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Detours and Ditches: COP26 and its impact on the ESG movement

November 25, 2021

Detours and Ditches: COP26 and its impact on the ESG movement

Synopsis
13 Minute Read

The outcome of the 26th United Nations Climate Change Conference of the Parties (COP26) might have fallen short of expectations, but it provided some much-needed clarity for businesses, policymakers and investors focused on environmental, social and governance issues (ESG).

Leader, Environmental Social & Governance and Regional Leader, Enterprise Risk Services
Leader, Consulting – Organizational Renewal

Table of contents


This opening blog of a four-part series on ESG covers takeaways from COP26 - stay tuned for future insights which will take a deeper dive in to the implications for International Financial Reporting Standards (IFRS), examine industry specific takes, and address the often-overlooked "S" and "G" components of ESG.

The Paris Agreement of 2015 was a landmark climate change treaty, one that required countries to regularly review their pollution-reduction pledges to ensure the rise in global average temperature would stay below compared to pre-industrial levels. Yet, six years later, that target seems as difficult to attain as ever. In its latest report released in August, the United Nations Intergovernmental Panel on Climate Change (IPCC) found that unless governments and businesses step up and make “immediate, rapid and large-scale reductions in greenhouse gas emissions, limiting warming to close to 1.5°C or even 2°C will be beyond reach.” Without such action, the IPCC said there will be sweeping economic and environmental catastrophes around the world.

That warning put even more focus on COP26 held in Glasgow in November 2021. The organizers described the event’s theme as “coal, cars, cash and trees.” More specifically, the roughly 120 world leaders and tens of thousands of delegates at COP26 were tasked with finding ways to reduce coal use, to phase out the internal combustion engine, to raise trillions of dollars to protect against the impacts of climate change, and help developing countries transition to cleaner energy, and to reverse deforestation. Curbing methane emissions was also a key area of focus.

But COP26 was a focal point for environmentalists, policymakers, and media. The conference also called to align the finance sector with net-zero by 2050. Business leaders and the financial industry were already watching closely – particularly those who have increasingly embraced the principles of the ESG movement, which aims to improve business results by improving businesses’ ESG performance.

For ESG-oriented companies and investors, the hope was COP26 would provide clear – and perhaps long-overdue – direction about what they need to do to adapt their own strategies in the age of climate change, and how they should adopt ESG principles or perhaps change their existing ones. In particular, they hoped for clear guidance on what is considered “green” or sustainable, how it should be measured and how it will be standardized, putting everyone – regulators, businesses and stakeholders – on a level playing field.

On some issues, it was hoped COP26 would demarcate which countries were on board with climate change action and which were not. Instead, COP26 mostly blurred the edges and created uncertainty, which can lead to private-sector inaction. For instance, a proposal to phase out coal use was watered down to a “phase-down” – a nod to resistance from coal-dependent nations such as India and China.

Yet on other issues, important progress was made, including agreement on setting up a global carbon pricing system. Even more significantly for ESG, the IFRS Foundation announced during COP26 its International Sustainability Standards Board would standardize corporate disclosures on ESG issues in 37 countries, including Canada, the United States and China.

Obviously, it was never going to be easy to get almost 200 countries to agree on ways to prevent the catastrophic warming of the planet, the effects of which are already being felt in an ever-increasing string of extreme weather events. Yet, despite criticism the conference came up short of hoped-for agreements and principles, COP26 succeeded on a general level in drawing high profile attention to the issues, which are clearly no longer the domain of sleepy bureaucrats and eager environmentalists.

As UN Secretary General, António Guterres, pointed out in a wrap-up video statement, “the path of progress is not always a straight line. Sometimes there are detours. Sometimes there are ditches. But I know we can get there. We are in the fight of our lives, and this fight must be won. Never give up. Never retreat. Keep pushing forward.”

That the United Nations (UN) should be so integral to establishing ESG guidelines makes sense, given the UN came up with the term ESG in the first place. ‘ESG’ dates back to a study entitled Who Cares Wins, published by the UN Global Compact with the support of International Finance Corp. (IFC) and the Swiss government. “The institutions endorsing this report are convinced that in a more globalised, interconnected and competitive world, the way that environmental, social and corporate governance issues are managed is part of companies’ overall management quality needed to compete successfully,” the report stated. “Companies that perform better with regard to these issues can increase shareholder value by, for example, properly managing risks, anticipating regulatory action or accessing new markets, while at the same time contributing to the sustainable development of the societies in which they operate. Moreover, these issues can have a strong impact on reputation and brands, an increasingly important part of company value.”

From there, the ESG movement picked up momentum. In the mid-2000s, researchers at New York University reviewed more than 1,000 studies looking at ESG metrics and found that 58 percent showed a positive correlation between ESG measures and corporate financial performance; a third showed a positive correlation between ESG and the investment performance of related funds, portfolios and indexes. In another report, the UN Environment Programme Finance Initiative found ESG issues are relevant for financial valuation. Together, those two studies formed the backbone for the launch of the Principles for Responsible Investment (PRI) at the New York Stock Exchange in 2006 and the launch of the Sustainable Stock Exchange Initiative (SSEI) the following year.

Since then, ESG has been adapted in a myriad ways as it has grown. That growth itself has led to confusion among regulators, companies, and investors. For example, a study by Morningstar found that 77 percent of the almost 500 open-ended and exchange-traded funds in the U.S. that identify themselves as “sustainable” have some exposure to fossil fuel companies. The Rainforest Action Network has calculated the world's 60 largest banks provided US$3.8 trillion in fossil fuel financing between 2016 and 2020.

Still, many of the world’s biggest banks, including the Big Six in Canada, have now signed on to the Net-Zero Banking Alliance that is part of the wider Glasgow Financial Alliance for Net Zero. Chaired by former Bank of Canada governor Mark Carney, the industry-led alliance commits the banks to align their lending and investment portfolios with net-zero emissions by 2050, and it sets intermediate reduction targets for 2030 or sooner. Canada’s six largest banks had previously made individual commitments to achieve net zero by 2050, and they have even added ESG components to their chief executives’ compensation frameworks, putting them in a small minority of companies that tie executive pay to such measures.

Despite apparently conflicting forces, such private-sector alliances are crucial to putting ESG principles into practice. So too, are clear standards and metrics to be used by companies and investors alike; such standards and metrics are also imperative to helping businesses and policymakers get a better handle on the costs associated with transitioning to a greener economy. Executives must be purposeful, specific, and understand what is being done at their companies with respect to ESG so they can communicate their current position meaningfully to investors, as well as their goals moving forward.

On the communication front, COP26 brought several important developments. For the private sector, the IFRS Foundation’s introduction of a shared set of sustainability disclosures for corporations could provide some clarity, although it remains to be seen how widely adopted its recommendations will be. More generally within the private sector, there were other signs of action on climate change. For instance, it was announced more than 450 financial firms, including major asset owners and banks, now belong to the Glasgow Financial Alliance for Net Zero. The alliance was established in April 2021 to ensure financial systems work collaboratively to accelerate the transition to a net-zero global economy. Those 450 firms collectively represent US$130 trillion in assets – almost double the roughly US$70 trillion when the alliance was launched.

Within the conference proper, however, policymakers’ progress demonstrated how creating ambitious goals and following through on them are two different things, even with the most basic aspirations. For instance, one of COP26’s unrealized goals was to get all parties to agree on common definitions for what is “green” or “sustainable.” The European Union has been setting its own standards, which could become the basis for a global framework, but other jurisdictions remain outliers.

Among those outliers is Canada. The Expert Panel on Sustainable Finance set up by Ottawa in 2018 had already recommended that Canada use its own definitions if international ones hurt our resource-heavy economy. “Ideally, Canada would adopt a single internationally-aligned taxonomy encompassing not just green definitions, but a broader mapping of transition and resiliency-linked economic activities and asset classes,” the panel said in its final report, Mobilizing Finance for Sustainable Growth. “It should then work either independently, or with other countries with similar resource endowments, to develop supplemental coverage for industry transition activities that are essential to Canada but not captured under current criteria.”

On greenhouse gas (GHG) emissions, the delegates were more successful, though those successes might prove to be marginal. During the conference, 100 countries representing 85 percent of the world's forests, including Canada, agreed to spend US$19 billion to halt and reverse deforestation within nine years. Meanwhile, developed countries at COP26 pledged to double their share of funding within the US$100-billion annual target to help developing nations adapt to climate change by 2025. (However, a system to pay for damages caused by climate change was left unsettled.)

Another win was agreement on rules for a new global carbon market, which includes a centralized system open to the public and private sectors, as well as a separate bilateral system to allow countries to trade credits in an effort to reach their climate change targets.

Perhaps the most important outcome of COP26 was it reinforced the general agreement that there is a need for a real reduction in GHG emissions. Such emissions increased during the pandemic despite a decrease in industrial activity, and so did the strength and number of climate-caused natural risks. At the very least, COP26 signaled policymakers and the world’s leading financial institutions recognize the urgency of the issues. This makes it critical for countries and businesses to prepare and adapt in order to manage risks not just to their own stakeholders, but worldwide, as performance on environmental standards could well become increasingly required to access global markets.

One thing is clear: the transition to a green economy needs to be properly managed. The private sector has pushed the climate-change agenda further forward than governments have, perhaps, at least based on the agreements struck at COP26. Yet, businesses need also to have a clear-eyed view of the costs of climate change policy.

For example, many of the world’s largest asset managers adhering to ESG principles are divesting assets associated with fossil fuels. The divestment is leading to lack of investment in conventional energy companies – and driving up energy costs, including for the estimated one billion people living in energy poverty. According to the International Energy Agency (IEA), fossil fuels will still contribute at least 20 percent of global energy in 2050 as compared with today of approximately 80%, and governments will need to act collectively to plan, execute and pay for the transition to net zero or risk political backlash and economic upheaval. They will have to use incentives and regulations to entice the private sector to invest as well, since the IEA estimates almost US$4 trillion in investment will be needed by 2030 for clean energy projects and infrastructure. Such investment has hovered around US$1 trillion annually from 2018 through this year.

Increasingly, however, there is also a cost associated with not adopting ESG principles – a reality that will become more important for businesses as emissions targets become more stringent. For example, companies looking to export may have to comply that could be much stronger than those at home, such as the resolution by the European Parliament calling for mandatory human rights, environmental and governance due diligence standards across the value chain for companies operating in the European Union internal market. Money is also coming with more strings attached, because many major financial institutions, particularly in Canada, have adopted the Principles for Responsible Banking. Among other things, those principles require financial institutions to incorporate ESG factors into their investment analysis and decision-making processes, and to seek appropriate disclosure on ESG issues from the companies they support.

A major key to making all of this work is helping governments, investors and the general public understand what ESG means and how it can be implemented. However, having a consistent understanding as to what net zero means is a huge communications challenge. As the Carbon Pricing Leadership Coalition remarks, “Net-zero is understood differently by different stakeholders, which makes it difficult for stakeholders to compare targets and assess what is needed to meet global climate goals. This understanding often varies across a range of emission sources and activities, timelines, and the means by which companies intend to achieve their targets.”

It is also important to remember adhering to ESG principles is not just about the environment, though that’s certainly what COP26 focused on. Social and governance issues, such as the use of child labour, remain significant ESG concerns many may be skeptical will be solved. Then again, the idea of a minimum global corporate tax would have been unthinkable just a couple years ago, but the G20 agreed to just such a thing in October 2021.

To be sure, COP26 did not achieve a breakthrough on that scale, but some progress was made; more is promised. And while confusion over ESG definitions and metrics will no doubt remain, COP26 has at least reaffirmed the issue of climate change is firmly at the top of the global political and corporate agendas. In short, any business or investor hoping the ESG movement will disappear anytime soon is ultimately going to be very disappointed.

Follow the remainder of this four-part series on ESG as we take a deeper dive into the implications for IFRS, examine industry specific takes, and address the often-overlooked "S" and "G" components of ESG.

 

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