The biggest difference between now and five years ago is that ESG is no longer a niche area but an integral part of how key players think about not only financial markets but also the real-world economy, both of which need to undergo a wholesale transformation to meet ambitious net-zero targets.
While much has already been done, and most key players are, for the first time in history, sitting at the same table with the same targets, the prevailing mood among market participants is that this is only the beginning.
2022, then, marks the next stage of the beginning, a shift from ambitious thinking, to ambitious action.
Action falls broadly speaking into “two currents”: what markets are doing and what regulators are doing, according to Roland Mees, director of sustainable finance at ING. How firms and authorities implement ambitious transition plans as well as mitigate the risk that goes hand-in-hand with ambition will be a theme for the coming years.
This article attempts to provide a clear, albeit introductory, view of the fast-developing, multifaceted and risky terrain that is ESG in 2022.
1) ESG data to become more democratised
Increasing the availability of comparable and meaningful ESG information, or ‘democratising ESG data’, is essential to assess whether companies’ sustainability strategies and initiatives are effective.
“This coming year will see more freely accessible resources: the Transition Pathway Initiative’s new Global Climate Transition Centre, for example, set to open in 2022, will expand the number of companies assessed from 400 to 10,000, a 25-fold increase,” said Dr Arthur Krebbers, head of sustainable finance, corporates at NatWest Markets.
Krebbers also said the EU’s revised Non-Financial Reporting Directive (NFRD) will help fill the data gap. The NFRD has been expanded to nearly 50,000 companies via the Corporate Sustainability Reporting Directive (CSRD) in April, with the first set of standards to be adopted by October 2022.
See also: IFRS' new international sustainability disclosure standards broadly welcomed
While markets generally welcome transparency initiatives such as the EU’s Sustainable Finance Disclosure Regulation (SFDR), many lament the lack of data needed to fully comply with the regulation. “The process of reporting for SFDR will gradually improve as the data improves,” said Hans Biemans, head of sustainable markets at ING. “The exact buckets of exposures we need to report are frequently based on data that is not yet available.”
Luca de Lorenzo, head of sustainability at NIB, said he would be watching how the various disclosures and reporting regimes spur activity in the ESG data market and ultimately plug gaps. “All the big players, be they credit rating agencies, or ESG providers, are ramping up fast to provide services and increase coverage,” he added.
The market is moving beyond ambitious pledges by hiring more and more ESG specialists, and spending more money on ESG tools and data as part of their implementation strategies, according to Jacob Michaelsen, head of sustainable finance advisory at Nordea Markets.
2) Disclosures across the world
Transparency will increase in sustainability markets, despite the data shortfall, as banks and corporates navigate the complex, evolving landscape for disclosure requirements. 2022 will see the finalisation of the EU standards under the CSRD, the implementation of disclosures under the EU Taxonomy Regulation and SFDR, and the development of the UK’s Sustainability Disclosure Requirements (SDR).
“It is key to maximise the consistency of requirements across jurisdictions,” said Oliver Moullin, managing director of sustainable finance at Association for Financial Markets in Europe (AFME). He added that all eyes would be on “the development of international disclosure standards through the newly established International Sustainability Standards Board”.
See also: FCA draws from EU experience with simplified sustainability disclosure requirements
Markets are also watching carefully how disclosures evolve in the US, especially the US Securities and Exchange Commission’s (SEC) proposed mandatory climate disclosure rules, which could help set a global standard in non-financial reporting, if they are closely aligned with the recommendations of the Taskforce for Climate-related Financial Disclosure (TCFD).
Driven by Commissioner Allison Herren Lee, the SEC’s mandatory climate disclosures seek to provide decision useful information to investor as they look to make investment and voting decisions. The exact characterisation of how these disclosures will look and feel has not yet been made clear.
See also: PRIMER: the EU Corporate Sustainability Reporting Directive
“It would be helpful to have a single global standard for non-financial reporting, or as close to a single global standard as can be achieve,” said Rudolf Bless, chief accounting officer at the Bank of America. “This would make it easier for investors and other stakeholders to evaluate the progress companies are making toward established goals.”
As for other jurisdictions, Japan’s Financial Services Agency (FSA) is considering making climate risk disclosure mandatory for listed companies on the Prime segment of the Tokyo Stock Exchange in April 2022, as well as widening their scope to include all listed companies in 2023.
3) Science-based transition plans
Leading on from the data theme, markets expect firms to deliver clearer transition plans together with the introduction of clearer regulatory guidelines as to what those transition plans should include.
Firms should expect rigorous scrutiny of transition plans by regulators, the media and NGOs.
“Those plans need to be science based,” said Karen Ellis, director of sustainable economy at WWF. “For example, we need to make sure the TCFD recommendations are aligned with the standards set by the science-based targets initiative, to ensure it delivers the pace and scale of the transition required to achieve our net zero goals."
According to the UK Government’s commitment to creating the first net zero aligned financial centre, financial institutions and publicly listed firms will need to produce net zero transition plans by 2023, and clear regulatory guidelines will be developed as to what those transition plans should include.
“Firms need to publish their transition plans, so they can be monitored against them,” Ellis added. “They should also incorporate scope 3 emissions and interim targets, ideally focusing on 2025, to avoid the temptation of kicking the can down the road. They should involve the board in decision-making around them, so they’re not just an add-on but central to the company’s DNA. They should also focus on reducing emissions with a minimal reliance on offsetting.”
See also: COP26 finance pledges are insufficient for real change
Scope 3 emissions are the result of activities from assets not owned or controlled by the reporting organization, but that the organisation indirectly impacts in its value chain. Although difficult to calculate, Scope 3 emissions often make up the bulk of a firm’s overall emissions and are therefore widely seen as critical to include in transition plans.
"Transition plans have come to the fore for financial institutions following the commitments at COP26 and an increased focus amongst regulators and investors," said AFME's Moullin. "These will be an important area as firms flesh out their plans and progress in meeting climate change objectives."
4) Prioritising holistic decarbonisation
Companies will see further pressure to reduce Scope 1, 2 and 3 greenhouse gas emissions in line with the science-based target.
“Seeking to reduce Scope 3 emissions, the ability to engage with supply chains in emerging markets is likely to present challenges,” said Krebbers. “Therefore, companies will most likely rely on partnerships across sectors to deliver on broader decarbonisation targets.”
5) Green and social taxonomies will move to the fore
As markets acknowledge the extensive progress made with the EU taxonomy, other jurisdictions, such as the UK, are also in the midst of developing their own taxonomies, all aiming to increase firms’ reporting obligations and enable ESG criteria to be further embedded in global financing activities.
Taxonomies are essential for standardising definitions of green and reducing greenwashing risk caused by divergent standards in sustainability markets. Once an investment is taxonomy aligned, its green credentials are supposed to be watertight.
See also: Mixed feelings as Taxonomy set to pass divided European Council
“What we want to see is how the EU taxonomy is adopted by member countries, how it is implemented by firms, and how it is received by investors, and specifically impact investors,” said de Lorenzo. “Will they use it in their entirety or only elements? So far it is not entirely clear.”
From 2022, the EU Taxonomy will oblige companies to report on their alignment with climate change mitigation and adaptation objectives.
“The EU has signalled a potential expansion to include social factors, with further details expected in 2022,” said Krebbers. “As a result, stakeholder pressure to account for social aspects will increase.”
Meanwhile, the controversial debate surrounding the potential inclusion of nuclear and gas in the EU taxonomy rages on, an area of great concern for NGOs such as WWF and other market observers that would prefer “purer” definitions of green. Nuclear has serious issues with the “do no significant harm” of the taxonomy while gas is still a fossil fuel, albeit of a lighter shade of brown.
“If the Commission goes through with its plan, there is a severe risk that market participants will simply reject a taxonomy that allows for nuclear energy to be labelled as sustainable,” said MEP Markus Ferber. “If the Commission takes its own aspiration to make the taxonomy the gold standard for sustainable investment seriously, it should revise the delegated act.”
6) Scrutiny of greenwashing will intensify
Scrutiny of greenwashing has increased in recent times, not least because of a series of high-profile whistle-blowers.
“I predict investors and other stakeholders will analyse corporate disclosures in greater depth and breadth - sharpening the focus on companies’ projects and expenditures to ensure they can evidence the real-world impact of their claims,” said NatWest’s Krebbers.
Nordea’s Michaelsen stressed that more and more companies and investors are looking at science based standards as a way of combating greenwashing risk. “We see that more and more investors are performing a climate analysis of their portfolios, to align with the Paris Agreement and a 1.5C/Below 2C scenario," he said. Many of these have realised that their current portfolios are implicitly supporting a future well-above 2C. There is a lot of discussion at the moment around ‘climate neutrality’ and ‘net zero’. But we have some way to go before we all are on the same page.”
Regulators, the media and activists will intensify their scrutiny by sifting through the ESG data and disclosures that are released publically.
“With on-going issues with ESG standards, corporates and financials will continue to come into conflict over the quality of their disclosures and whether the rhetoric meets their commitments on ESG,” said Navin Rauniar, partner at TCS. “This is a sensitive issue for the board to consider and I expect regulatory and compliance teams to be further beefed up to cope with the possible fallout, in similar ways to the issues that DWS faced in 2021.”
All this means that chief sustainability officers will have their work cut out in 2022. Rauniar expects them to be placed in the difficult position of balancing the demands from cost centres and profit centres.
7) Private ESG funding markets to take off
While sustainable finance first emerged within public funding markets – the first ESG labelled instruments were bonds issued by multinational organisations – private ESG markets are catching up: ESG-labelled private debt transactions totalled around €2 billion in 2021 (Bloomberg data) due to improved ESG disclosures and data enabling investors to evaluate the sustainability characteristics of private assets
“The availability of a sustainability-linked structure for a sustainable private placement, and US-domiciled investors – which are among the largest investors in PPs – are under increasing pressure to incorporate sustainability into their mandates and will continue to drive execution dynamics in the private markets in 2022,” said Krebbers.
8) Carbon markets transparency will improve
With about one fifth of the world’s largest companies now having set out a net-zero or carbon-neutral pledge, Krebbers notes how attention has turned to the way firms are using voluntary carbon markets to achieve these goals.
“Companies will need to be more transparent in the use case of carbon credits, either to offset residual emissions, compensate for emissions in the value chain [Scope 3] or pursue “negative emissions”,” he said. “I expect the transparency of carbon offset projects to improve in the near to medium term, as companies will want to understand what the return on each credit looks like, particularly as they seek to avoid accusations of greenwashing.”
See also: COP26: gaps in emissions reporting could dampen effects of Sunak's net zero target
This will, he added, help carbon to be accurately priced on a company’s or lender’s balance sheet, and in turn, help develop the liquidity of carbon as an asset class.
