Christopher Pinney is CEO of Boston-based think tank High Meadows Institute. Ed Waitzer is a lawyer and serves on its advisory board.
To read the headlines, one might easily think that the application of environmental, social and governance (ESG) factors in investment decision-making is in full flight. ESG investing has soared to US$40.5-trillion and represented more than a third of the US$95-trillion global equity market last year. Indeed, many argue that ESG is becoming a victim of its own success – its currency has made it a popular marketing device and has driven up prices as a result of demand pressure.
This investment frenzy, however, masks some critical gaps in the allocation of capital in support of sustainability.
For one, most of the focus of ESG integration has been on investment in public equity markets, which are a relatively minor (and diminishing) segment of global capital markets. When it comes to debt financing, a 2020 global markets research report from multinational bank BBVA estimates that the current size of the green, social and sustainable bond market is now approaching US$1-trillion – a drop in the bucket of the US$128-trillion bond market.
This gap is more concerning when one considers that, according a 2017 study by CDP – a non-profit that has developed a global disclosure system to help manage environmental impacts – 70 per cent of greenhouse gasses are emitted by about 100 companies, of which 38 are private or state-owned (and hence do not raise public equity). Many of those that are public have been actively returning equity to their shareholders through share buybacks and dividends. Others are responding to the growing investor sensitivity to ESG concerns by divesting problematic carbon-intensive assets to private equity firms, which, in turn, are funded with debt.
The International Energy Agency has published a roadmap for “net zero by 2050” that outlines massive investment requirements for buildings, transportation and energy infrastructure. While the CEO of BlackRock recently proclaimed that “The climate transition presents a historic investment opportunity,” the vast majority of North American-listed companies are not yet credibly aligned with net zero goals, and we are a long way from the capital reallocation required.
Research prepared by the corporate governance adviser Future Net Zero and the Close Consulting Group shows greenhouse gas metrics and targets are used less than 10 per cent of the time in the executive compensation plans of such companies. In this environment, it should not be surprising that markets continue to misprice a future rise in the price of carbon and are lagging in the reallocation of capital to climate transition investment.
A concerted focus on the E in ESG integration in debt markets is critical for businesses (and our market economy) to successfully transition in a reasonable (for our planet) time frame. Sharp changes in valuations owing to unanticipated market or regulatory developments could also have domino effects and threaten the stability of the financial sector.
There is no historical precedent for the market co-ordination of a massive and rapid transformation of capital allocation even close to the scale that is now required without a deliberate push from governments. The shift to coal, railways and steam power that drove the Industrial Revolution (and the demise of feudal society) in 18th- and 19th-century Britain was made possible by the advent of the corporation – a legal fiction that greatly enhanced the ability of markets to co-ordinate the mobilization and allocation of investment capital (by affording investors limited liability and transferability of their investments). Similar public intervention and market innovation is needed to facilitate the de-risking and market funding of energy transitions.
What might this look like? The current U.S. administration’s efforts to craft a bipartisan infrastructure deal (and similar initiatives already implemented in Europe) are illustrative, as was China’s recent government-approved real estate trust for infrastructure. Other proposals draw their roots from initiatives such as the Reconstruction Finance Corporation, a U.S. government-owned organization that funded housing and energy infrastructure in the Depression era. Some have proposed new ratings agencies, staffed by scientists and economists, that would assess all debt offerings for climate impact and penalize polluters (with less attractive financing terms), while subsidizing (with public guarantees) top-rated bonds.
Without ESG integration across all asset classes – embedded in the cultures of corporate issuers and institutional investors – and timely support from governments, the progress we need on climate and other systemic sustainability issues is unlikely. Turning to human rights for example, more than 37 per cent of the debt in the JP Morgan Emerging Market Bond Index is issued by countries currently classified as “not free” by U.S. non-profit Freedom House. And according to a 2020 study by ShareAction, a group that promotes responsible investment, 84 per cent of 75 of the world’s largest asset managers did not have a policy excluding bonds issued by countries involved in human-rights violations.
The challenge of ESG integration in capital markets has only just begun. It is unlikely that markets alone, as currently structured and regulated, will be able to achieve the impact needed without the co-operation and support of governments. Now is the time to be thinking about creative solutions.
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