MFC108 Why Climate is more than just the E in ESG Blog Image V1

Climate is Beyond ESG

April 20, 2022

A summarized version of this blog can be found here.

Environmental, Social and Governance (ESG) and climate considerations are regularly conflated, but there are important distinctions and connections between the two. In this blog we take a step back and lay out the differences between ESG and climate, and their connections with the Task Force on Climate-related Financial Disclosures (TCFD). Overall, we believe ESG Reporting should start with Climate-related Considerations (aligned with TCFD). Think of this as a short cheat sheet for you to use as a refresher or first time discovery of these concepts.

Defining ESG & Climate

ESG spotlights three specific sets of historically non-financial considerations that fall outside of what is traditionally considered when valuing an investment. While ESG-related risks have increasingly become material to company performance, which has ramifications for credit risk and investment performance, it means very different things to different organizations and investors. This means that as ESG issues become more relevant, stakeholders such as asset managers increasingly subscribe to multiple databases but have no easy button to screen for ESG.

ESG issues, which can be a catchall for non-financial priorities of the moment, exhibit in a variety of ways, such as a business’s ability to obtain permits to operate and their ability to gain and retain employees and customers, among others. Importantly, ESG issues tend to be intertwined. For example, oil and gas pipeline development in North America often faces opposition from environmental and Indigenous groups, with the former opposing these developments for environmental reasons and the latter opposing them for a combination of social, environmental and economic reasons. Reaction to these protests can include regulation, litigation, and the review of permits, which fall across environmental and social considerations.

Today, investors and other stakeholders are increasingly focused on ESG’s first pillar, the ‘E’, a firm’s impact on the environment.

Our perspective: In a world and business landscape shaped by climate disruption, ESG is best used alongside, or as an add-on to other business planning and investment strategies, including climate focused investment strategies. In other words: start with climate action, a foundational challenge with both risk and opportunity surfacing potential, to strengthen ESG outcomes.

Be Climate-focused. Climate change will impact most ESG issues 

Our Perspective: We are climate-focused because climate change is the most significant systemic risk we face today on all levels, including our economic viability. Climate risks cut across all sectors and life itself. But these risks can be turned into opportunities as we harness the solutions required to achieve a climate transformation

It is useful to think of climate change as the force that will reshape the environment and with it societies, economies and nearly every possible ESG issue across jurisdictions. In fact, the most fundamental driver of environmental change is climate change. So, it would be a mistake to think of climate change as simply a subset of environmental issues covered under the ‘E’ in the ESG umbrella. The unique test that is climate change presents a broader challenge to companies, governments, society and investors, which is not fully captured by treating it as a subset of ‘E’. The impacts of climate change, and the response to this challenge by policymakers, regulators, investors and others, known as the low carbon transition, are global, albeit different across regions. If the ESG umbrella is used to protect investors from potential negative impacts, some ESG issues are a drizzle, climate is a hurricane. In other words, climate is the root issue and the only way to fully identify and manage risks, while improving operations for the long-term. Physical climate impacts drive our most likely and most consequential risks overall (World Economic Forum’s 2020 Outlook). The best available science warns this will worsen.

It is useful to think of ESG and climate as lenses through which to analyze organizations. This is both due to the scale of the climate challenge and the response to this challenge, as well as the broad nature of ESG. Using a climate lens enables a deeper analysis of a very important topic.

Figure 1: Climate will impact all ESG issues

The Relationship between ESG and Climate

ESG and climate issues have increasingly been on the radar of investors and policymakers. 

Same Same…

Financial institutions are facing increased demand for products that do not exacerbate certain ESG-related concerns, or that deliver an impact. To meet this demand, a variety of ESG-related financial products have emerged, including loans and bonds, funds, and exchange-traded funds (ETFs), among others.

To support the integration of ESG and climate considerations into lending and investment decisions and to support the development of impact-focused financial products, financial institutions have turned to ESG and climate analysis, calling on organizations to disclose ESG and climate-related issues. Specific climate-related metrics are critical to effectively respond to the most significant challenge and seize potential opportunities.

Our perspective: Nearly 7 trillion dollars per annum is needed in clean energy infrastructure to meet the Paris Agreement decarbonization goals. Furthermore, climate action is expected to generate 26 trillion dollars in direct economic gain by 2030, while 130 countries have made or are considering net-zero commitments and will have to make significant investments in decarbonization. All this results in many climate-related financial opportunities for firms to explore. Manifest Climate can help guide businesses through these opportunities, making the most out of them for organizations and their stakeholders.

… But Different

Scale 

Although both ESG and climate disclosures are increasingly in demand by investors and regulators, the scale of the demand for climate disclosures, especially those in line with the TCFD recommendations exceeds the demand for ESG information. This is due to a simple reason: climate change and the risks it poses are better understood than certain ESG issues, as are methods to quantify key metrics and targets.

This is not a zero sum game, and although we do have some regulatory demand for disclosure of ESG issues (e.g. disclosing the gender pay gap in the United Kingdom), financial regulators worldwide are beginning to demand climate-related disclosures aligned to the to recommendations of the Task Force on Climate-related Financial Disclosures (TCFD). The G20 endorsed the use of this disclosure framework in the summer of 2021 and at the time of this writing had not yet endorsed a sustainability/ESG reporting framework. 

Structure

The G20 has not yet endorsed a sustainability/ESG reporting framework because there is no widely accepted framework for broad ESG  reporting. In contrast, the TCFD recommendations, which were published in 2017, have been embraced by the world’s largest asset managers, regulators, and companies disclosing climate-related information. 

Our perspective: The viability and resilience of business operations is tied to effective and consistent climate action. Since climate risk is a permanent and evolving macro risk, it cannot be effectively addressed as a subcategory. Your traditional risk management toolkit is now incomplete without a comprehensive climate lens. Manifest Climate can help companies build physical and transitional resilience in a climate shaped business environment.

Policy and Regulation

Our perspective: It is pragmatic to disentangle environmental concerns from ESG mandates. Markets are already recognizing the need to treat environmental concerns as a standalone (for instance, we are seeing the proliferation of financial instruments and products such as green and climate bonds). Treating climate concerns as an independent concern would help investors distinguish companies and their exposure (e.g. low social and governance scores means combined ESG mandates can put Amazon and Netflix in the same excluded category as Exxon for many ESG exchange-traded funds).

While some ESG issues have been on policymakers’ radar recently, this is not the case of all ESG issues (e.g. executive compensation). In contrast, due to the cross-cutting nature of climate change, climate issues have in some way or other made their way into policy discussions in most countries, across different governmental offices from Ministries of the Environment to Ministries of Finance. The scale of policy and regulatory scrutiny is greater on climate issues than it is on ESG issues as a whole, with many of the world’s largest economies committing to reaching net-zero emissions by mid-century. 

In recognition of the importance of climate change and the low carbon transition, some jurisdictions, including the United Kingdom and New Zealand now require climate-related financial disclosures aligned with the TCFD recommendations. Other jurisdictions are considering next steps along that same path, including Canada and the United States, with regulatory requirements expected shortly.

How should we think about “ESG Scores” & Climate Change?

A company with a good ESG score may not have a solid climate strategy, and vice versa. ESG scores are typically assessed relative to other companies in the same sector but not usually against objective benchmarks. With climate, although comparison to peers is important, the soundness of a climate strategy is better assessed against scientific truths and macro climate and market trends. As a result, a company may have a (relatively) good ESG score when being assessed against peers on broader ESG issues and have significant and unaddressed climate-related risks. Also, a company could have a market-leading climate strategy and still have “lower” ESG scores due to performance on less material issues to their business that are more wildly managed by their sector. This situation can result in inflated ESG scores as a result of  “managing to achieve a score” rather than assessing material risk to a business. By focusing on material climate-related risk and opportunities organizations can set foundational strategies that support strong climate performance and in turn ESG performance over time.

Our perspective: TCFD-alignment prepares your business to achieve your ESG priorities. Broader ESG considerations (irrespective of the drivers or focus) can complement TCFD, but your ESG focus may be incomplete without the foresight of TCFD, combined with Manifest’s real-time support through software and climate experts, as well as our proprietary benchmarking capabilities.

The Bottom Line

A solid ESG strategy must include a climate strategy as the climate is consistently a material risk factor for companies and their financial performance. Climate change and the ways governments, companies, and investors plan to respond to it present significant risks and opportunities. The TCFD recommendations are a widely accepted framework that is increasingly in demand by investors and regulators. When it comes to climate change, the only constant is change and there are great benefits to meaningfully addressing both the way your organization impacts the climate and how climate change and countries’ responses to climate will impact your organization.

Manifest Climate’s role

At Manifest Climate, we support alignment with the TCFD recommendations. In fact, we have structured a large part of our offerings around the framework. Climate action is an economic, social and environmental imperative. It begins with an understanding of your organization’s climate maturity. We can help. We’ll work with you to turn climate disclosures into actionable steps.

Our tools and support are real-time, up-to-date and built to function against evolving climate risks. We are a long-term partner because climate risk is an evolving long-term business risk. Our approach is necessary and advantageous because climate risks must be disentangled from catchall considerations. This includes ESG’s general focus on the environment, alongside other social and governance measures. When you start with climate, you inevitably generate positive social benefits and support a strong ESG story. Contact us today.