🏦 It’s a tough job, but someone’s gotta do it. In the week since World Bank President David Malpass announced his premature resignation, speculation has surged about the identify of his successor. The ultimate decision lies (not uncontroversially) with the US, given its sizeable stake in the multilateral bank. The White House is expected to select a candidate for whom climate change is a priority. Increasingly, shareholders have called on the bank to avail crippling emerging-market debt and unleash its balance sheet on international green finance. Malpass, of course, did not do that. Back in September, when asked whether he believed in global warming, the Donald Trump appointee responded “I don’t even know, I’m not a scientist.” Thanks to that gaffe, Malpass is no longer World Bank President, either. His replacement — right now, odds are on Rockefeller Foundation head Rajiv Shah — will be tasked with reforming the 1944 institution to meet the challenges of a 21st Century economy. Climate crisis to the left of it, a sovereign debt one to the right, the future of the bank hangs in the balance. No pressure.

🦅 Nobody wins the ESG culture war. Last week, Florida Governor Ron DeSantis announced new legislation barring investors for state and local entities from a) considering ESG factors in any investment decision, and b) requesting ESG information from suppliers in procurement. DeSantis’s latest efforts to “protect Floridians from the woke ESG scam” may backfire. Local US banks are fighting back, as new evidence suggests blacklists drive up state borrowing costs. Bloomberg data show that Texas and Florida are paying $1.9M and $4.3M more than California on every $1B of bonds, despite having superior credit ratings. Freedom isn’t free, and nor are large underwriters with the resources to ensure low borrowing costs and institutional capital access. The backlash may have further implications for regulation. Following BlackRock CEO Larry Fink’s recent calls for leeway, the SEC is considering dropping Scope 3 emissions from its climate disclosure requirements. Things could get tricky for companies operating internationally, given the opposing routes taken by the EU and global standard-setter the ISSB.

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Planes, trains, and chemical spills

The debate about Scope 3 emissions is back, resurfacing uncomfortable conversations about supply chains and the planes, trains, and automobiles that link them together. From aviation’s bold bid for green-standard taxonomy status to the EU’s ban on new combustion cars and vans from 2035, transport has been making headlines.

For once, we’re not talking exclusively about esoteric sustainable finance headlines.

Ordinarily a relative outlier in recent ESG debates — if not most investor conversations outside of Berkshire Hathaway — railroad operators have trundled into the spotlight on the back of the escalating Ohio disaster.

Driving regulation off the rails

On 3 February, a Norfolk Southern train derailed in the small town of East Palestine while on route to Pennsylvania. The train was hauling about 150 freight carriages from Illinois to Pennsylvania. Of those, around 20 were carrying hazardous materials and five vinyl chloride. Residents were evacuated, and emergency crews conducted a controlled burn of the toxic chemical to prevent further explosions. Unfortunately for residents, not to mention Norfolk Southern management and shareholders, the burning carriages released plumes of hydrogen chloride and phosgene — alternatively used as warfare agents — into the surrounding air, soil, and surface water.

The backlash has been fierce, compounded by revelations that the accident was entirely preventable. Norfolk Southern not only ignored but actively campaigned against long list of expensive preventative measures. Management spent hundreds of millions lobbying against rail safety rules; costs it recouped, presumably, by adopting a cost-saving ‘precision scheduled railroading’ model that relies on fewer staff and longer trains. Norfolk Southern accidents multiplied on the back of rising profit margins and share buybacks.

On two lobbying fronts has the company attracted particular vitriol. In 2014, Norfolk Southern fought the Obama administration on proposed safety regulations for trains carrying hazardous materials. Then, in 2017, it persuaded the Trump administration to repeal the requirement for brakes of the type that might have stopped its car from going off the rails this month.

New normal for plastic pollution

This is, evidently, a story that underscores the importance of the G in ESG. Though we sometimes rail (sorry) against the methodologies underpinning traditional ratings, here’s a situation where analysis of company-specific operational risk could have saved lives and lawsuits. But it’s not only a story about that.

Vinyl chloride is the base material for PVC. Norfolk Southern had been transporting vinyl chloride (or attempting to) on behalf of polymer and petrochemical industry customer(s). Somewhere in Illinois, as in Pennsylvania, company lawyers are breathing a sigh of relief for having escaped scrutiny thus far. The New York Times was one of the few national publications to take a swing at the plastics industry in light of the disaster.

In the US, reports Barrons, vinyl chloride is produced by Westlake; OxyChem (Occidental Petroleum subsidiary); Olin; divisions of Formosa Plastics; and Shintech, (Shin-Etsu Chemical subsidiary). Formosa Plastics and Olin claim its products weren’t involved. The others have yet to comment. For whatever it’s worth, a September 2022 press release, issued by Norfolk Southern, cites all three companies as winners of the 2021 “Thoroughbred Chemical Safety Award for safely handling products regulated as hazardous materials.” The reserve of companies that “safely transported or originated 100% of their shipments over Norfolk Southern’s rail network without a single incident in 2021,” the benchmark is nothing to be scoffed at.

The total ecosystem encompasses far more than a handful of PVC producers. The American Chemistry Council, which counts among its members subsidiaries of ExxonMobil, Shell, and BP, campaigns alongside the Association of American Railroads on everything from carbon denial to freight safety. It was in the engine room fighting railroad union action last year, as it was in involved in the 2014 and 2017 rail regulation showdowns for which Norfolk Southern has been criticised.

The mutual support of petrochemical and railroad industries makes sense. Of the c.12M freight cars that cross US railroads each year, about 2.2M carry chemical products. It’s not a new relationship, even if the material has changed. Freight and fossil fuel companies have been bedfellows for a very long time.

Renewable leaders of tomorrolololol

The purpose of a fossil fuel company is to sell fossil fuels, not to generate low-cost energy. Most assumptions otherwise are, regretfully, wishful thinking. Even as Shell fights high-profile greenwashing lawsuits (the major stands accused of inflating its renewable expenditure), petrochemicals have, quietly, been claiming an ever-growing share of its total revenue. Not that they factor into Shell’s Scope 3 net-zero target, which applies only to its energy products.

The International Energy Agency claims plastic manufacturing will account for more than a third of the growth in oil demand by 2030 and nearly half by 2050, ahead of trucks, aviation, and shipping. At that point, finds the Centre for International Environmental Law, the cumulative greenhouse gas emissions from plastic could reach over 56 gigatons, or 10-13% of the entire remaining carbon budget.

For sustainable investors assessing the fallout of the Norfolk Southern disaster, the foremost concern is whether it represents an idiosyncratic or systemic event for the company and broader US railroad industry. But there’s another question attracting less interest, despite potentially larger ramifications: Is this an idiosyncratic or systemic event for the petrochemical and polymer industry?

In other words, is it a Deepwater Horizon spill — a potentially repeatable event that informs perceptions of risk and impact at a sector level — or a one-off for which the industry bears no responsibility? Evidence on the ground is conclusive. Environmental and human health hazards are no aberration but a feature of plastic production.

🔋 The International Energy Agency (IEA) has identified bright sparks in its annual assessment of the global power sector. The biggest carbon emitter is now leading the transition to net zero, according to the Electricity Market Report 2023, bringing the sector “close to a tipping point.” The IEA forecasts that new electricity demand will be almost entirely met by renewable and nuclear sources of energy from 2025, bringing clean energy, as a share of total generation, to 35% (2025) from 29% (2022). China is expected to account for 45% of clean-energy growth during that period, followed by the EU at 15%. It must be accompanied by greater investment in grid security, resilience, and flexibility, adds the IEA, which warns the sector will only grow more vulnerable to extreme weather events.

⛽ Plot twist: ‘Energy security’ isn’t the only reason fossil fuel companies might want to defend their revenue streams. Oil companies are finally being honest about renewable energy, reports The New Republic, as record profits prompt a rapid retreat from lofty commitments. Having pledged to cut oil and gas production to 40% by 2030, BP last week adjusted its target to a rather more modest 25% — during, incidentally, an earnings call on which the company announced its highest profits in 114 years. The about-turn is an assurance that fossil fuel production will increase well into the next decade, warns the FT’s Simon Mundy. Should that come as a surprise? As we’ve argued before, it’s naive to expect the industry to pivot voluntarily from a lucrative business to one in which it has less expertise and less profit.

🗳️ If the court of public opinion doesn’t cut it, there’s always the other kind. Non-profit group ClientEarth has filed a lawsuit against all 11 directors of Shell for failing to manage “the material and foreseeable risks posed to the company by climate change.” The first-ever attempt to hold directors personally liable for transition risk has garnered support from institutional asset owners and managers, many of whom are pushing listed FTSE companies to put their transition plans to the vote under a ‘Say on Climate’ resolution. Meanwhile, the FCA told firms to get moving with their transition plans ahead of formal regulatory guidance. There’s a lot to be done, according to a new report from CDP. Of nearly 20,000 companies disclosing in line with its framework, just 81 have a credible strategy to reach net zero by 2050.

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Developing (market) polycrisis

Perhaps now more than ever, the state of sustainable development depends on where you look.

On the one hand, there’s the incredible rapid fire climate action emerging from global superpowers. Leaning towards public spending and tax breaks over carbon prices and regulation, policymakers are rolling out the red carpet for green industry, innovation, and investment. The new arms race is a powerful lever for tackling climate change, writes Hugo Dixon in Reuters. It’s also deeply unfair.

Discriminatory by definition, protectionist policies make for a rugged playing field. It’s a discomforting refutation of the Western democratic ideals represented, albeit imperfectly, by ‘free global trade’. In theory if not practice, the implicit promise of equal economic opportunity serves to mollify even the gross inequity of climate change, for which developing countries bear least responsibility and most brunt.

To make explicit that a country’s odds of competing in this industrial revolution were cemented in the last one? You’re not supposed to say that part out loud!

Economic bifurcation is a risk even within — and to — the single market, say critics of the EU Green Deal Industrial Plan. Relaxed rules on state aid could widen the chasm between countries that can afford to cultivate their clean-energy industries (France, Germany) and the more fragile economies that cannot. Right now, warns ESMA, there are quite a few of the latter.

And that’s just in Europe.

Deepening sovereign debt crisis

Briefing the UN General Assembly last week, UN Secretary-General Antonio Guterres made emerging economies the focus of his 2023 priorities. He has his work cut out. This year already, Egypt, Pakistan, and Lebanon have been forced to drop their exchange rates to unlock IMF assistance. No fewer than two dozen more countries are in the queue for bailout packages, reports Bloomberg.

Cleaning up the debt mess is just part of the solution to the deepening crisis, warn the FT’s Martin Wolf and Rebeca Grynspan, respectively. Just as important is a better framework for financing development, without which, parts of the world risk losing a decade to escalating disasters and dwindling resources. The costs would be impossible to contain. In the context of growing environmental and geopolitical distress, says Grynspan, the debt crisis facing the developing world is one the biggest threats to global security and financial stability.

Never one to pull punches, Guterres appealed for “radical transformation” of the global financial system under “a new Bretton Woods” framework, one centred on the “dramatic needs of developing countries.” The alternative, he warned, is “global catastrophe.” Guterres sketched out several potential systemic reforms to unlock private capital flows towards developing countries and “rescue the Sustainable Development Goals” ahead of the SDG summit September.

Fixing international financing

At their upcoming spring meetings, the World Bank and IMF face pressure to reform international financing by easing the path for blended and — increasingly importantly — private flows.

Guterres has called on multilateral development banks to adopt first loss positions to reassure and incentivise private-sector investors. The suggestion was echoed by US Treasury secretary Janet Yellen in a recent speech to Washington, during which she urged the World Bank to expand its remit to “address global challenges head on” by reforming international financing — and not just by lowering borrowing costs or issuing low-interest debt instruments. Yellen was emphatic. Reforms must incentivise “stronger mobilization of private capital.”

“International public finance alone will come nowhere close to the level of financing needed to effectively tackle global challenges and achieve the Sustainable Development Goals.”

Lack of investable solutions is often cited as an obstacle to investing in developing economies. It’s an exaggerated claim, reports Natasha Turner at ESG Clarity. Nonetheless, many emerging markets can ill afford to look less investable.

Seeing the wood for the trees

Last week, we explored the Adani scandal in the specific context of sustainable investing. From here, the ESG complex is looking at two possible responses: a) work harder to ensure it doesn’t happen next time, or b) remove any possibility of there being a ‘next time’ by retreating from higher-risk emerging market opportunities

The latter would be another catastrophic development for emerging markets and another characteristic one by the ESG industry.

In an utterly counterintuitive twist, ‘sustainable’ funds are, reportedly, diverting money away from the places that need it most. Put simply — as we did in our August research report and the FT in October 2022 — ESG, as practiced, is bad for emerging markets. Since the strategy once understood to mean ‘invest in positive change’ (impact) is now practiced as ‘invest to avoid risk’ (ESG), emerging markets are at a distinct disadvantage. Their perceived risks, coupled with scant coverage by traditional ESG data providers, exclude them from growing pools of international capital.

The annual shortfall in investment required to meet the SDGs is $4.3T and ticking upwards. To address climate change alone, emerging economies require an extra $2T each year, of which 70% must derive from private finance. The Adani scandal threatens to cast a longer shadow over the financing plans of Indian and, potentially, other emerging market companies, for which foreign investment had already been drying up. Investors must not let that happen.

🇪🇺 The EU has hit back at the Inflation Reduction Act (IRA) with a stimulus package of its own. Designed to stimulate cleantech innovation and investment on the continent, the Green Deal Industrial Plan includes initiatives to simplify the regulatory environment of, provide faster funding to, enhance the workforce underpinning, and relax trading conditions for green energy projects. Of particular note: Measures to streamline and fast-track permitting for new production sites, as well those geared towards relaxing state-aid rules and providing more manufacturing subsidies. European Commission President Ursula von der Leyen has been emphatic in her ambition to “make Europe the home of cleantech.” Given it currently takes longer to permit a wind farm than to build it, the stimulus may be the type of aggressive action that the EU needs to secure its industrial lead. In addition to stopping a potential flight of money and talent to the US, S&P suggests it could bring capacity back to Europe from lower-cost manufacturing centres in Asia. But at what cost? The FT suggests the panicked ‘race to the bottom’ sparked by the IRA puts the entire EU economic model at risk, as relaxed state aid rules threaten to fragment the single market. For European as for world trade, then.

🛢️ Record-breaking earnings are in for oil and gas companies. Slated as ‘obscene’ (Shell, $40B) and ‘outrageous’ (Exxon, $55.7B), GDP-beating 2022 profits are prompting renewed calls for bigger windfall taxes. Oil majors are pushing back. Their case would be stronger had they a clearer plan for putting their profits to work, argues ESG Investor. Conflicting pressure from investors and customers creates a fertile ground for greenwash. The clues are in the capex. BP is reportedly planning to pump the brakes on its renewables drive. Shell, meanwhile, spends a fraction of its reported expenditure on clean energy, according to Global Witness. In 2021, the oil major claimed it directed 12% towards its Renewables and Energy Solutions division. Global Witness puts the figure closer to 1.5%. Having lodged a complaint with the SEC, the NGO is urging regulators to investigate Shell’s “misleading claims.” CEO Wael Sawan blames Shell’s structural complexity for any confusion, reports ESG Investor. Structural complexity can hide a multitude of sins (more on that below), but it can’t obscure the inevitability of peak oil. As Carbon Tracker noted recently, “an awful lot of oil refinery capacity [is] going to have to be written down.” The mistake, however — as we’ve argued before — is believing that oil companies will go quietly. Or cleanly.

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Adani was ESG

Gautam Adani and his eponymous empire have had a bad week.

In late January, US short-seller Hindenburg Research published the results of its two-year investigation into Adani Group. Uncovering “brazen stock manipulation and accounting fraud scheme,” the bruising report claims the industrial conglomerate inflated its valuation artificially through a combination of offshore shell companies and engineered accounting and earnings. The state of its leverage was described as a “house of cards.”

It’s never a good time to be accused of “pulling the largest con in corporate history.” Days ahead of a planned $2.5B share sale definitely isn’t it. By Wednesday of last week, Adani Enterprises was forced to call off the sale. As of today, the rout had vaporised $112B from the market capitalisation of Adani Group’s seven listed companies.

From index providers if not investors, the response was swift. S&P Dow Jones ousted Adani Enterprises from its sustainability indexes, “after a media and stakeholder analysis triggered by allegations of stock manipulation and accounting fraud.” But the unaddressed question remains: Should a dedicated sustainable index or asset manager have had exposure to any Adani subsidiary in the first place?

The dubious value of an ESG score

In its 413-page response to Hindenburg’s allegations, Adani’s defence is peppered with over 100 ESG-related terms and couched in its ESG track record. Prominent coverage of the group’s adherence to various standards and frameworks doesn’t just complement the defence; it is the defence.

We learn about the “ESG credentials and environmental commitments of Adani Portfolio companies,” each of which has a “robust ESG framework and glide path in place, which is focused on assurance framework.” Those include “best-in-class global disclosures and standards like TCFD, SBTi, CDP, SDGs.” Its “governance standards [are aligned with] Global Best practices,” and it recently implemented a “Corporate Responsibility Committee in all… portfolio companies, which does the review of the ESG progress and framework alignment.” Adani is “fully committed to ESG aspects,” as evidenced by its practice of “[identifying] key ESG risks and [adopting] multiple mitigation measures.”

The fact it’s not all fluff says a lot more about ESG ratings than it does Adani.

In recent years, Adani has managed to master ‘sustainability’ (albeit not, as it turns out, on the debt front) on behalf of all its subsidiaries. As recently as November 2022, Adani Ports received a top ESG score from Moody’s ESG Solutions. This is a conglomerate with operations in commodities, utilities, gas, and airports; one engaged in some of the most controversial coal mining projects in recent history, including the largest open-pit coal mining operation — christened the “most insane energy project” — in the world.

Thanks to the “convoluted structures” and “multiplicity of subsidiaries” cited in the Hindenburg report, Adani has long been able to finance its dirtier operations with the proceeds of sustainable fund flows and — more alarmingly — sustainability-linked bonds. Adani Green, a staple in ESG funds, may have funded the thermal coal exploration of its sister companies. Allegations of cross-contamination aren’t, however, new. (For what it’s worth, nor are they restricted to Adani.)

Indexes amplify ESG failings

Back in 2020, Ulf Erlandsson of Anthropocene Fixed Income Institute sat down with Responsible investor to discuss the curious case of Adani Group and its sky-high ESG ratings. “This is not a story about how coal companies can get it right,” said the vindicated bond vigilante, “but rather one about the ESG industry can get it wrong.”

In the same year and a younger iteration of this newsletter, we expanded on Erlandsson’s research. Our position then — as it is today — was that Adani Group isn’t a logical contender for the FTSE4Good and Dow Jones Emerging Markets sustainability indexes. Nor could we understand why the conglomerate was ranked in the 94th percentile of responsible businesses by CSRHub.

At the time, CSRHub said it doesn’t “pretend to uncover the truth about a company’s social performance,” but instead seeks to “estimate a consensus view of a company based on the opinions of all data sources we can find,” i.e. those of incumbent ESG-as-risk data providers. Those opinions carry serious weight for any company seeking to raise finance. They inform its cost of capital and its odds of gaining entry into the type of sustainability index on which popular ETFs are modelled.

Given their influence, one would hope the ratings are well informed. Not, unfortunately, a given.

In 2020, Adani Ports secured a spot in the Dow Jones Emerging Markets Sustainability Index when CDP bumped its rating to a B- from a C. (Its stock jumped 8% on the news.) The company earned the upgrade because it answered “Yes” to the the question “Have you identified any inherent climate-related risks with the potential to have a substantive financial impact on your business?” The only other details it provided on that front were the fact the risk would be “reputational,” and, if realised, may lead to “increased stakeholder concern or negative stakeholder feedback.”

Disappointingly unimaginative for a company alleged to have pulled the “largest con in corporate history” through “brazen stock manipulation and accounting fraud scheme.” It also suggests corporate disclosures aren’t the only weak link in the ESG data market. Regardless of whether their objective was to evaluate sustainability in terms of risk or impact, plenty of ratings providers got Adani very wrong. It was an expensive mistake.

🏦 On the question of climate, banks are battling scrutiny from every angle. Last week, Europe’s biggest pension fund warned it would divest from lenders that fail to decarbonise their portfolios in three years. ABP head of investments Dominique Dijkhuis told Bloomberg the sector has “really lagged” in meeting words with action. Now, the asset owner is implementing strict performance indicators to hold it accountable. Commitments by banks are notoriously difficult to evaluate, not least because portfolio exposure isn’t public knowledge. Making them even more inscrutable, financing tends to happen at the level of parent companies rather than specific projects (91% and 4% of global fossil-fuel financing, respectively, according to the Rainforest Action Network). As pointed out by the FT, that renders virtuous decisions to cut ties with fossil fuels — such as that taken by HSBC in December — largely symbolic. But it may prove harder to run rings around the regulators, which have been busy issuing climate-related risk guidance for the US and EU. Soon after the Fed rolled out its scenario analysis exercise for the six largest US banks, the ECB published its first set of indicators for risks facing financial institutions.

🧮 Get excited, accountants. The ISSB has confirmed its Global Sustainability and Climate Reporting Standards will go live in June, with re-deliberations winding up in February. Last week, we touched on the single vs. double materiality debate fracturing the deceptively dull world of sustainability standards. The lightning rod is Scope 3 emissions, on which the ISSB recently changed position following consultation feedback. Its decision to include Scope 3 guidance is now attracting counter criticism. Expect increasingly divergent views on Scope 3 impact analysis, particularly as standardisation and regulation drive influence from company marketing to compliance departments. Already, reports the FT, board support is dwindling on fears of legal liabilities incurred through green accounting. For larger businesses with sprawling supply chains — and, within those, exposure to smaller developing-market companies — gathering granular Scope 3 data is no easy feat. But the alternative could bring legal headaches of a different kind, as JBS is finding out. For companies under the remit of the German Supply Chain Due Diligence Act — which came into effect this month — indirect risk analysis is no longer optional.

📊 The last quarter of 2022 put Article 9 to the test. In anticipation of stricter SFDR disclosure standards, finds Morningstar, 307 funds representing €175B were downgraded to Article 8. That’s 40% of the ‘dark green’ category, which now accounts for just 3.3% of capital earmarked for sustainability. Passive vehicles were represented disproportionately, prompting the question “can any pure sustainable fund be rules-based?” Even with a 52.2% SFDR market share, Article 8 fund providers can’t relax. ESMA is threatening a “greenwashing lawsuit tsunami” with its proposed names rule, under which funds claiming to be ‘sustainable’ must be 80% sustainable. Only 27% of qualifying Article 8 funds meet that threshold. In effect, the rule would expose more providers to the challenge (one we like to explore) of satisfying fund purity and liquidity/diversification simultaneously. Thankfully, fiscal stimulus is expected to expand the investable universe with an avalanche of greennovation. Which is good, because end investors are still pouring in. In Q4, Articles 8 and 9 accrued almost €16B (+7.3% on Q3) as Article 6 shed €3.3B (-1.1% on Q3). Globally, sustainable funds attracted $37B (+50% on Q3), even as the broader fund universe suffered $200B in outflows.

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ExxonMobil keeps it in the ground

In 2015, leaked memos and an eight-month-long investigation revealed ExxonMobil, in the words of environmental campaigners, “knew about climate change as early as the 1970s, but chose to mislead the public about the crisis in order to maximize their profits from fossil fuels.”

Thanks to its ambitious and well-funded research programme, the conglomerate didn’t just understand the science. It understood the science over a decade before climate change became a public issue in 1988, when NASA’s James Hansen testified to Congress about global warming.

It gets worse. According to analysis published this month, the climate models developed by ExxonMobil either matched or surpassed those developed by contemporary independent scientists. They were more accurate than even those developed by Hansen. From the 1970s onwards, ExxonMobil climate scientists “correctly and skilfully” predicted that global temperatures would rise 0.2C per decade and become detectable between 1995 and 2005.

What did ExxonMobil do with its groundbreaking findings? Try to prevent (what its own scientists characterised as) “potentially catastrophic events” that would afflict “a substantial fraction of the earth’s population”? Take advantage of the opportunity to lead the market on clean energy? Save the economy trillions in future climate costs and itself years of lawsuits, windfall taxes, and terminal decline?

Of course it didn’t.

I mean, we know the rest. The facts were a profit risk and so were concealed from policymakers, shareholders, and customers. Today, ExxonMobil is among the 20 fossil fuel firms responsible for one third of all modern greenhouse gas emissions.

Together, fossil fuel companies have worked diligently to keep their role under wraps. In 1998, ExxonMobil partnered with its peers on one of the most consequential disinformation campaigns in history. In their agenda plan, ‘success’ was defined as the moment when “‘climate change’ becomes a non-issue, meaning the Kyoto Proposal is defeated and there are no further initiatives to thwart the threat of climate change.”

In 1996, then-CEO Lee Raymond referred to “the unproven theory that [fossil fuels] affect the earth’s climate.” In 2013, then-CEO Rex Tillerson called climate models “not competent” and “not that good.”

The oil major spent tens of millions on disinformation over tens of decades, while publicly downplaying and denying the environmental impact of its business activities. PR firms were contracted, governments lobbied, and — when climate change could no longer be ignored — ExxonMobil perfected ESG reporting to help it preen for sustainability indexes and investors.

Was it worth it?

ExxonMobil hosts its fourth-quarter earnings call tomorrow. Since 2022 was a bumper year for oil & gas profits, shareholder loyalty may well be rewarded. But a year of windfall profits seems small consolation for four missed decades of policy, innovation, and investment.

The total cost to the company and its investors isn’t limited to climate risk. The research published in the last couple of weeks has, reportedly, strengthened existing US state lawsuits against ExxonMobil, deepening the expensive and protracted legal peril it faces on multiple fronts.

One other interesting study came out last week. Inmarsat found that 76% of business leaders distrust the ESG reporting of their competitors, while 80% believe their peers are working harder to appear sustainable than to achieve sustainable outcomes. Somewhat counterintuitively, 81% believe their own companies to be more sustainable than their competitors, yet only 47% were willing to share the entirety of their ESG data with third parties. Weird.

🛩️ The World Economic Forum at Davos exemplifies crony rather than free-market capitalism, writes The Spectator. This year, claims of hypocrisy are louder than usual. Criticism amplified by a cost-of-living crisis, conference attendees are accused of paying lip service to economic equality while shying away from action. But not everyone need worry about bad optics. In its 2023 Trust Barometer — published to coincide with Davos — PR firm Edelman finds Business is “the sole institution seen as competent and ethical.” (“Government and Media,” by contrast, “Fuel Cycle of Distrust, Seen as Sources of Misleading Information.”) The only group identified as more trustworthy is Scientists, 450 of whom just published an open letter imploring PR companies to ditch their fossil-fuel clients. Signatories cite a 2021 study on the unsung “major players in the climate political arena.” Through their campaigns on behalf of fossil-fuel companies, PR firms have “promulgated misinformation” (in Media) and “obstructed climate action” (in Government), effectively “shifting public discourse and the prospects for [policy].”

🗳️ Once the ‘Big Three’ asset managers extended proxy voting powers to clients, it was only a matter of time until advisers felt the political heat. Together, ISS and Glass Lewis control 97% of the proxy voting market. Their recommendations carry considerable weight. In a letter sent to both firms on Tuesday, Republican state-attorneys general challenged those relating to “climate and diversity, equity, and inclusion.” “Climate change advocacy and goals suggests potential violations of your contractual obligation [to] consider only one goal: the economic value of the investments,” wrote the attorneys of 21 states haemorrhaging hundreds of millions in higher-interest payments. The letter “reveals a fundamental misunderstanding of market forces at work,” responded ISS. Neither its voting strategy nor state activism has done BlackRock much harm. Speaking last week, CEO Larry Fink noted the $4B withdrawn by Republican states was more than offset by $230B in US inflows last year. “If you don’t have a lens to decarbonisation,” he added, “you’re not going to win one euro of business.”

🌐 Fault lines are deepening between the US and EU. In rhetoric if not action, central banks are diverging: The Fed “will not be a climate policymaker,” whereas the ECB has committed to aligning all policy with the Paris Agreement. But the real battle is playing out in green trade. (Ostensibly ‘green’, anyway. Those asking whether John Kerry were a protectionist in 2002 finally have an answer.) Seeking to alleviate European fears about the “discriminatory” Inflation Reduction Act, Commission president Ursula von der Leyen unveiled a Green Deal Industrial Plan at Davos. The counter package will channel capital towards, loosen restrictions on, and accelerate permits for green projects. “The story of the cleantech economy will be written in Europe,” she concluded. This is what the US wants, says the FT: coaxing the EU to its preferred territory of cash over rules. Carrot over stick, public spending over carbon pricing. EU dismay is understandable if naive. The ideological frontrunner has been overtaken and undercut by an ally that didn’t need to waste two years arguing about definitions. In one stroke, the US redefined 'sustainable'. And the WTO.

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Story of the week: Math(s) isn’t universal

Here’s a fun number. New analysis reveals that over 90% of rainforest carbon offsets by the world’s biggest provider are worthless.

The Guardian, Die Zeit and SourceMaterial undertook a nine-month investigation into carbon credits approved by the world-leading Verra carbon standard, which accounts for two-thirds of the (rapidly growing) $2B voluntary offset market. Their conclusion: The vast majority are ‘phantom credits’ and may exacerbate global warming, on top of human rights abuses such as forced evictions.

The net-zero pathways of most multinationals depend on carbon offsets. Shell — which, just last week, published a report on the “record growth” in voluntary and regulated markets — has set aside more than $450M for offsetting projects, according to The Guardian. The oil major plans to buy the equivalent of half the current market every year, having been ordered to cut emissions by 45% by 2030 in a landmark 2021 case. The Dutch ruling marked the first time a company had been legally obliged to align its policies with the Paris Agreement targets. It won’t be the last. 

Conceding the industry can ill afford a crisis of confidence, supporters argue that achieving net zero is impossible without offsets. Even the IPCC deems them “unavoidable.” Critics, however, say they just don’t work. 

How you read this story depends on whether you see it as:

1. an aberration in the system; or

2. a function of the system itself.

… and that, in turn, has very real ramifications for how you interpret company reports. 

Nobody wants to do harm (again)

It’s often said that sustainability is entering the mainstream. More accurately, sustainability is coming to define the mainstream, fuelled by supranational and national action of the type best exemplified by the Paris Agreement. 

Broadly, reactions can be split into two buckets: Primarily supportive, on ideological grounds; and primarily opposing, on financial grounds. The former is best represented by the EU. To the latter, we can safely assign higher-emitting companies and economies that rely on carbon-intensive industrial activity. They might like the tenets of sustainability in theory. (This isn’t in a Marvel movie. It'’s unlikely anyone has a deep-seated planetary vendetta.) But compliance can be a nuisance.

Nobody in Group #2 wants to admit they’re in Group #2. The membership fee is high and rising, as governments and regulators reconfigure global financial frameworks to meet ambitious sustainability targets. Forget subsidies or taxes. Even if only reputational, there are enormous costs associated with being labelled a “brown” company (or a “do-harm” fund provider), particularly if your inclusion in an ESG-rating-weighted index depends on it. And so, they lie.

For a time, the “alphabet soup” of fragmented standards facilitated compliance arbitrage. But that form of greenwash was never going to last, which was clear to everyone involved. Investors wanted consistent and comparable disclosures, adding to the pressure on regulators to condense everything into one framework. 

You don’t need to create standards to control them

It was this landscape into which the WEF stepped in 2019, armed with the ambition of harmonising the standard-setters (whether by mediation or co-option is a matter of opinion).

In conjunction with the Big Four, it published a report designed to serve as the basis for any ubiquitous framework: Measuring Stakeholder Capitalism: Towards Common Metrics and Consistent Reporting of Sustainable Value Creation. The ‘Common Metrics’ cherry-picked elements developed by the five standard-setters of the day, which were combined into a “nested ecosystem” under WEF’s second initiative: the Impact Management Project (IMP). The IMP was ultimately folded into accounting body the IFRS Foundation, whose global framework for sustainability disclosures is expected this year. 

The trouble is, “sustainable value creation” is not the same as sustainable development. Littering your work with SDG icons, pretty though they are, does not translate into shared international prosperity. And social and environmental risk to enterprise value (known in the accounting world as ‘single materiality’) is not the same as social and environmental impact (‘double materiality’).

Based on the draft proposals issued by the IFRS last year — behind which the WEF has thrown its support — we can expect very little of the latter in its final framework.

Accounting regulators are among the most powerful and independent in the world. Companies manage what they measure, and they measure what accounting boards tell them matters. Between them, the WEF and IFRS have determined that means risks to enterprise value, and, of those, primarily the ones relating to climate.

It creates a fertile ground for another explicit WEF project. The highly complex carbon offsetting, sequestration, and trading market has been commoditised as a ‘win-win’ solution to meet the net-zero obligations of the Global North under the Paris Agreement. The Global South has land and livelihoods, the Global North capital and technology. It also owns and runs the markets.

The ultimate irony is that the defendants of carbon colonialism can do so while cloaked in the unimpeachable respectability of saving the planet.

Kenneth Pucker said it best in the Harvard Business Review. Backed by what Greta Thunberg describes as the machinery of “clever accounting and creative PR,” Sustainability Inc.’s focus on corporate reporting is not a proxy for progress.

👨‍⚖️ Last year was one of the top-five warmest on record, setting the stage for a 2023 characterised by climate litigation (which had, already, doubled between 2015 and 2022). The Guardian spotlights a case of unprecedented magnitude, filed against the state of Montana by citizens claiming violation of their constitutional rights including to “a healthy and clean environment.” Financial rights haven’t fared much better in some states. According to a new study, the boycott of ESG-friendly financial groups by Republican state officials has cost taxpayers $708M in higher-interest payments.

⛵ Did Vanguard quit NZAM because US retail customers in passive funds are less motivated by and/or able to act on climate? So Reuters argues. Of the $8T overseen by Vanguard, 80% sits in (mostly retail) vanilla index funds, which can’t be tailored to specific social or environmental objectives. By contrast, the other ‘Big Three’ firms — BlackRock and State Street — are NZAM loyalists. Perhaps it’s easier to ignore the GOP backlash when you cater to a higher relative proportion of institutional (and, indeed, European) clients, who are more likely to demand sustainable products.

💰 The energy crisis (coupled with a tech sell off) made it a challenging year for their relative performance, but 2022 flow data underscores the enduring appeal of sustainable investments. ESG ETFs accounted for 65% of all flows into European ETFs in 2022, up from 53% in 2021. The €51B in new capital brought total assets from €235.3B to €248.8B, or nearly 20% of the total European ETF market. Potentially a bigger threat to 2023 data, the rising benchmark for sustainable products is putting pressure on providers to justify or downgrade their strategies.

💳 2022 was a “brutally” expensive year for natural disasters, reports the FT. Munich Re recorded global losses of $270B, of which $150B were uninsured. Developing nations suffer more and yet are less likely to have coverage, warns Simon Mundy. Pakistan is an alarming case in point. Munich Re assessed its $15B in flood damage (the highest disaster bill of any event, bar Hurricane Ian) as “minor,” i.e. too low for a meaningful insurance estimate. Not even middle-income nations are insulated: In China, flooding losses came to $5B, of which only $300M were covered.

🗺️ Pakistan’s national debt is $274B (c.90% of its GDP), of which $100B is owed to external lenders. Reeling from interest rate rises, many low-income countries are one economic or environmental shock away from bankruptcy. Unfortunately, the global sovereign debt crisis comes as natural disasters are escalating in economies already in dire need of adaptation and mitigation funds. Defaults would jeopardise private investment from risk-averse institutions. Facing calls for a dramatic international financial response, the IMF and multilateral banks have a busy year ahead.

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The watershed year for H2O

Just before the credits roll in the Big Short, a caption tells viewers that Michael Burry/Christian Bale — famous for having called time on the subprime mortgage crisis — is “focusing all his trading on one commodity: water.”

Of all the stuff covering the world’s surface, 3% is freshwater or suitable for crop irrigation. Of that, just 1% is safe for human consumption. UN data show that one quarter of the world’s population lacks access to drinking water; up to a half will live in water-stressed areas by 2025. By 2030, finds Morgan Stanley, demand will exceed supply by 40%. The dislocation presents enormous risks. It also creates opportunities.

For now, the former is dangerously underpriced by investors, warns CDP. Despite having caused 75% of recent disasters, water-related events were identified as a portfolio risk by just 18% of institutions in 2022. Sure, it’s easier to turn a blind eye to events happening in regions of the world that you can’t see — or, from an investment perspective, to which your capital isn’t exposed. But ravaging water crises risks permeate most regions and sectors.

Take the US. Having cost California $34B so far, recent floods are still not enough to mitigate the effects of record-setting droughts in 2022. The Colorado Basin, which supplies water to 40M people in seven states, remains endangered. Jackson, Mississippi faces more shortages, after 150K citizens lost access in August.

It isn’t a crisis with ‘only’ humanitarian casualties (were that the case, it’s safe to assume Burry wouldn’t be interested). Water is a vital resource and component in the production of almost everything, particularly in the agriculture, textiles, mining, and energy industries.

Some US$15.5B has been or is at risk of being been stranded. It makes access to or more efficient use of water a valuable advantage for the winnowing number of companies able to feed, clothe, or connect a growing population without interruption. Insulation from the operational and supply-chain damage wrought by droughts or floods will only grow more critical.

Financial risk is investment opportunity

Among January outlooks, there was one notable consensus view: 2023 will unleash a torrent of nature-based investments.

Though the nature and climate crises are inextricably linked, nature-related risk has long been in the shadow of its cousin. That began to change at COP 15, where the finalised Global Biodiversity Framework unlocked commitments to and capital for nature. Coming up in March is the first dedicated UN water conference in recent memory, which is expected to fan awareness — and investment appetite.

RBC Capital Markets predicts forestry, agriculture, and especially water will outperform other sustainability themes in the year ahead. Beyond creating a fertile ground for companies with access to water, shortages (coupled with a growing population and industry reshoring) are a tailwind for water infrastructure, innovation, and efficiency. There, argues RBC, investors will find high-quality defensive exposure. It certainly has upside potential: Today, 80% of wastewater is released untreated.

But the early stage of adoption yields obstacles as well as opportunities. Compared to climate or emissions, investors are dealing with a data deficiency when it comes to water-related risks and impacts. Neither reporting frameworks nor regulations are fully evolved, resulting in a relative dearth of first-party company information.

Every time a year is characterised as being even more ‘unprecedented’ than its predecessor, somewhere in the world, faith in market forecasting (and the English language) dies. 

It’s not easy to predict the trajectory of a complex adaptive economy, let alone one shaped by an ever-growing fistful of exogenous factors. Climate change, global pandemics, territorial wars: none is traditional market-data fare.

This January, at least, there’s plenty of evidence to support the consensus outlook, which tells us to strap in for a rough ride. Still, you can never discount the potential for shock events. Fortunately, that includes those on the upside.

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All eyes on the Fed

Investors are bracing for one of the most anticipated recessions ever, as central banks double down on aggressive policies to tame inflation at any cost. Having slimmed down its balance sheet with the fervour of a January gym-goer trying to shed 10 years of accumulated weight, the US Federal Reserve is unlikely — at least in the near term — to let even peak inflation data derail its historic tightening campaign.

That’s bad news for growth stocks, which owe a decade of outperformance to low borrowing costs and a sprinkle of imagination. Price corrections are one thing, but an economic downturn would extend and exacerbate the terrible, horrible, no-good, very-bad year suffered by somewhat-less-Big Tech.

If the events of 2022 compound in 2023, so too will the specific challenges faced by sustainable investors. Gone are the easy victories, such as labelling as ‘sustainable’ any fund with a performance-boosting bias towards technology. 

Investors must look further afield for positive-impact and above-market returns.

Cementing the dichotomy

Past consensus cast a sustained market downturn as the true test of sustainable investing. Current consensus agrees it will emerge from this one, albeit in a very different shape.

Coupled with escalating political attacks in the US, an economic crunch may prompt a retreat from explicit social and environmental objectives by larger asset managers: particularly those besieged, on the third front, by the growing threat of antitrust litigation. Real though they are to a specific market segment, however, headwinds are unlikely to drive sustainability off course within broader capital markets.

Every cycle is different. Baked into this one are a number of structural trends that may not only insulate sustainable finance but accelerate and — we hope — improve it.

Be wary of corporate disclosures

Regulatory activity is ramping up on both sides of the Atlantic. While banks steel themselves for climate stress tests, companies are preparing for disclosure requirements.

• 🇪🇺 In December, the European Financial Reporting Advisory Group (EFRAG) submitted the first set of draft EU Sustainability Reporting Standards (ESRS) to the European Commission. Marking a “major step” towards a reporting framework for companies operating in the bloc, the standards are expected to be finalised mid-2023 and apply from 2024.

• 🗺️ That means many companies will have to comply with the EU rulebook ahead of the global counterpart being drawn up by the International Sustainability Standards Board (ISSB). ISSB plans to finalise two proposed disclosure rules for climate-related risks in 2023. Despite broadening its focus to include biodiversity, the guidelines will cover fewer topics: EFRAG, by contrast, has reportedly identified around 1,000 datapoints on which companies need to report.

• 🇺🇸 In the US, the SEC is expected to introduce rules requiring companies to disclose material climate change risk and risk management. The Biden administration has, already, made clear its support in its biannual regulatory to-do list, issued on Wednesday. Prepare for a “robust response” from the anti-ESG Republican faction, led by Florida governor (and 2024 presidential candidate frontrunner for the GOP) Ron DeSantis.

Despite progress by regulators — and, as surfaced in a recent Deloitte study, company management — it’s the wrong time to get complacent about corporate disclosures. In 2022, greenhushing emerged as the new greenwashing.

Should the market or political landscape turn unfavourable, will disclosures continue to be a reliable proxy for data and transparency?

Regulatory requirements bound to bite

For investors preparing for (or adjusting to) their own regulatory requirements, it’s not an immaterial question. 

• 🇪🇺 In the EU, Level 2 of the Sustainable Finance Disclosure Regulation (SFDR), introduced last week, requires fund providers to identify and disclose the principal adverse impacts (PAIs) of financial products on sustainability factors. Building on the reporting obligations outlined in Level 1, Level 2 includes a new mandatory reporting template for 14 core and 31 additional indicators. Firms will need to report on all 14 core, plus 2 additional, factors.

• 🇺🇸 In the US, after a year of cracking down on misleading claims (see: last year’s fines for GSAM and BNY Mellon), the SEC is expected to provide more clarity about what, exactly, fund groups need to do to market sustainable funds safely. The regulator has already proposed changes to its Names Rule, under whose expanded remit a fund could claim the term only if 80% of assets were invested sustainably. Again, however, any SEC action is bound to be challenged in court.

The threat of watchdog punishments prompted a retreat from sustainability in 2022, which provides some insight about what lies ahead.

US SIF calculated assets in US strategies totalled $8.4T in 2022 — or less than half of the $17.1T reported for 2020 — thanks to not outflows but stricter criteria. In the EU, funds representing more than $100B were downgraded from Article 9. With new research showing just 0.5% of Article 8 and 9 funds meet a “greenness” threshold of 50%, it’s safe to bet on more downgrades in the new year.

2023 heralds market bifurcation

And yet, demand for sustainable investments is booming. Per PwC, 81% of institutional investors in the US and 83% in Europe plan to increase their allocations to sustainable products over the next two years.

Meanwhile, companies are catering to customer and employee demand: the latter of which, as the Fed is discovering, may prove hard to disempower. (Particularly if ageing demographics are forcing the tight labour market, and particularly if the tight labour market is unalleviated by ongoing protectionist policies.)

If sustainable flows continue to soar while the funds market shrinks, we expect an absolute bifurcation between ESG and impact in 2023. If so, it will mark the culmination of a journey that began all the way back in December 2021, when Bloomberg shone the light on the chasm between ESG and impact. 

The fact something so obvious caused such a stir — and just one year ago — seems extraordinary today. It will appear even more remarkable in 12 months.

“Many ESG ratings evaluate: “Does this ESG issue impact the profitability of the company?” We need a system that evaluates: “Does the growth of this company have a positive impact on the world?” This evolution of ESG needs to be championed by institutional investors, rating agencies, public companies and the general public. As the world needs to strive for a substantial positive impact, we won’t be referring to ESG. Instead, we’ll talk about Impact.”

Tesla Impact Report, 2022

The new nemeses of the GOP zeitgeist, defensive asset managers have been quick to paint ESG factors as material risk and ESG strategies as risk management. That may be true, and it may warrant ESG becoming the base setting for companies and funds. But it does little for an audience of investors, institutional and retail, clamouring for true sustainability. 

For investment firms that can no longer rely on the competitive advantage of ESG at a time when their future depends on enshrining one, there are worse strategic ambitions than ‘impact’ in 2023. Moreover, with protectionist fiscal policy driving explosive growth among homegrown technology and energy industries, those fund alignment targets may begin to look not-so insurmountable, after all. 

If nothing else, social and environmental data is indispensable to anyone trying to make sense of an economy shaped, increasingly, by exogenous shocks: climate change, global pandemics, territorial wars — plus whatever else 2023 has in store. 

🐾 Hot on the heels of COP 27, the UN Biodiversity Conference, COP 15, is underway. Negotiating parties are working to finalise an agreement on the post-2020 Global Biodiversity Framework, with targets to conserve 30% of the world’s surface by 2030. In his opening remarks, UN Secretary-General António Guterres appealed for an end to the “orgy of destruction” and for “tough regulatory frameworks and disclosure measures.” Those look imminent. The draft agreement mandates that businesses “report on their dependencies and impacts on biodiversity,” towards which standard-setters are making progress. On top of the TNFD, which publishes its recommendations in 2023, the GRI has opened a consultation on biodiversity standards. Contentious biocredits will attract outsized interest this week, warns the FT’s Patrick Temple-West, but Frédéric Hache of the Green Finance Observatory argues there’s a less greenwash-y way to mitigate biodiversity loss: taxes on commodity exports and marine traffic. Systemic, any ‘Paris moment’ for nature must attend to global value chains in the context of the energy transition. (On which note, one left-field spark of hope: Yesterday, nuclear fusion achieved energy breakeven.)

⛵ Forget knife catching: On Wall Street, tightrope walking is the trick to master in 2023. Having floated a bill to block SEC climate disclosure rules, Senate Republicans are “amping up efforts to rein in BlackRock, State Street and Vanguard on ESG issues,” reports Bloomberg. Their crusade is a preview of the fight to come when the GOP takes control of the House next month. In a blow to nominative determinism, Vanguard is its first major victim. Last week, the world’s second-largest asset manager pulled out of the Net-Zero Asset Managers Initiative (NZAM). Defending its commitment to help clients navigate the “far-reaching economic consequences” of climate change, Vanguard blamed “confusion about the views of individual investment firms,” particularly “regarding the applicability of net-zero approaches to broadly diversified index funds.” Blame anti-ESG politicking, says Kirsten Snow Spalding of investor network and NZAM founding partner Ceres, itself facing GOP scrutiny. Last month, Republican attorneys general petitioned the Federal Energy Regulatory Commission to ban Vanguard from buying shares in US utilities, claiming its NZAM association would “affect the cost and reliability of energy supplies.”

🎲 Following one defection, will fellow investment firms go down or double down? Morningstar’s Hortense Bioy warns of a domino effect, as US “ESG polarisation reaches untenable levels.” Al Gore caveats that Vanguard represents, in his view, an exception among firms demonstrating a “real, growing commitment” to fighting climate change. Not everyone agrees. BlackRock CEO Larry Fink faces calls to resign by activist investor Bluebell Capital Partners, which accuses BlackRock of ESG “hypocrisy” due to its changing position on coal and ongoing support of Glencore. Activists: Join the queue — or is it a melee? On the other side of Republican legal action, JPMorgan has warned of snowballing regulatory crackdowns on greenwashing claims. This comes after the Australian Securities and Investments Commission fined Vanguard for “misleading” product disclosures that overstated tobacco-related exclusions. (The funds excluded companies making, though not those selling, tobacco goods.) Between anti-ESG GOP and pro-ESG consumer-group lawsuits, reports the FT, “litigious fervour” is the new “multidimensional headache” for firms caught in the crosshairs of the new culture war. It’s a lawyer’s world; we’re just living in it.

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Sustainable investing is hard

If you were a sustainable fund manager, and you had spent the last year caught between anti-ESG (as-imagined) backlash and anti-ESG (as-performed) regulation, you might think: why bother?

Sure, responsible investing is part of your DNA and your clients are at the heart of everything you do, but corporate biology is meagre insulation here. EU regulators have delivered opaque guidelines (“build sustainable funds, we just won’t tell you how”) and arbitrary action (“not knowing is part of the fun!”). US politicians have made perennially boring pensions the unexpected lightning rod in their culture war, though their action is, at least, predictable: AUM x ESG commitments = higher likelihood of a reaction.

Which is frustrating, because the assets under management (AUM) aren’t even yours. They belong to your clients. Most commitments to social and environmental principles are straightforward customer service. Free-market capitalism is under attack from an anti-free-market movement feigning free-market values to imply, wrongly, that an asset manager’s AUM sits on its balance sheet, leaving you with all of the suspicion of 2000s banking and none of the fun.

Of course, customer service is the reason you do continue to bother. Clients really want the green goods, and you really want clients — particularly those willing to pay a product premium. The irony is that AUM has a shrinking bearing on balance sheets: From 2015-2020, industry-wide revenue as share of assets fell 0.45% to 0.23%, operating profit, 26%. To survive, asset managers need to boost either flows or fees. To thrive, they need to do both — all while cutting costs. And litigation is expensive.

Vanguard’s decision to retire from the Net-Zero Asset Manager Initiative isn’t without context. Equally, it’s unlikely to hinder sustainable investment progress in the US. As it is for corporate pledges, the risk or reward associated with corporate defections is primarily a PR thing. Changes are unlikely to manifest at a product level. In the meantime, it gets politicians off Vanguard’s back.

Corporate decoration to product necessity

Sustainable investing has been a salve for an industry facing long-term challenges that far outweigh those capturing headlines in 2022. End investors want and will pay for — even tolerate more risk for — innovative funds that cater to their values.

Unsurprisingly, everyone boarded the bandwagon. Regulation took a while to catch up, leaving exuberant product teams with plenty of room to reinterpret ‘innovative’ and ‘sustainable’. Now it has caught up and yet the rules remain unclear, catalysing a backtrack among asset managers.

In Europe, firms have downgraded Article 9 funds representing at least $100B since September, from a total pool of $470B. The green-standard category now accounts for 87% of reclassifications in the EU, and Jeffries anticipates “close to zero” fund launches in the new year. To date, Article 8 has absorbed the influx. Now, however, fund managers are “bracing for an ESG correction” in Article 8, after the European Securities and Markets Authority (ESMA) issued new proposals for funds labelled ‘ESG’ or ‘sustainable’. The latter will need to demonstrate that 80% of holdings are aligned to an ESG strategy and 40% of assets meet SFDR definitions of sustainable.

Article 8 funds account for $4T (and counting): far more than the drying pool of Article 9 capital. Yet, says Linklaters partner Martin Mager to Bloomberg, “asset managers can’t afford to downgrade from Article 8 if they want to keep ESG clients. “Managers realise they need it in order to do their marketing.””

The numbers bear him out. Global sustainable funds attracted $143B of net new money over the first nine months of 2022. The overall global fund universe, on the other hand, saw outflows of $335B.

Where do sustainable funds go from here?

Vapid marketing to premium products

As the window closes to deploy capital into Article 9 funds, those that remain are likely to become coveted products. But they won’t look like the vanilla ESG funds of yesteryear.

It’s over for the “rising tide strategy of the past decade of buying growth stocks,” warns the FT’s Alice Ross. “Next year, we should find out who is actually good at sustainable investing.” Characteristics shared by a winnowing number of Article 9 funds yields clues about what ‘good’ might look like: More VC-like, thematic objectives; Systematic and multi-asset strategies; Emerging market or international exposure, to meet reported asset owner demand.

For smaller players in particular, the backlash represents opportunity both ethical and financial. After years of success, the strategy favoured by larger index providers of being ‘all things to all people’ has hit a stumbling block. While they grapple with the scrutiny that comes with size, there’s a widening gap for specialist, innovative, and premium sustainable products that qualify for the increasingly exclusive — and elusive — Article 8/9 label.

Unrelenting demand is the reward for products innovative enough to meet it.

🐘 From boom to backlash, but not to bust. Last week, Florida CFO Jimmy Patronis announced plans to pull $2B from BlackRock and its “social-engineering projects.” (No word on the 11 other firms managing the state treasury portfolio, 10 of which are signatories of the UN Principles for Responsible Investment.) “I need partners within the financial services industry who are as committed to the bottom line as we are — and I don’t trust BlackRock’s ability to deliver,” said restaurateur Patronis of the company that reported revenues of $20B in 2021. BlackRock admitted to being “surprised, given the strong returns [it] has delivered to Florida.” But this is not about returns. Or facts. This is a culture war, and culture wars only care about feelings. Though $2B is a drop in BlackRock’s $8T (as are Florida state pensions relative to US private pensions), the rift between the GOP and “its longtime corporate allies” is likely to deepen — particularly if Florida governor and ESG shouter Ron DeSantis becomes Republican presidential candidate.

💰 Investors are unfazed. In a survey of 550 Terminal users, Bloomberg finds broad support for ESG. “For all the talk of a backlash, sustainable-investment funds have been much more resilient than other funds during this year’s downturn,” echoes The Economist, even despite recent underperformance due to sector exposure. Their popularity is attributed to a customer base focused on longer term trends over short-term returns, such as those offered by oil majors in 2022. “Social values give investors a non-pecuniary reason for allocating money and sticking with their choice, a rare advantage for funds in an industry where a competitive edge normally means lower fees.” Rare — and underexploited. In a new report, Morgan Stanley reveals a yawning gap between asset owner demands and asset manager delivery. Of the asset owners surveyed, 88% want ESG performance disclosures, 76% dedicated ESG resources, and 73% information about sustainability outcomes: needs that are met by just 39%, 41%, and 45% of asset managers, respectively.

🚩 The rules start coming and they don’t stop coming. (Here’s a helpful recap of a busy month for regulation.) The European Council signed off its long-awaited corporate sustainability reporting directive (CSRD), which aligns company reporting requirements to SFDR and the EU Taxonomy. Draft Sustainability Reporting Standards have also been approved. Under CSRD, companies must report on both their risks from and impact on a suite of social and environmental issues (i.e. double materiality) and to obtain third-party assurance or audits on those disclosures. New research published in the Stanford Social Innovation Review, however, pours cold water on sustainability assurances, described as a case study in “deception, obfuscation, and diversion” and “ultimately just a form of greenwashing.” They have become a healthy source of growth for the Big Four accounting firms, notes the FT. Soon required of all companies reporting in Europe and also, potentially, the US, assurances may become a healthy source of growth for law firms, too.

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How clean is the global green arms race?

Sparked by climate awareness and turbocharged by (fast-evolving) geopolitical necessity, the global green arms race is on.

In China, clean energy and electric vehicle (EV) sector growth is outpacing ambitious climate (and sales) targets. Booming renewables investment and expansion have erased energy shortages in India. The risk threatening to “fragment the West,” meanwhile, is neither Russia nor oil prices (on that, there is unanimity) but clean energy: In response to the US Inflation Reduction Act and its sprawling $400B in climate subsidies, the EU is seeking to change its state-aid rules and activate funding to compete for investment and industry.

The headline numbers represent a remarkable opportunity, regardless of your brand of capitalism. One consequence of the clean-energy transition entering full swing, however, is that its dirtier realities are hard to ignore — if easy to hide. Relative to other energy industries, the worst outcomes of clean energy are distributed unevenly across global supply chains. Even as European member states and environmental organisations mount legal challenges against the EU’s inclusion of (much-needed) nuclear in its green taxonomy, unchallenged solar and wind are exacerbating social and environmental taxes in less visible parts of the world.

It is no secret that mining and manufacturing present an ethical — albeit unavoidable — bump in the road to decarbonisation. “Expanding mining and building supply chains for the minerals needed for the net-zero objective” is one of the four urgent challenges identified by the IMF. Burgeoning demand for commodities is driving up prices, encouraging mining giants such as BHP to ditch fossil fuels for mission-critical metals. “Huge volumes of a diverse range of minerals are required to shift the world to renewable energy,” adds a new study. “Production of even a common material such as iron must double, copper nearly treble and lithium increase by a factor of five.” Yet: “Many of these are being sourced from the lands of vulnerable people.”

On top of mounting evidence of forced labour and slavery in solar panel and wind turbine production, the mining costs include decimated water, land, and human health in regions escaping traditional scrutiny. Negative outcomes could compound as mining scales. But there are reasons to be optimistic.

Unlike its predecessors, this industrial revolution is happening during an era in which governments, investors, and companies have both the motive and tools to drive an equitable transition. Supply chains are complex but not inscrutable, thanks to technological progress on everything from big data to satellite imagery to blockchain.

Meanwhile, the staying power of sustainable investing has surprised detractors and supporters alike. Take the collaboration unveiled at the the annual Principles for Responsible Investment (PRI) conference last week, where the human consequences of the low-carbon transition have garnered fresh attention. Established to galvanise “action on human rights and social issues,” the Advance initiative represents 220 institutional investors.

The impact of resource extraction may be of little interest to Florida’s Jimmy Patronis when not acting in his personal capacity as seafood restaurant owner and possible Deepwater Horizon oil spill plaintiff. But it matters to the asset managers and PRI signatories managing his state treasury funds. Even as the GOP rails against climate action, the finance industry is widening its scope.

🌡️ Post-mortem reflections on COP27 are in. Reasons to celebrate: The hard-won victory by small island states to set up a new fund for “loss and damage” resulting from climate change. Reasons for concern: Little progress — beyond that which had been decided at COP26 — towards keeping 1.5°C alive. The final decision text was conspicuously absent any agreement to phase out fossil fuels, without which it will be virtually impossible to halve carbon emissions by 2030. This year was marked by a shift in focus from mitigation to adaptation, underscored by an acknowledgement (if unspoken) that 1.5°C is “on life support.” On the one hand, as we wrote earlier this month: If 2°C or more is irreversible, the conversation has got to evolve from existential abstractions to high-stakes realism. Relative to lofty pledges, adaptation has been critically overlooked and underfunded. On the other: The controversial ‘phase out’ proposal was vetoed by a coalition of fossil fuel-producing countries led by Saudi Arabia, with one delegate reported to have said “we should not target sources of energy… [or] mention fossil fuels.” It makes any 1.5°C obituary feel less pragmatic and more, I don’t know, purchased? Hope for more ambitious progress rests on COP28 in Dubai, barring which, there’s always the option of distraction courtesy of FIFA.

🦣 Next up: Biodiversity in Montreal, where the UN Biodiversity Conference (COP 15) begins in December. Organisers hope to finalise the Post-2020 Global Biodiversity Framework, stylised as the ‘Paris moment for nature’. “Paris — or Copenhagen,” cautions Carlos Manuel Rodríguez, CEO of the Global Environmental Facility. The 2009 Copenhagen summit failed where the 2015 Paris summit succeeded, in part because the latter ignited an unexpected explosion of innovation and decarbonisation. Implicit in the ‘Paris moment for nature’ is an urgent hope that the private sector throws its weight behind biodiversity with the same gusto that drove climate to the top of the business, investment, and political agenda. Plenty hangs in the balance. In its latest flagship publication, The Living Planet Report 2022, WWF revealed global wildlife populations have plummeted 69% since 1970. Despite a 2010 pledge to halt a 2.5% annual decline in animal loss, extinction has marched on at the same pace in the intervening years. Fortunately, the biodiversity investment and disclosure landscape is growing — the TNFD recently released a third draft of its beta framework — but Will Goodhart of the CFA tells investors to learn from the mistakes of ESG: More focus on real outcomes; less trying to be “all things to all people.”

💸 Elsewhere, coordinated regulators continue to plug away. The FCA is developing a Code of Conduct for sustainability data and ratings providers, as Bloomberg reports that fund managers are finding alpha among the ‘artificially low’ scores of emerging market companies overlooked by traditional providers. ESMA, which launched a review of the data landscape earlier this year, is now seeking feedback on its draft guidelines for fund naming conventions. The rules will establish a quantitative threshold for funds claiming to be ‘ESG’, ‘sustainable’, etc. ESMA has proposed that qualifying funds demonstrate 80% holding adherence to sustainability criteria, which aligns with the threshold set out by the SEC. “The objective is to ensure that investors are protected against unsubstantiated or exaggerated sustainability claims,” says ESMA in its press release. In other news: The SEC has fined Goldman Sachs $4M for rebranding as ESG some non-ESG-looking funds, following an investigation it opened in June. Defection from the EU’s ‘greenest’ fund category continues unabated, with asset managers citing confusion about requirements. Amundi, Europe’s largest asset manager, announced plans to downgrade the majority of the €45B it holds in Article 9; DWS, five SDG-themed funds worth €2B; and HSBC, a smaller pool of seven funds.

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Big Tech’s Big Reckoning

For a long time, the sustainable investment mantra “doing well by doing good” owed much of its success to FAANG stocks: Meta-owned Facebook, Apple, Amazon, Netflix, Alphabet-owned Google, and now Microsoft (making it MAGMA? MAAMA? Spare a thought for the sub editors who launched 22,000 'bite' puns and are left now with only Apple.).

The clutch of low-emitting Big Tech firms were a “fast fix” for the environmental objectives of ESG investors, reports Bloomberg. They tilted heavily towards — and reaped the outsized returns of — a sector buoyed by low borrowing costs and high risk appetites. Then came aggressive volatility, inflation, and interest rates, which took the teeth out of FAANGs, the fire out of MAGMA.

In January, we predicted an industry downturn would prompt well-timed scrutiny of its hitherto celebrated ESG credentials, just as this year witnessed sustainable investors pivot on weapons and fossil fuels just in time to take advantage of higher returns, which lends credence to the argument that ‘doing good’ is ’doing well’.

To be fair, scrutiny is overdue. For two decades, tech companies — shielded by mysticism — have been managed, engaged, and regulated with relative laxity, prompting unheeded calls to tame the tech titans. The bear market shakeout put an end to that, dispelling blind faith in both Silicon Valley and the Silicon Valley-tilted market indexes onto which many a ‘sustainable’ sticker has been slapped.

Beyond schadenfreude, there are a couple of reasons to pay attention to Big Tech’s Big Reckoning. Just as it became the token sector of (and eventual proxy for) sustainable finance on the way up, their respective battles are symmetrical in a cyclical downturn. Or, as Protocol put it: ESG’s struggles are Big Tech’s problem; and Big Tech’s struggles are a sustainable investor’s problem. Both must fight fires from two angles, with one set of accusations justified (‘offshoring’ negative impact; poor governance; absent regulation; even antitrust — all reasonable), the other, less so (‘woke’ culture; free-speech/market censorship — clearly political). The former must be confronted, the latter, discredited, which is a tricky tension to navigate.

Babies and bathwater

For Big Tech as it is for BlackRock, the priority (and challenge) is to protect the concept while repairing trust in the execution. It is against ‘governance’ metrics, such as management, risk, and regulation, that the tech industry falls short. In terms of impact, however, the positives are frequently overlooked.

Take Microsoft. Through the direct sale of its products and services, the company turbocharges sustainable development. Computer hardware and software have transformed education globally. Digital adoption lowers barriers to Internet access, boosting literacy and academic performance in rural regions. The shift is one of both function and form. ‘Any time, any place, any pace’ information engenders democratic, collectivist, collaborative learning. Innovations have catalysed similar leaps in healthcare quality and access and food production and security, not to mention innovation, efficiency, and productivity.

Even against gender equality and global partnerships Big Tech, on the whole, scores well — perhaps surprisingly so, given negative perceptions about social media in particular. Nonetheless, aggregated academic consensus associates it with higher adoption of healthcare and contraceptive access among women, as well as equal rights and freedom of speech generally.

As sustainable investing evolves, the ‘good vs. bad’ binary against which companies were once evaluated looks less relevant. It grows harder to justify bundling E+S+G factors — particularly across both operations and externalities — into a cute score. Instead, argued the CFA’s Will Goodhart, exercise discernment and get comfortable with nuance: Though sustainable investing cannot be “all things to all people,” it can have real impact.

In short, the world is complicated. (The argument for conglomerates paying tax is not.)