There was a very interesting article in the Financial Times recently: Companies with good ESG scores pollute as much as low-rated rivals | Financial Times (ft.com)
Analysts had examined the environmental, social, and governance (ESG) ratings produced by the main ESG ratings providers and found that companies which score highly on widely used ESG ratings can still pollute as much as a company with a low ESG rating. This does seem like a rather perverse outcome.
The problems inherent in ESG ratings is symptomatic of the wider flaws in the market-led approach adopted by financial policymakers and regulators towards climate change.
The current approach to ESG ratings is flawed
There are major flaws in the current approach to ESG ratings. First, the focus is on the consequences of climate change for companies and financial institutions, not the causes of climate change. A spokesperson for MSCI ESG Research, one of the major ratings providers, said its ratings ‘are fundamentally designed to measure a company’s resilience to financially material environmental, societal, and governance risks. They are not designed to measure a company’s impact on climate change.’ The current approach to ESG ratings does not allow us to readily identify which companies (and financial institutions who invest in/ lend to those companies) are causing the most climate harm.
Second, ESG ratings can include an allowance for future plans to curb emissions. Why should companies be rewarded for things they haven’t delivered yet? There is no guarantee that these future commitments will be honoured. This approach can obscure the amount of climate harm a firm is causing now. It makes it harder to establish baseline data to allow for objective measurement of progress against published transition plans.
Third, ESG ratings are aggregate ratings which conflate E,S, and G factors. There is a risk that a company’s poor performance on pollution can be obscured by a higher rating on social and governance issues. Worryingly, the FCA’s flagship sustainable investment label proposals conflate the separate goals – as well as being, in effect, a voluntary scheme. Our analysis of the flaws in the FCA’s sustainable investment label initiative and our proposals for a more objective rating system can be found here: Financial Conduct Authority consultation on Sustainability Disclosure Requirements (SDR) and Investment Labels CP22/20 | The Financial Inclusion Centre
Flawed ESG ratings are symptomatic of a much bigger problem with climate finance policy and regulation
The flawed nature of ESG ratings is symptomatic of the overall approach adopted by financial policymakers and regulators towards financial markets and climate change. As with ESG ratings providers, financial policymakers and regulators focus primarily on the consequences of climate change for the financial system and financial institutions. They do not focus anywhere near enough on the role of financial markets in causing climate change. In doing so, they are not playing their full role in protecting us from the consequences of climate change.
If we are serious about preventing climate catastrophe we need to radically restructure the ‘real’ economy and financial markets. Financial market activities are a root cause of climate change. Preventing climate catastrophe means stopping financial institutions financing, at scale, economic activities that cause climate harm.
Financial markets helped propel us to the edge of climate abyss. Yet, for the most part, politicians and regulators are leaving it to the same financial sector to voluntarily clean up its act and the operation of market forces to engineer the necessary realignment of finance with climate goals.
To be fair, there is a huge amount of policy and regulatory activity in this field. An assessment of all the major initiatives can be found here: The Devil is the policy detail – will financial regulation support a move to a net zero financial system? | The Financial Inclusion Centre The response of policymakers and regulators can be summarised as relying on:
- Initiatives intended to encourage or reward ‘good’ financial market behaviours. These initiatives include greater transparency and disclosure, voluntary labelling schemes, and incentivisation (whether through tax breaks or deregulation – see, for example, how Solvency II deregulation is being sold as a way of incentivising insurers to invest in the green transition: Submission to HM Treasury Review of Solvency II consultation | The Financial Inclusion Centre).
- Enlightened market self-interest. The theory goes that market signals will cause financial market participants to recognise, before it’s too late, how climate change could affect their portfolios; and, to protect their own commercial self-interest, stop financing climate harm.
The history of financial markets tells us that encouragement or incentivisation is not effective at producing the outcomes we need. Similarly, the great financial crisis of 2008 tells us that, left to their own devices, financial markets are not good at recognising and acting on market signals. Indeed, a powerful new report found that markets are gravely underestimating the amount of climate risk the financial system is exposed to due to flawed economic models: Millions of pensions at risk because investment consultants overlook threat of climate tipping points – Carbon Tracker Initiative
Major, direct policy and regulatory interventions have been deployed to deal with the consequences of historic financial crises and market failures. Policymakers and regulators sought to identify the root causes of those crises and deployed major interventions to reduce the risk of recurrences.
Policymakers and regulators know that failure to tackle the root causes of financial crises and market failures has serious consequences for the economy and households. They have not left it to the market to prevent future financial crises and market failures. So, it is genuinely hard to understand why policymakers and regulators are relying on a market-led approach to address the climate crisis.
In the UK, financial regulators are charged by Parliament with preventing: financial crises; consumers being ripped off; insider dealing; the financing of terrorism; and money laundering. In other words, financial regulators play a critical role in stopping financial market failures harming the UK’s national economic, financial, and security interests (and given the importance of the UK as a global financial centre, UK financial markets harming global financial market, economic, and security interests).
Yet, financial regulators are not charged with directly preventing financial institutions funding climate harm. Protecting the environment from finance is given nowhere near the same status in the regulators’ statutory objectives as those other objectives. This is a grave failure of political governance considering the role finance has played in creating a climate crisis of this magnitude.
If we are going to prevent climate catastrophe, then financial markets need to know there is a price to pay for funding climate harm. Individual financial institutions need to be held to account for funding climate damage. This requires objective, trustworthy and relevant data on how much climate harm individual financial institutions are funding. ESG ratings do not give us that data. A new, objective climate-focused system of disclosure, along with meaningful ratings, is needed. Policymakers and regulators then need to ensure financial markets and institutions act responsibly using targeted regulations. Our policy recommendations can be found here: The Devil is the policy detail – will financial regulation support a move to a net zero financial system? | The Financial Inclusion Centre
We just do not have the luxury of waiting for market forces or enlightened self-interest to cause the necessary realignment. Time is running out.