The U.S. has European role models for ESG
Coinciding social, economic and public health crises have ravaged the United States in less than a year and a half. Yet, accenting America’s ongoing racial reckoning, economic recovery and pandemic response are a series of damaging, extreme climate events that have pushed already stressed infrastructure and systems to near breaking points. We need only look to the western wildfires of summer 2020 or Texas power outages in February 2021 to acknowledge that the climate risks once thought to be far off appear to be right at America’s doorstep.
Change is starting, but the U.S. is lagging
Just as new policy directives, offices and special appointments across the federal government signal a renewed commitment to fighting climate change in the public sector, trends like environmental, social and governance (ESG) and climate-related financial disclosures have continued to accelerate in American financial markets. Investors, likewise, have taken heed of these events and now correlate sustainability risks as investment risks. As of the end of 2020, 60% of Russell 3000 companies mentioned climate risk in filings, up from 35% in 2009. Likewise, the Forum for Sustainable and Responsible Investment reported that between 2018 and 2020, total U.S.-domiciled, sustainably invested assets under management surged 42% to $17.1 trillion, up from $12 trillion, now accounting for 33% of all U.S. assets under professional management. Leading investment management firms have also taken heed; Vanguard, BlackRock, Transamerica, Goldman Sachs and Franklin Templeton all launched ESG products in 2020, and BlackRock achieved its goal of integrating 100% of its approximately 5,600 active and advisory strategies into ESG investment process, covering $2.7 trillion USD in assets.
Climate change is expected to impact nearly every facet of the U.S. economy, including infrastructure, agriculture, residential and commercial property, and human health and labor productivity. Indeed, we are already seeing how climate change is affecting our economy. In 2020 alone, the United States experienced 22 billion-dollar weather events — severe storms, tropical cyclones, wildfire and drought — to the tune of USD $92 billion in damages. In addition to these rapid-fire disasters, the risks associated with a transition to a net-zero-emissions economy may prove substantial if markets and market participants are unable to adapt to swift changes in policy, technology and consumer preferences. These physical and transitional risks, coupled with relative uncertainty about future climate scenarios, threaten to disrupt the U.S. financial system and its ability to sustain the American economy. In recognition of these threats, President Joe Biden was quick to deliver on a number of campaign pledges to advance climate adoption at all levels of government, chart a path toward a net-zero and 100% renewable energy economy by 2050, and provide renewed global leadership in meeting the threat of climate change.
Case study: UK leads in expectation setting
As European institutions push forward and integrate climate-related and additional sustainability risks into their wider strategies, the UK remains a global leader. For years, proactive UK regulators have expected firms to manage and disclose climate-related financial risks, and these expectations have been codified in a number of recent provisions. The Bank of England (BoE) has introduced the Climate Biennial Exploratory Scenario, advising firms to conduct stress scenarios in assessing the impact of climate risk on the large banks and insurers. Similarly, the Climate Financial Risk Forum, chaired by the BoE’s Prudential Regulation Authority and Financial Conduct Authority, has published comprehensive guidance for risk management, disclosures, governance and scenario analysis.
Even while climate risk remediation, sustainable investing, and policies governing corporate behavior are increasingly emerging into mainstream American politics and the financial sector, the United States still trails many countries around the world. Across Europe, governments with significantly more mature regulatory regimes have already begun transitioning to action around ESG legislation. Announced in December 2019, the European Union (EU) president’s flagship policy, the “European Green Deal,” outlined the bloc’s long-term strategy and ambition in relation to both climate change and the wider sustainability agenda. A key pillar of the Green Deal is the EU Commission’s Action Plan on Financing Sustainable Growth, which aims to reorient capital flow toward more sustainable economies and mainstream sustainability into risk management. Climate-related disclosure and risk integration are key to delivering these objectives, leading to mandatory requirements.
Flowing from this plan, several key pieces of legislation have been published — including the EU taxonomy and guidance documents like the European Banking Authority’s Action Plan on Sustainable Finance — that provide more detail about upcoming changes to the regulatory landscape, with 2021 marking the start of the implementation phase for many of the obligations. These changes include disclosing the level of alignment of an institution’s economic activities with the taxonomy and the extent to which its activities are environmentally sustainable, taxonomy disclosures for funds and pension products, considerations of climate-related risk in the loan origination process, and preparations in advance of the European Central Bank’s plan to conduct a supervisory stress test on climate risk in 2022.
Preparing for coming sustainability requirements with an eye toward Europe
As the U.S. federal government and American industries look to countries with greater levels of ESG experience and maturity, they need to be prepared for the impact that future climate-related reporting requirements may have on daily operations and regulation forthcoming.
In navigating a voluntary disclosure market, executives are advised to pay special attention to emerging trends that will shape the way boards and investors will talk about ESG in 2021:
- The SEC is leading the way: The SEC is driving change guided by new federal leadership and multiple legislative proposals, like the Climate Risk Disclosure Act of 2019 and ESG Disclosure Simplification Act of 2019. Leading players should watch the SEC which is considering climate-change disclosure and issuing guidance on ESG disclosure more broadly.
- Borrowing lessons learned from the UK: With the Financial Conduct Authority’s adoption of the Task Force on Climate-Related Financial Disclosures principles in the UK Listing Rules as the standard framework to solicit environmental disclosure statements in their annual reporting for accounting periods that began on Jan. 1, 2021, we expect the continuation of shared practices to bridge the knowledge and execution gap across the Atlantic.
- Harmonization on the horizon: The International Financial Reporting Standards (IFRS) Foundation stated in February 2021 that it will “produce a definitive proposal for international sustainability reporting standards, including a roadmap with timeline by the end of September 2021, possibly leading to an announcement on the establishment of a sustainability standards board at the meeting of the United Nations Climate Change Conference COP26 in November 2021.
- Climate getting complex: If the aim to-date with reporting standards and the “license to operate” pressure coming from activists, investors, consumers and employees wasn’t already pushing companies whose leadership felt a variation of “greenwashing” was sufficient for their investor reports or websites, the development of “brown” finance and the debate around carbon-neutral portfolios in the net-zero agenda-setting era would be further inducement. Without digging into the weeds and implementing a sincere, strategic approach, companies risk getting into the crossfire when their actual impact is reviewed in the upcoming years.
- Making disclosure personal: ESG has already moved from being a CEO-agenda item to one that the board, audit committee, legal counsel and CFO are interested in. With the rise of ESG-tied compensation and performance-related pay, the personalization of ESG topics demonstrate the widespread actions that continue to maintain pressure at the top.
With daily updates and announcements, the seas of ESG continue to be turbulent with rapidly evolving information and new hot topics. But anchoring on these trends and staying up to date with lessons learned and regulations passed will help companies and their executives navigate these often confusing and frenzied waters.
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