Greenwashing, a bewildering array of sustainability performance metrics, uncorrelated ESG ratings, and delivering on Scope 3 emissions are among the many hurdles on the path towards a low-carbon future. Here, three experts discuss the myriad challenges facing corporates, and highlight the rethinking and compromise that may yet be necessary to address them effectively.
With concerns over greenwashing continuing to mount there are signs that regulators, especially in the US and Europe, are finally beginning to crack down on organisations that make misleading claims about their environmental credentials.
In the UK, for instance, the government is pushing through new legislation that has greenwashers very much in its sights. Under the proposals, expected to become law in the second half of 2024, large businesses face the threat of civil penalties of up to 10% of their global turnover for making false environmental claims.
The UK’s Competition and Markets Authority (CMA), which would be given new powers under the legislation, already has a laser focus on the fast-moving consumer goods (FMCG) sector. The CMA is concerned about the accuracy of green claims made about household essentials such as food, drink, and toiletries and wants to ensure shoppers are not being misled. As one of the largest goods sectors in the UK, worth over £100bn annually, the impact of any large-scale alleged greenwashing in FMCG products could be far reaching, impacting many other sectors.
The UK is not alone in taking a tougher stance against greenwashing. In March the European Commission (EC) published its proposed Green Claims Directive. It features stiff penalties for false green claims, including fines of up to 4% of turnover, a confiscation of breach-related profits and a 12-month ban from public procurement processes. The directive from the EC follows an EU study in 2020 finding that more than 50% of green claims examined were vague, misleading or unfounded, while 40% were completely unsubstantiated.
As for the US, 2022 was something of a watershed year for its crackdown on greenwashing. Not only did the Securities and Exchange Commission (SEC) unveil a landmark proposal for companies to disclose a wide variety of data on their climate-related risks – currently being finalised – but it also dished out its first penalties to financial institutions. The watchdog fined BNY Mellon and Goldman Sachs Group $1.5m and $4m respectively for ESG misstatements and policy and procedural failures within their investment management units.
Waking up to ESG realities
Kevin Cook, Co-Founder and CEO of fixed-term fund platform TreasurySpring, says greenwashing has become as much a perceived as an actual challenge over the last decade. He explains: “As awareness of ESG grew, the desire to do something accelerated. But since the first media articles about greenwashing began appearing a few years ago, and fines started being handed out, there has been growing circumspection over green instruments. It’s caused a lot of worry among corporates and their treasurers. Many have concluded there is more investment and reputational risk associated with ESG than they perhaps realised.”
That concern is clearly highlighted in a 2022 TreasurySpring global survey (in partnership with ICD and the London Stock Exchange) of corporate treasurers on sustainable finance. Asked what risks they see associated with sustainable forms of financing, greenwashing trumped all other issues among respondents. Nearly 70% pointed to it as their biggest concern. Other major worries include lack of regulation (53%), lack of standardisation (53%), and lack of product transparency (46%).
The fact that there are three responses with more than 50% (and a fourth with almost 50%) indicates, says Cook, that treasurers perceive there are still major hurdles to overcome regarding sustainable borrowing.
One of the biggest challenges for corporates is being able to present accurate metrics on ESG performance to investors and regulators. The TreasurySpring survey is highly revealing in this respect and reflects widespread uncertainty over the best methodologies to use to generate ESG metrics.
Asked how they measure the success of their ESG initiatives, 41% of respondents pointed to internal KPIs while 32% of respondents admitted they do not have processes in place to measure it. Only 19% cited the use of external ratings from providers such as MSCI and Standard & Poor’s (S&P). Cook says the relatively low use of external metrics reflects the uncertainty that has resulted from a huge variation in ESG ratings and methodologies across agencies.
Uncorrelated ratings
To starkly illustrate just how out of kilter these ratings are among themselves, Cook points to a 2021 study by the CFA Institute that analysed six ESG ratings providers for a cross section of more than 400 companies across 24 industries.
The CFA analysis reveals “obvious disconnects” between ESG ratings across the six providers (see fig.1 on next page). The study notes, for example, that MSCI, S&P, and Sustainalytics all boast comprehensive ESG ratings and should have a high correlation. Yet the analysis clearly shows that MSCI’s correlation with both S&P and Sustainalytics is below 50% while the S&P and Sustainalytics correlation is higher but still lower than expected.
FIG 1: ESG ratings correlation
Source: BDO USA, LLP
To provide a contextual indication of just how severe this lack of ESG ratings correlation is across providers, the CFA Institute looked at long-term debt ratings for the same 400 firms across the same 24 sectors. On this measure, S&P, Moody’s, and Fitch Ratings scores showed correlations between 94% and 96%.
All told, says the Institute, the results of its study are “conflicting and contradictory … different ratings methodologies tell vastly different stories about the same company. This demonstrates the immaturity of the current ESG ratings environment and highlights the need for improvements.”
Cook says the Institute’s findings show starkly that there is “a massive lack of certainty” around how ESG characteristics of a company should be measured. “Looking at those findings, you can readily understand why there is a lot of wariness among treasurers at present when it comes to actively engaging with ESG,” he says.
“At the same time though, while acknowledging it is imperative we move to low carbon quickly, we should remember it is still relatively early days for ESG. The whole space is evolving rapidly but we are almost certainly on a multi-decade journey with it.”
A difficult nut to crack
That the road to low carbon is going to be long and hard is clear from even a cursory look at the kind of emissions that need to be brought under control. Organisations are currently mainly focused on dealing with Scope 1 and Scope 2 emissions, as defined by the Greenhouse Gas (GHG) Protocol, the most widely used corporate accounting standards for assessing emissions. These two groups of emissions are largely under organisations’ control and amenable to relatively accurate tracking – most of them will have access to all the data they need, such as gas and electricity purchases.
Scope 3 emissions, the third and last group under the GHG Protocol, however, represents a far more formidable challenge. These emissions require organisations to address all other indirect emissions impacts from company activity, ranging from the goods it purchases, the suppliers it deals with, to the disposal of the products they sell.
With Scope 3 emissions falling outside a company’s direct management or ownership, gathering high-quality data about them represents an especially thorny challenge. Yet getting to grips with them is crucial: the UN for one estimates that for many businesses across most industries they account for more than 70% of global greenhouse emissions. Getting them under control therefore will be critical for achieving the global ambition of net zero by 2050.
Cook says gathering accurate data on Scope 3 is indeed proving to be a headache for corporates. “The feedback we are getting from some of those tasked with looking at Scope 3 within treasury teams is that it’s an extremely difficult nut to crack. A common concern is that many of the upstream and downstream parties, from which they need to obtain the emissions information for Scope 3 declarations, actually self-certify.
“So, the big worry here is the accuracy of the information being given to them by these parties. Corporates need to be much more confident that the information they are being provided [with], and therefore formally reporting to authorities, is true and accurate.”
More broadly, Cook is convinced that all parties will need to learn how to walk the ESG line before trying to run with it. He says: “It is becoming clear that the only way we will get success with ESG, most especially with regards to the ‘S’ element, is to go step by step and not try to do everything all at the same time. Scope 3 emissions control is an incredibly hard thing to action effectively and needs a lot of furniture in place to stand a chance of success.
“I think there needs to be a much greater focus on getting Scope 1 and 2 right, and learning lessons that will be useful for Scope 3. That’s not to say we forget about Scope 3 for now of course. We must continue working on it, develop essential infrastructure, tools and processes, figure out exactly what we need and how we are going to get it, some of which will no doubt be novel. We absolutely need to consider the increased pace needed to create significant change but also that any change should be achievable and lasting to be truly effective.”
Proliferating metrics
Like Cook, Julle Pedersen, Director, EMIA Treasury at automotive group Bridgestone also makes clear the enormous difficulties faced by corporates in delivering on Scope 3. He says: “Measuring indirect emissions that occur in the value chain brings major challenges for corporations. Tracking upstream and downstream performance attributable to the business partners is an extremely complex process, requiring a fully integrated and mature ecosystem where third-party data is accessible, transparent, and trustworthy.”
Pedersen says guidance from standards agencies – including the International Sustainability Standards Board (ISSB) – on how corporates can best deliver on Scope 3 is “absolutely necessary”. He adds: “Those who set the standards must ensure full convergence of approaches and harmonisation of principles to simplify the current reporting landscape.
“As it stands, this already comprises numerous voluntary sets of recommendations and statutory requirements such as those generated by the Global Reporting Initiative [GRI] and Task Force on Climate-Related Financial Disclosures [TCFD] and the upcoming SEC climate-related disclosures, to name just a few.”
On the greenwashing front specifically, Pedersen says that while it is a growing problem globally, increased awareness of it within a company can lead to more thorough discussions internally about sustainability policies and strategies and how best to communicate them to the outside world.
He says: “Greenwashing makes external communication even more challenging for corporates and here reporting standards and frameworks play a key role by providing direction and clarifying and standardising measurement, data and disclosures.
“Putting the ESG business direction and reporting frameworks together does have cost implications [in order] to comply, but on the other hand is essential in order to be able to identify corporate financial risk associated with sustainability so that a company can prioritise investment to achieve its sustainability objectives.”
Upping the game
Echoing Cook, Pedersen also believes that the general lack of standardisation and comparability of data across the ESG space, not least the ‘S’ element, is a major problem undermining progress. The bewildering array of ESG performance metrics is another cause for concern, with Pedersen pointing to the explosion in the number of ESG KPIs as a case in point.
He cites the example of the incoming European Sustainability Reporting Standards (ESRS). The new standards will effectively form the framework used by companies to report under the EU’s Corporate Sustainability Reporting Directive. The ESRS proposes 84 disclosure requirements that incorporate more than 1,000 data points and aims to capture “double materiality”, a relatively new concept developed by the EU to glean the impact of business activities on the environment as well as the financial impact of sustainability issues on companies.
“Having so many KPIs out there is making it difficult to determine which data points are really meaningful for organisations and their stakeholders,” says Pedersen, adding that a reliable double materiality assessment framework will be vital to make sure the right topics emerge front and centre for discussion as the new standards are rolled out.
Concern has been growing in recent years that banks, with their critical role in providing capital to industry and supporting corporate clients with their needs, are not doing enough to help companies action ESG initiatives, notably their transition to low carbon. However, Pedersen says that, especially on the sustainability front, it’s not just banks and the financial services industry generally that need to show greater commitment and action.
“Everybody needs to up their game – businesses, regulators and that includes the financial community too. So it seems we’re all in it together. Having said that, practical application of some of the new ESG legal requirements, for example taxonomies, leads to certain challenges for banks that we believe can be more easily dealt with in partnership with their clients.
“As a result, we are expecting more and more banks to have specific ESG/capital markets advisory divisions to guide companies on their ESG agendas. In addition, corporates also need to bring their bankers closer to them than before to identify the opportunities for funding and reflect investor reaction on possible game-changing investments.”
It is questionable which other parts of the economy can credibly claim their investments make a huge difference to global emissions before the core of the problem has been addressed.
As if greenwashing isn’t enough…
Even as concerns over greenwashing, delivering on Scope emissions, and measuring ESG performance accurately grow, however, new types of hurdles are being identified. Greenwashing undoubtedly has the potential to greatly undermine the credibility of low-carbon investing, but other types of ‘washing’ are being added to the lexicon of those looking to hold corporates and financial institutions accountable for their claimed green credentials.
Dierk Brandenburg, Head of ESG and Credit Research at Berlin-based Scope Ratings, says that “impact washing”, where companies raising green bonds to refinance existing assets without any incremental impact on climate risk, are proving equally damaging. “Competence washing”, when fund managers or bond issuers overstate or falsely claim an investment’s positive impact on the environment or society, adds yet another dimension to ESG washing.
Brandenburg says: “Science-based targets are hard to define and monitor by finance professionals who mostly lack a suitable background. Above all, this means companies need to be very careful not to overstate their green credentials. Admittedly, that often goes against the instincts of corporate PR in a context where investors are putting increasing emphasis on the environment, social impacts and governance.”
More broadly, Brandenburg observes that there are actually only a few industries that account for the bulk of global emissions – energy, transport, and agriculture – where emission reduction really matters, at least at the current stage of the journey to low carbon. “It is questionable which other parts of the economy can credibly claim their investments make a huge difference to global emissions before the core of the problem has been addressed,” he says.
Let’s be realistic
While many of the weaknesses in ESG reporting can be attributed to lack of standards, Brandenburg says it is worth noting that the standard setters themselves are caught in the middle of a debate about what is desirable and what can realistically be implemented at a global level.
He says: “The debate about Scope 3 emissions is a good example here, pitching the interests of investors and activists against how much information companies can reliably produce at a reasonable cost. The same applies to green bond standards that need to make a trade-off between the virtues of a large and liquid market against purist standards that drive away issuers.
“It is therefore important for both sides to become more realistic about how much transparency can be credibly achieved, always bearing in mind that, eventually, better pricing of carbon dioxide emissions can achieve transparency much better than cumbersome reporting, while all bonds from an issuer will trade off the same credit curve.”
In Brandenburg’s view, precise data is not the only solution to curb greenwashing and restore credibility. Top-down modelling of supply chains and Scope 3 emissions and stress testing of business models according to agreed climate scenarios, such as those proposed by the Network for Greening the Financial System (NGFS), can help overcome the credibility issues. The NGFS is a network of more than 100 central banks and financial supervisors committed to taking due account of the climate risk to global financial stability.
He concludes: “While such techniques are less precise than the thorough but rather cumbersome bottom-up accounting of CO² emissions and other ESG factors, they do provide investors with the big picture. They also help quantify the impacts on the environment and society of corporate activity and the ESG-related risks facing the companies themselves.”
