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While Climate Finance is Booming, “Green Lemons” Need to be Squeezed Out from the ESG Market

Climate finance continues to expand, driving the energy transition and rapid growth in net-zero technologies. At the same time, a lack of reliable data and robust governance has led to declining investments in environmental, social and governance (ESG) funds; meanwhile nervous asset managers are moving away funds to avoid claims of greenwashing.

The stubborn problems with ESG funds have prompted calls to replace the current framework with a single climate indicator: greenhouse gas emissions. However, the proposal is flawed, ignoring the financing needed to increase nature finance and tackle entrenched pollution threats. More promisingly, new ESG regulations and disclosure standards proposed in a growing number of jurisdictions can show the way on how to build comparability across practices, curb greenwashing and counter the credibility deficit in ESG markets.

So too is the newly-proposed ESG and climate risk disclosure standards from the International Financial Reporting Standards (IFRS) Foundation.  Final rules are expected in mid-2023 and promise to be the most significant development in company reporting in a generation.

“Aggregate confusion” in ESG reporting

Green finance is largely continuing its impressive growth, despite global financial and energy security concerns. Preliminary estimates show global climate finance volumes of between USD 850 billion and USD 940 billion in 2021, a 40 percent increase from the previous year. Similarly, global investments in energy transition technologies like renewable energy and energy efficiency reached USD 1.3 trillion in 2022. Surging green bond markets reportedly exceeded USD 1 trillion in 2022.

And the green investments are having an impact: in Europe, the record clean energy investments in 2022 were the main driver in the 2.5% drop in greenhouse gas emissions last year.

Climate finance forms the largest part of a much wider pool of investments falling under ESG funds. Globally, ESG funds comprise an estimated USD 100 trillion.

However, there is a marked divergence between the steady growth in climate finance, and downwards or sideways trends in wider green and ESG funds. S&P Global estimates that ESG funds dropped from USD 17 trillion in 2020 to USD 8.4 trillion in the U.S. at the beginning of 2022. In the European Union (EU), as the next stage of the “Sustainable Framework for Disclosure Regulations” (SFDR) entered into force at the start of this year, fund managers have already moved nearly 40% of asset funds classified as “Dark Green” under the SFDR to the lower “Light Green” level – a move representing roughly USD 100 billion.

Shuffling from nervous asset managers is part of the reason ESG funds have been decreasing and Bloomberg expects the shuffling to continue throughout 2023 as investors opt to reclassify billions now to avoid being accused of greenwashing when the new regulation kicks in.

ESG funds have become an easy target recently.  For decades, companies have made ESG claims that were sometimes untrue, often untested, and nearly always non-comparable. The Harvard Business Review has noted that the “data underlying ESG ratings are incomplete, mostly unaudited, and often dated.” Recent research from MIT, fittingly called “aggregate confusion”, has identified wide divergences across ESG reporting, making it nearly impossible for investors to compare companies and, in turn, reward higher ESG performance.

In light of this, “Economist” has proposed jettisoning ESG frameworks altogether, instead requiring companies to report a single climate indicator: greenhouse gas emissions. While a simplified climate metric would, in theory, allow financial markets to compare net-zero pledges and actions, it is a bad idea.  Investments are critical not only to curb industrial emissions, but also to increase conservation, finance nature-climate solutions, and tackle pollution.

Companies’ net-zero pledges require indicators that go beyond curbing emissions. Moreover, ESG assumes climate, nature, and pollution action must simultaneously integrate social, labor, human rights, and other standards to be truly sustainable.

Regulators looking to squeeze out the “green lemons”

Challenges with ESG frameworks pose a familiar problem for markets: how to overcome information failures in order to ensure efficient markets.

More than half a century ago, Nobel Prize-winning economist George Akeroff identified the problem of asymmetric information that stifled efficient market outcomes. Akeroff used the example of the used-car markets to illustrate asymmetric information failures; a market where few potential buyers possessed sufficient information to spot a defective used car, which he famously referred to as lemons. Akeroff proposed public intervention to help course-correct imperfect markets.

Which is exactly what is happening in many jurisdictions in order to correct risks of “green lemons”: from phantom carbon offset credits to companies mismatching green pledges with daily practices.

Many national regulators are making moves to help standardize and improve ESG and green finance information. In the United States, the Securities Exchange Commission proposed new rules setting out clear climate risk disclosure standards, and the U.S. Federal Trade Commission has proposed new guidelines to ensure that green claims – including claims related to carbon offsets – are truthful.

In addition to the more stringent SFDR rules, the EU is expected to introduce new regulations to counter greenwashing in bond markets, building on the “EU Green Taxonomy”.

Game-changing ESG and climate risk disclosure standards expected mid-year

There are promising signs that the convergence of climate information standards, metrics and measurement will replicate in the larger ESG market. By mid-2023, the IFRS Foundation is expected to finalize its new rules on how companies disclose ESG and climate risk. These new standards, developed by the International Sustainability Standards Board, mark the most important development in reporting in a generation.

The big question is whether all this effort to clearly differentiate green finance through better information matters much. Tim Buckley, the CEO of Vanguard, the world’s largest asset management group, recently said that they “cannot state that ESG investing is better performance-wise than broad index-based investing,” as the group exited the Net Zero Asset Owner Alliance.

The conclusion of a recent analysis by researchers at MIT and Peking University School of Mathematics offers a counterpoint at a vital period for green finance. Based on evidence from over 200 ESG funds, the report concluded that there is a “significant positive relationship” between ESG investments and performance, and that ESG funds outperformed their grey counterparts.

The new standards from the IFRS Foundation and different regulatory initiatives will allow investors to spot and crowd out “green lemons” in the critical years ahead. enabling the scaling-up of investments not only for cutting emissions but also for enhancing nature and strengthening social conditions.

Scott Vaughan, International Chief Advisor, CCICED

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