Green portfolio? Great! But does that truly mean a green planet?

ESG is rife with tension and even financial services companies at the vanguard of the ESG movement are simply not doing enough. It is now time to open up about the potentially massive trade-offs between a green portfolio and a green planet, said legal duo Eva Schram and Thom Wetzer during a lively conversation we had ahead of the Sustainable Finance and Climate Risk Event.

Eva Schram is a lawyer at the Financial Markets department of De Brauw Blackstone Westbroek where she specialises in the regulation of Dutch and EU financial markets and complex processes including ESG regulations. Thom Wetzer is Associate Professor of Law and Finance at the University of Oxford, where he also directs the Oxford Sustainable Law Programme. The Oxford Sustainable Law Programme is a research think-tank at the interface between law, finance, and sustainability but it also brings some unlikely experts to the table, including physicists and geo-scientists. He also acts as a consultant for De Brauw.

Is the financial services industry doing enough on sustainability?

Thom Wetzer: There’s substantial progress, and yet we are still lulling ourselves into a false sense of security. Even the parties which see themselves as being the vanguard of this trend are not, on average, doing nearly enough. Climate plans fall short of climate commitments, and even the commitments are in many cases insufficient. What’s more, these plans tend to cover only a small piece of an increasingly complicated puzzle. In short, a green portfolio does not necessarily equal a green planet. If we are genuinely interested in achieving positive impact on the ground, we must become more thoughtful.

Eva Schram: It is exactly that last point that deserves more attention. Making choices on ESG may imply fundamental trade-offs. Between value and values for example, but also between the “E” and the “S” and the “G”. What may be good from the perspective of reducing carbon emissions may have an undesirable social effect in a certain geography. I am not saying that knowing and understanding these trade-offs in a certain context will lead to a different decision, but to make a balanced decision you must understand what the trade-offs of that decision are. There can be huge trade-offs between a green planet, and a green portfolio.

What do you mean by There can be huge trade-offs between a green planet, and a green portfolio?

Eva Schram: A good example is the choices that institutional investors must make between an exclusion strategy or an engagement strategy. These issues are not black and white. On the one hand, getting rid of certain investments such as fossil fuel may green a specific portfolio but in turn pave the way for investors with a short-term horizon. On the other, investing in an engagement strategy and assisting in making the energy transition may only work if you can use exclusion as leverage.

But surely we can’t expect financial institutions to solve the world’s problems?

Thom Wetzer: Financial institutions certainly have a lot on their plate, and navigating these various responsibilities is complicated. However, financial institutions have voluntarily committed to act on climate change, and such commitments should count for something. A few years ago, ‘acting on climate change’ was a relatively modest exercise. Showing awareness and ticking a few boxes quickly made an organisation a front-runner. We are not living in that world anymore.

What ESG investor world are we then living in today?

Thom Wetzer: We have moved beyond acknowledging the problem. What matters now is the impact of your actions. Given the highly disruptive nature of climate change to our economic and legal systems, merely following the rules is frequently insufficient to maintain a social license to operate. Self-declared impact investors in the ESG space, for example, must start thinking beyond the still-developing rules and reflect critically and thoughtfully on the impact of their investment decisions, and be ready to share that reasoning with the people on whose behalf you are investing.

The idea that you are improving the climate because you only invest in low-emission technologies, or in low-emission regions, and can therefore claim to have a ‘green’ portfolio, may be in line with the rules as they currently stand, but it is analytically incomplete. A side effect of such a strategy may be, for example, that regions in the global south with high emissions will never get access to the finance they need to green their economies.

But aren’t the ESG regulations are designed to make the world a better place?

Eva Schram: There are currently a host of regulations currently being imposed on financial institutions and corporations. The number of regulations will only increase over time. They are now all seeking tools to implement these. We see that dealing with ESG is more and more embedded in the entire governance, including all processes of a financial institutions, and that that ESG integration is becoming more sophisticated over time. To make balanced decisions, merely looking at data doesn’t always do the trick.

You sometimes must look beyond the data and the ESG labels to really make sure you know what you are investing in. And to understand what the side effects of certain rules and regulations are, as Thom just alluded to. That’s a big ask for financial institutions, in particular the smaller ones who may want to do good but are forced, through lack of resources, to opt for simple exclusion strategies instead of tailored due diligence. The legal question, of course, is how far the responsibilities of financial institutions reach, to what extent may they rely on internal data, and what can they do to mitigate any potential risks in this respect?

Regulations and disclosures

Another dilemma which is important to note, is the side effects of certain regulations on disclosures. There is an increasingly strong focus on climate data, for example to run climate risk models, and on data required to evaluate ‘ESG impacts’. However, such data is not uniformly available. In certain geographies it is very difficult to provide the detailed and sophisticated data certain impact or (climate) risk disclosures require. Lacking such data, and therefore not being able to meet disclosure requirements, makes it much more difficult for institutions to invest in these countries. But if the objective of the investment portfolio is to have a positive ESG impact in a broad sense, simply ignoring these countries is problematic.

In the context of climate change, for example, we cannot transition to a clean energy system if we do not do so on a global scale. Equally, emission reduction strategies are unlikely to succeed if our investments do not support the most vulnerable countries in their transition planning. We are very happy that Ayaan Adam, CEO at Africa Finance Corporation, and José de Bruin, senior investment risk manager at PGGM, are joining us on the panel at the Sustainable Finance and Climate Risk Event to discuss these unintended consequences and the challenges that financial institutions are facing in this respect.

Thom Wetzer: Fully agreed. We kid ourselves when we think that that as long as we do something on climate action somewhere, that we are helping people to overcome this problem everywhere. There are many examples where good intentions and seemingly prudent strategies may inadvertently backfire. Eva mentioned disclosure requirements and data limitations, and another example is optimising a portfolio to minimise climate risk exposure. After all, climate risk is often particularly high where data quality is poor. If we focus on limiting climate risk exposure in a portfolio, the most climate-vulnerable parts of the world risk being shunned by the financial markets. Sadly, this is already a reality. But these are the countries that need more capital, not less. So, the inequality grows because of well-intentioned behaviour designed to manage climate risk in one’s portfolio.

What specific capabilities do companies need to have to be able to deal with this increasingly complex situation?

Eva: From a legal perspective it is important that the investment decisions which are made fit the ESG strategy, comply with the commitments that follow from the law or are signed up to voluntarily, and are aligned with reporting and disclosures. Having solid governance in place can be a control measure in this respect. A holistic view on ESG across the organisation is key: from CEO to procurement, risk management, accounting, and communications.

The same is true for us in our role as legal advisors. Navigating a world in transition requires us to be thoughtful, and to be informed about more than just the letter of the law. Knowing what our clients’ obligations are is not enough to chart the right course: effective advisors should not only understand the various obligations the sector faces but also the broader societal context in which these obligations arise, the objective that they are intended to achieve, and the dilemma’s that they create.

Isn’t there at times tension between the E, the S, and the G?

Thom Wetzer: ESG is rife with tension. We can pretend that there is no S (Social) component to shutting down a coal-fired power plant, but we must be awake to the fact that a whole community might lose its economic anchor. Equally, mining lithium in the Chilean desert using energy from coal-fired powerplants and polluting the local environment may be necessary for the lithium batteries in electric cars, but this may still have substantial adverse impacts on the environment.

Trade-offs like these are enormously complex and they are everywhere – that is a fact of life. The way to deal with such trade-offs is by acknowledging them and by being open about the real impacts of, say, an investment. Outsourcing those judgments to regulators by ticking boxes or, worse, completely ignoring them, is dishonest. The salient point is this: if you, as a financial institution, promise to care about a green planet, you must follow through. A say-do gap between promises and actions rightfully alerts regulators and even potential litigants. It’s a red flag.

Aren’t you being rather hard on the financial services sector?

Thom Wetzer: We are living through a massive societal transformation and it’s ok that we haven’t figured it all out yet. The perfect cannot be the enemy of the good. What is important is that we as a sector are open about our collective learning process and recognise that there is still much to do. It’s a volatile legal, economic, and societal environment and at the vanguard of climate action there are no clear answers. Such uncertainty, which includes legal uncertainty, may understandably be daunting. But merely ticking boxes and sticking to the letter of still-evolving legal frameworks only provides a false sense of security.

Instead, make sure your organisation has the capacity to genuinely and honestly reflect on the alignment of your words and actions. Don’t sidestep trade-offs by pretending they don’t exist. Adhere to your commitments. If you promise to have a positive impact, think beyond your portfolio. We have much to learn, and we won’t learn if we pretend we’re already at our destination.