By Dawid Bastiat-Jarosz
The environmental and social challenges the world is facing are becoming more and more apparent with every passing year of record-breaking temperatures, floods, droughts, and social unrest that can be linked to acute climate change. The problem has been well-identified, measured, and quantified. It has long been clear what the world needs to do to avoid the worst of scenarios, and the path has been clearly laid out since the 2015 COP in Paris. The failure of COP27 to increase decisive action on emissions reduction decreases our chances of hitting a 1.5 degrees Celsius target and makes the path to this target look increasingly tortuous.
Had we started reducing our emissions five years before the Paris Agreement, this would have given us 30 years to achieve a 50% cut in emissions. Had we started in 2020 – we would have had 10 years to make each 50% cut. Instead, year after year, humanity has achieved another record-breaking emissions year (with the exception of 2020). Let’s imagine a scenario where we finally start reducing our emissions in 2026 – this would give us mere months for each 50% cut.
It has been estimated that we will need around 9.2 trillion USD a year to reach net-zero emissions by 2050. The record shows that government spending has not been a reliable source of climate change financing, and we ought to look elsewhere.
The global failure to meet any emissions reduction targets clearly shows that addressing the burning issue of climate change won’t be easy moving forward and definitely won’t be cheap. It has been estimated that we will need around 9.2 trillion USD a year to reach net-zero emissions by 2050. The record shows that government spending has not been a reliable source of climate change financing, and we ought to look elsewhere. This is where the financial markets come in: the only place where the magnitude of the financial challenge is dwarfed by the size of markets such as the $128.3 trillion global bond market. If we only manage to channel a fraction of the funds being invested every day, the financial gap could be covered. To do this, financial market participants would need a map and relevant incentives to guide them to investments with environmental and social impact.
Since the end of the nineteenth century, there have been attempts to make investments more ethical or responsible. It started with negative screening, where some financial products were blacklisted, followed by positive screening, Environmental, Social, and Governance (ESG) scores, and best-in-class investments in the 1980s. Today’s sustainable investing is built around the Sustainable Development Goals (SDG), and redesigning business models need to be focused on impact and ever more granular measurement of the externalities that companies and investments have. One should ask why we haven’t been able to move the needle despite the growing number of frameworks and tools guiding financial flows in the right direction.
The answer to that question lies in the shortcomings and misuse of these tools or blunt efforts to greenwash (or impact wash) the real picture. The best-known market tool is an ESG reporting tool designed to map the risks that a company is exposed to rather than serve as a guide to impact investing. However, in practice, it is often treated as the latter. High ESG-scoring companies are regarded as “sustainable”, along with ESG funds. However, anyone who opens an investment fund based on ESG scores would find investments and companies there that one would not expect in sustainable products, and conversely, other companies that should be there and yet are not.
ESG standards are self-reported and unchecked, often rewarding categories or behaviours that do not translate into environmental or social impact or do so perversely.
This is because ESG standards are self-reported and unchecked, often rewarding categories or behaviours that do not translate into environmental or social impact or do so perversely. Big corporations would score points, for example, for paying above the benchmark, which translates into ESG positive social impact. Large companies also have the capacity to maintain many internal ESG-related policies, fill in multiple complicated ESG reports and fulfil criteria such as how many senior managers attended a climate conference last year. These behaviours are hardly related to environmental or social impact, but they help large companies improve their ESG scores (there is a strong positive correlation between ESG score and firm size and low correlations of scores for the same companies with ESG evaluations from different score providers). That is why companies that produce cars with mostly internal combustion engines score much higher than EV-only producers, or you will find tobacco industry companies ranking relatively high on the ESG risk-rating spectrum.
There are several problems with major non-financial reporting frameworks, but two are worth mentioning. First, the influence of companies and Financial Market Participants (FMP) on the way scoring criteria are designed has made these criteria too lenient. Second, the multitude of standards incentivises standard shopping and, for the unsophisticated investor, makes the picture extremely murky.
Having recognised this, the EU needed to finance its ambitious “Green Deal” plan to enable a 55% reduction in emissions by 2030 and carbon neutrality by 2050 and decided to design a comprehensive “Sustainable Finance Reform” consisting of several legal acts and the backbone: the EU Taxonomy (EUT). The taxonomy is a list of specific criteria a given economic activity needs to meet in order to be considered sustainable. These criteria were developed by the European Commission in cooperation with the Platform on Sustainable Finance, an advisory body consisting of scientists, industry representatives and environmentalists who worked together on creating science-based criteria.
Money managers and banks will have to start reporting how sustainable their financial products and loan portfolios are. All this is according to one standard backed by a regulatory stick.
What is truly revolutionary is that these criteria will be used for companies to report how much of their revenue, Capital Expenditure (CAPEX) or Operational Expenditure (OPEX), is aligned with the EUT or, in other words, what percentage of the company is, indeed, sustainable. At the same time, money managers and banks will have to start reporting how sustainable their financial products and loan portfolios are. All this is according to one standard backed by a regulatory stick.
This, in turn, will have several implications. Firstly, the retail customer will have a much clearer view of what is inside a financial product. Secondly, fund managers will have to review products that until now have been sold as sustainable and redesign them in a way that meets the new, more ambitious criteria. Finally, large institutional money managers such as pension funds ($40 Trillion in pension assets in the OECD area), banks, and structural EU funds will be increasingly incentivised to allocate larger parts of the capital they manage to financial assets aligned with EUT. This movement of capital is what policymakers hope will help cover the financial gap needed to address SDG goals.
The potential of one standardised taxonomy does not end there. We should start using the EUT in project or investment assessment outside of the EU, in development-related work in low-income and so-called developing countries. By doing this, we might be able not only to provide Development Finance Institutions (DFIs) and other investors with a common investing framework but also to make investments in sustainable companies easier for European investors, making money follow impact.
About the Author
Dr. Dawid Bastiat-Jarosz is the co-founder of Swisox, member of the EU’s Platform on Sustainable Finance, and a fellow at the Centre for Finance and Development at the Geneva Graduate Institute. Swisox is the first sustainable-only financial marketplace designed to help impact companies raise capital and investors buy and sell sustainable equity and bonds.
Disclaimer
The opinions expressed in this publication are those of the authors. They do not purport to reflect the opinions or views of the Geneva Policy Outlook or its partner organisations.
