Greenflation exposes ‘extra-financial’ myth

ESG puts disclosures before impact; more drama for DWS's greenwashing debacle; banks react to climate change. Plus, what does the energy crisis reveal about traditional approaches to risk?

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📰 How SDG-aligned are ESG funds? In our latest report, we put them to the test. As reported in the FT: “Thanks to insufficient ratings and data, sustainable funds do little to drive positive environmental change, finds London-based fintech Util.”

👎 We’re in good company. The OECD slammed ESG for failing to tackle climate change thanks to a lack of clarity and transparency, plus emphasis on disclosures over impact. EDHEC-Risk adds ESG has had no effect on emissions in the last decade.

🗣️ At least ESG disclosures are finally a corporate priority, reports Bloomberg. Data collection will be a “critical challenge” for 2022 thanks to impending regulation. Half of all companies surveyed have a strategy in place; 34% will have one within two years.

🗳️ They’ll need to match style with substance. BHP is bracing for a backlash at its upcoming AGM, after proxy adviser Glass Lewis criticised the scope and science of its Climate Transition Action Plan. It’s the latest signal that virtue signalling won’t cut it.

🤡 Speaking of style vs. substance: The FT reports PwC faces questions over conflicts of interest, having advised DWS on sustainability at the same time as investigating greenwashing claims against the firm (spoiler alert: DWS was exonerated).

🗂️ Contrary to PwC, the WSJ finds data was at the heart of DWS’s problems. Fund managers reportedly ignored calls to use ESG information, despite a recent annual report claiming “ESG knowledge is the cornerstone of [DWS’s] ESG evaluation.”

🚀 Though a key driver in the transition to net-zero, sustainable funds are constrained by size and scope—not to mention greenwashing, says the IMF, adding that governments, companies, and the broader finance industry must step up to the plate.

❌ European lenders are already acting, dropping clients that pose a climate risk rather than face higher capital requirements, according to the EBA. Banks are raising prices, denying loan requests, and “de-selecting industries and clients.”

🚨 Also under review are vulnerable sectors. Wise. Climate change could knock 10% off European GDP and drive 30% more defaults, says the ECB. In the US, regulators worry physical risks, to which trillions are exposed, may upend the financial system.

⛽ Finally, the elephant in the room: gas prices. Politicians need to act on greenflation, argues the FT’s Gillian Tett, as the costs of climate change reforms start to hit households. (Hey, at least winter really is transitory.) More on that below.

Util in the news

🗞️ Our report, How SDG-aligned are ESG funds, featured in the FT’s Moral Money, as well as a focused FT report on the standards holding back ESG. It was also covered in ESG Investor, Environmental Finance, Wealthnet and Responsible Investor.

🎙️ ICYMI: Speaking at the Sustainable Investment Forum North America 2021, Patrick Wood Uribe joined a panel debate on the critical role played by fintech in driving the transition to net zero. (You can catch a replay of the event here.)

🔗 Speaking to ESG Investor on the back of our latest report, Patrick says the methodologies of sustainable funds are too basic. “Strategies are not nuanced enough to capture complex, interlinked real-world needs. The missing link is data.”

Chart of the week

How good is ‘good’? That’s the question we set out to answer when we evaluated the exposure and impact of sustainable funds relative to their vanilla peers. We found:

  1. Plenty of greenwashing by the sustainable funds

  2. Little positive environmental impact from all but four funds

  3. Some curious connections between sector exposure and SDG targets

The first two takeways could be reduced to the fact—succinctly relayed by one sustainable finance researcher to GreenBiz—that “the folks constructing the funds aren’t the same folks who are marketing them."

The third point is more interesting, and speaks to the real future of (and opportunity in) sustainable investing. Download the full report here.

Greenflation exposes the ‘extra-financial’ myth

What does the energy crisis reveal about the relationship between society, environment, economy?

Earlier this summer, I asked which roadmap through the energy transition were more likely: that outlined by the Bank of England’s Andrew Bailey (delaying aggressive climate policy = higher materials costs = more inflation) or by BlackRock’s Larry Fink (introducing aggressive climate policy = higher energy prices = more inflation). 

Within a matter of weeks, both predictions turned out to be true. 

The world is on the precipice of an energy crisis. Demand for gas is soaring after electricity producers, under pressure from policymakers, shifted away from coal. The energy supply chain is stretched to breaking point, not helped by the fact renewable supply is floundering thanks to (climate-change-induced) extreme weather events. And efforts to build more renewable energy sources have been hampered by the selfsame move away from fossil fuels and mining. 

It’s a mess: one that underscores a reality that both Bailey and Fink understood. Coordination of myriad market and, yes, social and environmental factors and timelines is the key to the just transition. The critical question hanging over the energy transition isn’t if but when. Foresight, or the lack thereof, has critical implications for the environment, society, and economy.

The challenge isn’t—has never really been—collective action, but coordination

Team Bailey

On the one hand, we were too slow. 

Until recently, there was a pervasive assumption that the resources needed to build renewables were readily available. They weren’t. Now it’s crunch time, and there’s a bottleneck. The more forcefully spending is directed towards renewables, the more demand pushes prices up and supply down.

That’s the first of two major hurdles on the road to decarbonisation: Solar and wind technologies require a lot more materials than do fossil fuels. 

The result is greenflation, meaning higher metal and mineral prices. The Bloomberg Commodity Spot Index, a basket of 23 energy, metals and agricultural raw materials contracts, jumped to an all-time high on Monday, surpassing its 2008 and 2011 peaks set during the commodity super-cycle, according to Bloomberg’s Javier Blas

Team Fink

On the other hand, we were too fast. 

Investors and banks, motivated by pressures of both a social (asset owner demand and reputational risk) and financial (cost of capital and physical risk) nature, rapidly rotated away from fossil-fuel companies. Governments are hot on their heels, with net-zero pledges and announcements likely to ramp up at COP26. The result? Companies have shied away from the oil- and coal-based activities required to develop renewables.

Because here’s the second problem with the materials underpinning solar and wind power plants: Production is dirty.

The result is core inflation. With coal now a materia non grata, yet renewables nowhere near where they need to be, the price of energy has skyrocketed. 

The canary in the coalmine

Nowhere is the paradox more clearly on show than with aluminium. 

Global consumption of the metal, a core component for renewables, almost entirely originates in China. Development, however, requires a lot of electricity. Plants have two options: coal or hydropower. Thanks to climate-change induced droughts in China, the latter isn’t on the table this year. But, given net-zero targets coming from Beijing, not to mention European levies to account for production emissions, coal isn’t on the table either. Thus renewable development slows, fossil-fuel reliance continues, extreme weather events multiply, climate policies become more aggressive, materials more expensive, renewable development slows more, and the transition is further out of reach.

Ironically, while all eyes are on Evergrande, China’s energy supply crunch looms in the background as a far greater threat to the world economy.  

All factors are financial

Given the environmental, social and economic consequences of climate change, halting progress towards a decarbonised economy is not an option. While the costs of the transition are significant, the costs of ignoring it are far greater. 

The world must fundamentally reshape the way it produces and consumes energy. But the only way that will happen with minimal economic, social and environmental friction is via a clear perspective of economic, social and environmental factors.

Shut down the old economy too slowly, and the physical effects of climate change will hit households, while minerals become prohibitively expensive. Shut it too fast, and the financial effects of climate change will hit households, while minerals become inaccessible. 

In an echo of 2008, consumers—having benefited from a deflationary environment and higher purchasing power for years—are now picking up the bill, as governments step in to protect the financial exposure of banks, investors and companies. 

Hopefully we’ve learned the lesson that social events, like environmental and economic ones, never exist in a vacuum. 

Why do we care?

If COVID were an opportunity for governments to demonstrate their ability to coordinate in a time of crisis, then perhaps it’s good the finance industry is taking a lead on this one. While it requires careful planning, however, the transition doesn’t require a grandmaster at the helm—just wider scope and longer foresight.

Greenflation is the result of so-called ‘extra-financial’ and financial factors combining in the absence of scope or foresight. In the years to come, could impact data play a critical role in getting it right?

The clue is in the name. Impact data doesn’t just exist to help investors to ‘do good’ (though that’s certainly a nice benefit). It’s a lens through which to better understand the interconnectivity and causal relationships between people, planet and profits.

At its logical end point, impact data has a much more ambitious application than as the building blocks of marketable funds. It could ultimately help financiers, policymakers and consumers make sense of the fiendishly complicated network of social, environmental and economic events inexorably linked by globalisation.

The energy transition is the first real test of our ability to navigate all three.