Sustainable finance and ESG investing have gained significant traction in recent years, with investors increasingly seeking to align their financial goals with their values and issuers actively financing the transition to a more sustainable future.
The importance of this market is highlighted by the colossal investments entailed in reaching net-zero greenhouse gas (GHG) emissions globally, with Deloitte estimating decarbonization investments need to amount to over US$5 trillion a year until 2050 to reach these goals.
So, who is going to foot the bill? This was the topic of conversation at the world’s most important climate Conference, COP29 in November 2024. Under the deal agreed by almost 200 countries, wealthy nations said they would take the lead in providing “at least” $300 billion annually in climate finance by 2035 to help developing countries cope with climate change. This amount falls short of poorer countries’ expectations and is far from the $1.3 trillion economists say developing countries need yearly to shift to green energy and deal with climate change.
Not only is the market for sustainable finance and ESG huge, but investors and researchers find that a strong ESG proposition correlates with a reduction in downside risk and higher equity returns. As a result, the ESG market could surpass 28% of total assets under management (AUM) globally by 2030.
However, despite this boon in the market there are still major discrepancies in how ESG analysis is carried out by different rating agencies. These agencies evaluate companies according to their exposure to industry-specific threats and opportunities, and their need for ESG data has become fundamental to understanding and evaluating long-term value creation.
Despite this data being crucial for modern businesses and investors, there are significant inconsistencies and a lack of standardization in its collection, reporting, and scoring methodologies. In fact, leaders see the lack of robust data as the greatest barrier to the adoption of ESG. Therefore, the question is why don’t investors have access to consistent, high-quality, and material public information to assess sustainability risks and opportunities?
Firstly, ESG data represents a variety of information collected both inside and outside an organization. This mix of sources leads to fragmentation, as data from the company’s departments and stakeholders is compiled together with external reports. Not only are there discrepancies in the data collection methodologies and practices of different organizations, but these variations lead to concerns about the overall quality of the data they provide. As a result, organizations are facing difficulties in measuring and reporting their ESG performance effectively, and investors and stakeholders struggle to interpret and compare ESG data even when analyzing companies in the same industry.
Second, new requirements and evolving regulations have made it more challenging to find consistent and available data. Novel frameworks, standards, and reporting guidelines are constantly emerging as stakeholders demand greater transparency and accountability, but the absence of globally unified reporting standards makes comparisons between companies challenging and complicates both cross-industry and cross-country analyses.
Fortunately, progress has been made in increasing the alignment of reporting through the recommendations of the International Sustainability Standards Board (ISSB)and the Sustainability Accounting Standards Board (SASB). Standards dictate what should be reported, while frameworks provide the “how” in relation to ESG reporting. However, frameworks and standards are nothing more than principles and as such are non-mandatory requirements that are often ineffective.
Finally, the data provided by ESG rating agencies varies significantly. Consider Apple: one ESG data provider (ISS) ranked the tech giant as very good in its ESG scoring, while MSCI gave it an average ranking, and S&P rated it as poor. The deceptive truth is that with so many different ESG scoring methodologies on the market, there can be a wide spread of different views on the same company.
This rating discrepancy is due both to “what” is measured and “how”, meaning rating categories have different relative weightings for different data providers. To make things worse, much of ESG’s impact is qualitative, so developing a numerical value or objective measure for that impact is incredibly problematic.
Sustainability-Linked Bonds: A Case Study
The problems associated with ESG data and ratings are evident in the recent decline of “Sustainability-Linked Bonds” (SLBs). SLBs are a relatively new financial instrument that tie a company’s debt interest payments to its climate promises. Different from Green Bonds, whose issuance activity remained steady in 2024, Morgan Stanley reports the issuance of SLBs was down 51 percent in the first four months of 2024.
SLBs have drawn criticism for two main reasons. First, companies often fail to make significant green improvements after issuing these bonds. Second, the timeframe for achieving sustainability targets is frequently too short, raising concerns about the bonds’ effectiveness in driving meaningful environmental progress.
The case of Enel, the Italian energy group that issued the first SLB in 2019, highlights the challenges with these bonds. Enel recently announced that it had failed to meet a 2023 emissions reduction target, resulting in millions of euros in additional interest payments to bondholders, further fueling concerns about the credibility of SLBs and their ability to incentivize sustainable corporate behavior.
As a result, some investors argue that the absence of clear guidelines raises concerns about conflicts of interest and a potential framework for “greenwashing,” where companies mislead investors about their ESG performance.
The case for regulation
In November 2024, the European Council approved groundbreaking regulation on ESG ratings, marking a significant step towards enhancing transparency and accountability in sustainable finance.
This new framework recognizes the increasingly important impact of ESG ratings on the operation of capital markets and investor trust in sustainable products.
According to the council, the new regulation aims to boost investor confidence by introducing a standardized, trustworthy framework for the authorization and supervision of ESG rating providers. The European Securities and Markets Authority (ESMA) is set to take on this pivotal role and aims to bolster investor confidence and promote responsible investments.
The regulation’s impact is likely to be felt beyond Europe’s borders, as other countries look to implement similar frameworks. The UK, for example, is advancing its own regulatory framework for ESG ratings providers, aligning with international standards.
Europe’s new regulation represents a significant step towards creating a more transparent and accountable sustainable finance market, but fixing the current functioning of sustainable finance requires more than just frameworks and standards in specific regions. The future depends on the ability of global regulators and market participants to similarly address the challenges associated with ESG data. By promoting transparency, consistency, and comparability, the new regulation in Europe has set a positive example for the rest of the world to follow. Let’s see if they can.
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