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In the weeks and months that preceded the global Covid-19 lockdown, climate change and environmental, social and governance (ESG) factors were in the ascendant.
The Prudential Regulation Authority (PRA) had issued a statement (SS3/19) on “Enhancing banks’ and insurers’ approaches to managing financial risks from climate change”. From 15 October 2019 onwards, the PRA prescribed that regulated entities embed the assessment of financial risk arising from climate change into their governance arrangements and financial risk management.
Some years before, the Financial Stability Board initiated the Task Force on Climate-related Financial Disclosures (TCFD). Over time, TCFD secured well over 800 signatories amongst the world’s elite corporates and secured the official endorsement of governments of various leading economies.
The objective of creating a voluntary, climate-related set of financial disclosures to provide to investors, lenders and other stakeholders was being achieved, with a growing number of regulatory and prudential authorities pressing the case for mandatory disclosure regimes.
The Green Finance Strategy published in July 2019 stated that all listed companies and large asset owners should look to comply with TCFD by 2020. This was followed by the Financial Conduct Authority’s proposals (CP20/3) in March 2020, in which it proposed a new rule that would require all commercial companies with a premium listing either to make a climate-related disclosure consistent with TCFD, or if they chose not to, to explain why.
At the same time, leading bodies had started the process of aligning reporting frameworks with the TCFD recommendations. The Climate Disclosure Standards Board and the Sustainability Accounting Standards Board combined to reconcile reporting regimes around TCFD, with a view to recommending disclosures and illustrative example metrics.
During this period, ESG was establishing itself in the boardroom. Respected bodies such as the UN-backed Principles for Responsible Investment were making the case that an economically efficient, sustainable global financial system was a necessity for long-term value creation and that responsible investment consistent with those goals would provide long-term rewards.
And in early 2020, BlackRock was one of a number of asset managers to throw its weight behind the gathering importance of ESG in the context of investment criteria. This was a very clear signal to the corporate community as to the growing importance of ESG.
Finally, we witnessed palpably shifting consumer and societal demands – purchasing decisions being influenced by stated ESG credentials and landmark breakthroughs in courts by activist groups.
The Urgenda decision before the Dutch Supreme Court successfully invoked the European Convention of Human Rights to achieve state adherence to the Paris Agreement defined climate goals. And the Heathrow third runway decision saw the UK government checked in its plans for expansion of Heathrow Airport, after the Court of Appeal said the government’s decision to allow it was unlawful – although the UK’s Supreme Court has since granted the airport’s owners permission to appeal.
From almost every angle, boards were being driven to address ESG and climate risk factors. So where do ESG and climate-related disclosures sit in the aftermath of lockdown?
The answer seems to be more important than ever. Covid-19 has demonstrated that systemic risks to the established order of things are very real. Society and the financial community have witnessed first hand the need to build resilience into our systems and businesses. It is being argued that Covid-19 has also underscored the importance of ESG to corporate success.
According to research by HSBC, stock of companies with high ESG scores outperformed others by about 7 percent in the period between 10 December 2019 and 23 March 2020, including the first pandemic-stricken month of 24 February to 23 March 2020. Numerous commentators have linked ESG performance to a company’s resilience in this most difficult of periods.
Boards will be alert to these factors, and no doubt the overwhelming majority will address and adopt ESG in a way that enhances longer term shareholder value. But corporate history also tells us that the pressure to meet stakeholder expectations, particularly in an increasingly “comply or explain” environment, can lead to missteps or worse.
Against this background, it is perhaps unsurprising that in recent months there has been concern over the potential escalation of greenwashing. In January 2020, the European Commission instituted a consultation process (in the context of the development of sustainable finance) focussing on the consistency of companies’ ESG ratings, with specific reference to the potential for greenwashing.
In May this year, Jay Clayton, chairman of the US Securities and Exchange Commission (SEC), questioned the fitness for purpose of ESG ratings across a broad range of companies. The SEC has asked for feedback from asset managers in order to address concerns about the spread of greenwashing.
What is greenwashing? There are various definitions, and the concept has expanded since it was first conceived in the 1980s. But in short, greenwashing is the practice of making an unsubstantiated or misleading claim about the environmental status of a business or the environmental benefits of a product, service, technology or company practice.
Greenwashing is a function of the increasing awareness of the importance of ESG in a world where there is a perception that better sustainability and climate-integrated businesses can provide enhanced risk adjusted returns and improve the competitiveness of a business and its products or services.
There are numerous examples of greenwashing. Activists and environmental bodies such as Greenpeace track what they perceive to be the hypocrisy of financial institutions that proclaim green or climate-related objectives, whilst also supporting the hydrocarbon sector.
Asset managers have been condemned by luminaries such as Al Gore for voting against climate friendly resolutions relating to companies in which they hold investments, whilst professing that climate change poses a material risk to investment returns. Those asset managers have been described as “full of greenwash”.
In January 2020, the Italian Competition and Market Authority imposed the country’s first fine for greenwashing against Eni, a state-backed energy company. The fine of EUR5mn was brought for claiming its palm oil-based diesel was “green” when the production of palm oil drives deforestation.
And in 2015, the Environmental Protection Agency in the US issued a notice of violation of the Clean Air Act to Volkswagen, on the basis that the company had been found to programme its diesel engines to activate emission controls only during its laboratory emission testing to allow the nitrous oxide output to fall within permitted US guidelines.
There is a further chapter to the so-called “Dieselgate” scandal. In late May 2020, the first diesel claim was heard in the German Federal Court of Justice in Karlsruhe, leading to an order that Volkswagen pay more than EUR28,000 to the owner of a diesel minivan in a judgement that opened the gates to further claims and awards.
Finally, in December 2019, a complaint against energy giant BP was made under OECD guidelines concerning the misleading advertising about its focus on low carbon energy.
One of the most acute areas of legal exposure for any listed entity derives from its public disclosures, either in its annual reports or at the time of capital raising. And at a time of mounting consumer expectation (and protection), ESG misstatements will constitute a real legal and reputational vulnerability.
The Dieselgate scandal may be an extreme example – both of greenwashing and the financial impact it can lead to – but the examples above point to the very substantial exposures for the corporates that engage in it and for their boards and those who insure them.
Building a competitive business strategy around ESG is not straightforward. Nor is concurrent compliance with TCFD reporting in what is still very much an emerging discipline. The margin for innocent misstatement is wide.
The Covid-19 environment will be challenging on any number of levels. The case for ESG will have to be made alongside many other competing business priorities. The risk of “over-promising” will be material. And all of this will be happening when corporate behaviours are under scrutiny like they have never been before.
As businesses (particularly issuers and those in regulated sectors) move towards more consistent and accurate disclosures, the sustainability and ESG promises that they make will be monitored by increasingly sophisticated investors, and the self-same activist and pressure groups that were mounting successful legal campaigns before the Covid-19 lockdown hit.
Finally, this will play out in a world of increasingly accessible litigation funding and an ever more sophisticated claimant bar with access to collective consumer redress remedies and class actions.
The path to better sustainability and ESG in the way businesses are run is unequivocally in society’s immediate and longer-term interests. Those businesses that get it right will prosper and constitute better insured risks. But caution is needed to identify those that stray into greenwashing. The cost of association with those businesses could be very high.
Simon Konsta is a partner at law firm Clyde & Co.