EU work programme: What’s on for sustainable development and climate transition?
7 December 2022
Has ESG Investing a future as a contributor tofinancing sustainable development?
16 January 2023
By Marin Pitavy
This essay is a first-prize winner of the Fall 2022 Chair’s Essay Competition on the topic of: “Has ESG Investing a future as a contributor to financing sustainable development?”
“ESG is a scam”, Elon Musk stated assertively last May, after Tesla lost its place on the S&P 500 index of top-performing companies on environmental, social, and governance issues. A wave of protests followed and shook the ESG universe last summer, as major financial institutions faced scandals over greenwashing allegations. These recent turmoils are undermining the general confidence in sustainable finance at a time when COP27’s negotiations try to shift private investments to complete the 100 bn$ mobilized for developing countries. In this context, what can still be expected from sustainable finance? What framework has to be developed to ensure it achieves the goals of the ecological transition?
A statement of failure
The ecological transition is costly. In spite of massive efforts from governments, the investment gap remains significant: it is up to €30 billion per year in France[1], and reaches €180 billion per year in the EU[2]. It is clear that public funds won’t cover all the necessary expenditures for the transition to a low-carbon economy. Without sustainable private financial flows, the transition is a pipe dream.
More than a necessity, ESG investing is a powerful tool in a context where the societal shift required for a profound transition cannot be achieved in a sufficient time to avoid major climate degradation. Acting directly on financial flows has the double benefits of being a swift solution and a large-scale means, which can be easily deployed and generalized.
This potential, however, is slow to materialize, and the ESG world was brutally undermined last summer when the premises of DWS, a subsidiary of the Deutsche Bank and Europe’s second-largest asset manager, were searched by the German judiciary. The company has been targeted by an investigation over investment products that have been sold as greener and more sustainable than they actually were. The recent strengthening of European regulation on sustainable finance made the group reconsider its actual ESG investments, which collapsed from €459 billion to €115 billion[3].
This incapacity to precisely distinguish between what is sustainable and what is not is a thorn in the side of ESG investing and discredits the entire sector. The lack of consistency between different ESG data providers leads to poor data quality: ratings from Sustainalytics, a major provider dedicated to ESG data, have a correlation with those from different rating agencies as low as 0.19[4]. By comparison, credit quality ratings from Moody’s and Standard & Poor’s yield a correlation of 0.99[5].
A recent study by the OECD even shows that the environmental pillar scores of ESG data providers tend to be correlated with factors not directly related to climate transition actions such as market capitalization, and suggests that these financial features might play a greater role than climate-related metrics[6].
In turn, this poor data quality fuels uncertain decisions and limits investors’ ability to play their part in the transition. The future of ESG investing must be built on strong foundations and requires unbiased, comparable, and freely accessible information.
Knowledge is power
The transparency offered by public sustainability data does not only benefit institutional investors: it also makes information more accessible to society as a whole and allows the general public to take part in financing the ecological transition. In this context, household savings could be a major financing lever, if used in all consciousness. Let us not forget that domestic deposits in the EU reached €23 trillion after the pandemic[7]. In France, households’ savings went up to almost €6 trillion – or 3 times the GDP[8], and 200 times the annual investment gap. Even a small percentage of these amounts, operated by astute investors with clear ESG information, would represent a massive financial contribution.
Besides providing significant additional resources to the ecological transition, involving private individuals in sustainable finance is the opportunity to reach out to the general public and make them aware of the impact of their savings. While power concentration reaches records in the financial area, with the world’s largest asset manager operating the equivalent of the combined GDP of Germany and France with less than 15,000 employees[9] [10], it is time to democratize finance and make it evolve into a collective tool. We need to remove this instrument from the only hands of finance professionals and make it a means of contributing to the ecological transition.
A systemic shift
The excesses of finance, which led to the financial crisis of 2007-2008, and then to the euro-crisis in 2010, have made it a perfect target for public opinion. But one has to endeavor not to demonize it and consider it as a scapegoat: it is above all a reflection of the real economy. The general audience should not turn away in disgust. Rather, it must seize the matter to empower itself and assume a decisive role. To make sure not to repeat the past again, investments must benefit from a systemic change and become sustainable as a whole. The first step of this shift is to reconnect the link with reality. Investments must not be perceived as abstract tools and have to go along with policy measures in the real economy.
In light of this, ESG investing does not only concern the choice of financial products, but also and above all about the shareholder activity. The latter consists in exercising its right to vote, to table a resolution, and more generally, to support and put pressure on companies to make their practices evolve.
Furthermore, impact investing must broaden its scope of coverage. The environmental pillar, for instance, is often restrained to the climate concern. Far from being enough, it should also pay attention to biodiversity conservation and pollution reduction, among many other concerns.
This array of considerations cannot be encapsulated into a single score that sums up all the ESG efforts a company made to contribute to the ecological transition. Although The Economist recently titled one of its articles “ESG should be boiled down to one simple measure: emissions”[11], we cannot so easily narrow the definition of impact investing. The reality is far more complex and we must pursue in the opposite direction.
As an example, the EU taxonomy for sustainable activities offers a new classification framework for sustainable investing. The latter breaks with the past as it defines minimal requirements to fulfill rather than grading every pillar and calculating the average. This way, if Tesla does not meet the social criteria that have been set, then it cannot be considered a sustainable investment, regardless of its environmental performance.
For the implementation of this systemic change to be a success, ESG must not be “one among many” investing policies but the norm. To make this standard effective, one solution prevails: regulation.
The benefits of regulation
As stated before, data is the very first challenge of ESG investing. Major efforts have already been undertaken to report on companies’ ESG performances on open platforms, such as the Carbon Disclosure Project, or the OS-Climate project developed by the Linux foundation. But they all suffer from the lack of data from many companies which do not have any legal constraint to disclose, and sometimes even compute, their sustainability data.
The first contribution of regulation is to make sustainability reporting mandatory. Once this cornerstone is secured, the regulation would then allow its harmonization and standardization. The systemic framework also has the major benefit of providing long-term visibility to private actors who tend otherwise to suffer from short-sighted views and allow them to more easily plan ahead.
Finally, regulation within ESG investing prevents a pitfall well known to the environmental economy: the tragedy of the commons. Indeed, some asset managers defend their profit-oriented practices, justifying that they have a legal mandate to prioritize their clients’ interests despite the social and environmental damages they bring about.
Reshaping the regulation would make it possible to integrate the weight of negative externalities into the decision-making processes and to promote other aspects than the sole financial interest of their clients.
At a time when ESG investing is heavily challenged, there is no doubt that it has a future in financing sustainable development. But the state has to take responsibility and provide the best context for it to be successful.
[1] Ledez, M., Hainaut, H., (2021, 2 December). Edition 2021 du panorama des financements climat. Institute for Climate Economics. https://www.i4ce.org/publication/edition-2021-panorama-des-financements-climat/
[2] European Commission. (2019, 21 March). Financing sustainable growth. https://ec.europa.eu/info/sites/default/files/business_economy_euro/banking_and_finance/documents/finance-events-190321-factsheet_en_0.pdf
[3] Chocron, V. (2022, 2 June). Deutsche Bank executive resigns after ‘greenwashing’ raid. Le Monde. https://www.lemonde.fr/en/international/article/2022/06/02/deutsche-bank-executive-resigns-after-greenwashing-raid_5985505_4.html
[4] Bender, J., Maffina, S. (2022, March). The Importance of Data Quality in ESG Investing.The ESG Data Challenge. https://www.ssga.com/library-content/products/esg/esg-data-challenge.pdf
[5] Güttler, A., Wahrenburg, M. (2007, March). The adjustment of credit ratings in advance of defaults. Journal of Banking & Finance. https://www.sciencedirect.com/science/article/abs/pii/S0378426606001567
[6] OECD. (2022). ESG ratings and climate transition: An assessment of the alignment of E pillar scores and metrics. OECD Business and Finance Policy Papers. https://doi.org/10.1787/2fa21143-en
[7] European Banking Federation. (2021). Banking in Europe: EBF Facts & Figures 2021. https://www.ebf.eu/wp-content/uploads/2022/01/FINAL-Banking-in-Europe-EBF-Facts-and-Figures-2021.-11-January-2022.pdf
[8] Banque de France. (2022, 15 November). Présentation trimestrielle de l’épargne des ménages. https://www.banque-france.fr/statistiques/epargne-et-comptes-nationaux-financiers/epargne-des-menages/presentation-trimestrielle-de-lepargne-des-menages
[9] BlackRock. (2020, 31 March). History. BlackRock. https://www.blackrock.com/corporate/about-us/blackrock-history
[10] The World Bank. (2021). GDP (current US$). World Bank Group. https://data.worldbank.org/indicator/NY.GDP.MKTP.CD
[11] Harris, M. (2022, 21 June). ESG should be boiled down to one simple measure: emissions. The Economist. https://www.economist.com/leaders/2022/07/21/esg-should-be-boiled-down-to-one-simple-measure-emissions