ESG and the new methodological framework to avoid greenwashing

Vision paper by Francesco Grillo and Claudia De Sessa expanding Francesco's column published on the Italian newspapers Il Messaggero and Il Gazzettino del Nord Est.

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In its column titled “The uses and abuses of green finance”,The Economist - arguably the bible of the slowly disappearing species of liberals - downsizes the scope of the announcements that dominated the first week of the Glasgow climate conference. There is no doubt that statement such as the one made by Mark Carney – ex governor of the Bank of England and now leader of the “Glasgow Financial Alliance for Net Zero” (GFANZ) – may give a strong sense of acceleration to the fight against climate change. Carney indeed argues that banks and investment funds that pledged to stop all investment in polluting companies by 2050 account for more than 130 trillion dollars. This mission, however, does not only present implementation and monitoring challenges, but it also runs the risk of creating dangerous collateral effects both in the fight against climate change and for the European Union which once again is venturing in an uncharted territory that requires vision and pragmatism.

According to the International Energy Agency (IEA) report presented in Glasgow, in order to honor the commitments of the G20 final declaration, countries should commit about 4000 billion dollars to low carbon energy every year for the next eight years. It is clear that such an effort would require a huge reallocation of investments from more to less polluting activities. This could also be the “mission” that sparks new life in those financial institutions that never really recovered from the 2008 crisis. We already have methods that companies use to include their sustainability assessment in their financial statements. Up until ten years ago, this kind of exercise was mainly used as a marketing strategy. Nowadays, however, the idea that sustainability and corporate responsibility may be the key for financial survival is slowly settling in.

In 2016, The Global Reporting Initiative (GRI), an NGO that collaborates with the United Nations, presented a methodology to ensure how much a company is damaging social value. Two years later, non-financial accounting standards (SASB) were included next to traditional accounting standards. This allowed investors to compare how much different companies include those principles in their actions. The EU the first supranational organization that – is developing - starting from a last year initiative – a full blown taxonomy aimed at measuring how much one’s balance is dedicated to sustainable economic activities. This first attempt is aimed at the banking sector and should be operational starting from next month. However, this process presents at least three main conceptual issues.

First of all, there’s the issue of defining what is an economic activity (as it can go from a drilling operation to sending an email) and then establishing if it is sustainable or not.

This assessment can change radically in time - as technological innovation turns polluting activities into more sustainable operations (for example with green concrete) – and in space, as some countries may adopt these new options more quickly than others. This calls for more insightful and complex evaluations and we may no longer rely on the traditional double route evaluations (even though financial reliability assessments have already become more complex, even with the old method).

Secondly, basing evaluation on “economic activities” – if a sector-based approach was adopted - may stir away investments (see graph below) from those sectors that are yes, more at risk, but that are also in need of the most money to reorganize themselves.

Lastly, there’s the question of expanding the evaluation not only on the environmental impact but also to corporate governance (i.e. firing and employment practices). This is useful to strengthen human rights protection (which are already protected by law) but risks – on a larger scale – of adding complexity to the evaluation and reducing the autonomy of entrepreneurs that need to be able to decide, in order to innovate.

These three issues become even greater if we think about the fact that the analysis needs to be done by each bank for each company it finances and by each company in regards to their local and global suppliers (but with laws that are limited to the EU).

An alternative strategy could be reducing the complexity and follow and quicker but more gradual approach; making rules more transparent towards companies and making evaluations available to investors but also to consumers whose daily actions will determine the outcome of the battle we are fighting (and avoid the proliferation of obscure acronyms and technicalities). One possibility could be adopting evaluation instruments that already exist , much like the European Central Bank does with agencies (such as Moody’s and S&P) “ratings” as an instrument to assess the quality assets of financial institutions. However, we should focus on an “evaluation of evaluations” that would even involve civil society and that would push evaluation companies to further develop more understandable and all complete instruments that would better gauge the progress of industries in relation to their commitments.

Another thing to keep in mind when dealing with green financing and risk assessment, is the risk related to climate related litigations. This issue has been explored by the Central Banks and Supervisors Network for Greening the Financial System (NGFS) in their latest publication.

Climate related litigations are legal actions undertaken by private actors (often supported by NGOs that jump to the bandwagon in order to raise awareness on issues)/companies and states towards violations of environmental commitments. These can take the form, for example, of local farmers accusing big corporations of damaging water and soil; governments accusing banks of not disclosing environmental risks in their assets purchase or lastly, banks claiming that transition policies such as carbon taxes are a risk for their financial wellbeing. The number of litigations has more than doubles since 2015 and has spread across jurisdictions. As it is evident, it is necessary to understand and take the risk of climate litigations into account if we want to achieve the green goals and in particular to devise effective transition policies.

Climate litigations pose a number of risks for financial institutions.

Firstly, defendants who may have to pay fines if on the losing side, or still hefty legal costs if successful. This would have an impact on the value of the firm, with spillovers for the institutions in the same field. Moreover, firms may be impacted by the measures undertaken by insurance companies who could establish liability premia.

Secondly, the uncertainness of future climate policies creates an insecure environment for banks who have a harder time determining what actions to undertake. Indeed, climate litigations have the characteristic of having a big magnitude (as damage to one natural resource may create a chain of damages in other ecosystems), of being non-linear (as technological advance may increase our capacity of assessing liability), of encompassing many issues (from pollution to human rights abuses) and thus many institutions and lastly, of being bound by a plethora of sometimes conflicting national and international regulations.

There’s a crucial need for rules in this changing world but is important to take into account all aspects of the transition and thus enable the financial sector and the community at large to take sustainable and effective decisions.