yet being unlisted companies without quarterly reporting burdens make enforcing ESG frameworks on private companies trickier. There are two ways with which ESG compliance can be enforced for private companies, (i) LPs demanding more disclosure and making ESG scrutiny part of the investment process, and (ii) through value chain relationships, such as a public company demanding a private supplier to provide ESG related disclosures so the public company can comply with its own ESG commitments, for example a public garment manufacturer may demand a private cotton supplier to supply the public company with ESG data, and make ESG compliance a supplier selection criteria. Broad examples of greenhouse gas emissions throughout the value chain can be seen in figure 1 below.

Figure 1. GHG Emissions Throughout the Value Chain

For enforcing compliance through LPs, the European Commission implemented sustainability-related disclosure requirements which were first announced in 2018 in March 2021. The requirements are targeted at asset managers and financial advisors for disclosures about what actions they are taking on sustainable investing topics. In the US, the SEC announced the creation of a climate and ESG task force in the Division of Enforcement to develop initiatives to proactively identify ESG-related misconduct, which will find and hold responsible those who make unsubstantiated claims (Wiek, 2021).

For enforcement through the value chain, the recent merger of Sustainability Accounting Standards Board (SASB) Foundation and the International Integrated Reporting Council (IIRC) to form the Value Reporting Foundation supports the SEC’s increased interest and initiative in the area of sustainability-related financial disclosures. The standards provide a consistent, comparable, and reliable sustainability information that is material to investment decision making, and has participation from 225 asset owners and asset managers representing approximately $72 trillion in assets under management from around the world (Cohen, 2021).

It is certainly encouraging that public markets adoption of ESG practices are now well accepted and established, however we as advocates for the environment should continue to push for full adoption in private markets in order to expedite to correct the trend in rising global temperatures, as we cannot lose more time in combating climate change, a monumental challenge that will take every incremental change to overcome.

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