Investors increasingly care about a portfolio company’s exposure to climate change risk, and whether or not--and how--they adapt to those risks, argued Caroline Flammer, professor of international and public affairs at Columbia University. Flammer was one of the keynote speakers at the University of Luxembourg’s second conference in sustainable finance, which took place at the Banque de Luxembourg on 6 July.
However, “in most countries around the world, there’s unfortunately a lack of mandatory disclosure requirements of non-financial information,” noted Flammer. In the United States, for example, the Securities and Exchange Commission (SEC) “only recommends that companies disclose their climate change risks, but it does not mandate it, nor does it provide any guidance.”
“As a result, many companies fail to disclose this information, which is clearly relevant for investors.”
Climate risk disclosure brings long-term benefits, short-term downsides
But companies can benefit from disclosing climate change risks, said Flammer. Transparency can, for instance, help firms better mitigate climate risks in the long run, increase a firm’s accountability with the public, allow investors and stakeholders to engage with a firm and foster trust.
These benefits, however, “likely only kick in in the long term, while the potential downsides of disclosing the climate change risks are more likely to kick in in the short term.” Downsides include revealing vulnerabilities that firms would prefer to keep secret, increased direct costs due to the need to assess the risk or possible adverse reactions from business partners.
So if disclosing climate change risks bring long-term benefits but short-term downsides, what does this mean for a company and its managers?
“From a large repertory of psychology and economics, we know that individuals--not just managers, but individuals in general--are so-called hyperbolic discounters. That means they have an excessive preference for the present,” said Flammer. “As a result, we all, on average, tend to prefer short-term rewards over long-term rewards, even if long-term rewards are substantially higher.”
Managers and executives are, of course, humans, but they’re also under a lot of short-term pressure, argued Flammer, such as in terms of career concerns or pressure to meet company expectations. As a result, managers may turn out to be even more “myopic,” or focused on the short-term, when compared to the average individual.
To address this, Flammer suggested that managers’ compensation can instead be aligned with long-term financial performance or with social and environmental goals. For example, compensation could be tied to CO2-emission targets or compliance with ethical standards in developing countries.
Financial sector perspective
Literature suggests that “pursuing ESG investing strategies to improve the portfolio company’s environmental and social practices can be--on average--beneficial to investors,” said Flammer. Tools include investing in equity--both passively and actively--and via debt, such as through green bonds.
Investors commonly use ESG screening and integration when passively investing in equity, but research suggests that active engagement is more effective in influencing a portfolio company’s environmental and social performance and triggering “real change in the real economy,” said Flammer.
Green bonds are the “oldest child on the block,” said Flammer. Since the issuance of the first climate awareness bond by the Luxembourg-based European Investment Bank, which took place in 2007, there has been a “green bond boom,” leading to other bonds, such as social impact bonds or sustainability bonds. But are these really effective financial instruments, or are they just engaging in greenwashing?
“Mix of public and private governance”
“Certified bonds can be a promising tool to finance the transition to a low-carbon economy,” said Flammer. “But let’s not be fooled. Some companies might actually issue green bonds to fool investors.”
“It also means that in the absence of public governments, certification plays an important role,” she added. But although certification can be an “effective tool,” it’s “unlikely” to be ideal.
Green bond certification faces several challenges, noted Flammer. The definition of “green” is ambiguous, which complicates certification, while multiple taxonomies and a lack of standardisation can have a negative impact on the market. “Binary certification,” meaning a bond is either certified or not certified also has “limited informativeness;” Flammer instead suggested a “tiered certification” system, such as that used for credit ratings, could be more helpful.
“And last, but not least, at this very moment, certification does not include the requirements of additionality,” she added.
“There’s a lot of promise, there’s a lot of hope. But there’s also a lot of risk if we don’t get our act together,” said Flammer. More research and policy discussion is needed. “Probably a mix of public and private governance would be better than the current situation.”
Public pension funds have “long-term horizon” needed for green transition
We are in the midst of multiple crises, from climate change to biodiversity loss, from social inequality to poverty, said Flammer. It’s “imperative” to ensure a “just transition that mitigates the risk of worsening social inequalities.”
“The typical response by academics and practitioners is: it’s the government’s role to fix this crisis. Now, whatever the governments are doing, unfortunately, it’s not sufficient, because we would otherwise not be in the midst of this crisis. And so this puts the spotlight on the private sector.”
How can systemic change be triggered? Lobbying activities of companies are, for example, not “captured” by the way their environmental and social performances are assessed, said Flammer. Better metrics need to be developed in order to obtain a more holistic view of what companies and investors are actually doing.
To move to a more sustainable world, “we need to adopt a systems-focused approach, moving away from firm-level and portfolio-level thinking. We need new theories, new models, new frameworks, new practices, we need to develop better metrics that allow us to track progress,” said Flammer, “and to create public partnerships.”
Public pension funds are amongst the biggest investors and own a large part of global assets, concluded Flammer. They’re exposed to these systemic risks, but “they also have the long-term horizon needed to actually provide long-term capital to companies to transition, to make a change.”
“Public funds have a unique opportunity--if you will, a responsibility, here--to not only improve their own environmental and social practices, but also to actively engage with their portfolio companies to improve their act, to engage with policymakers to trigger systemic change, and to invest in certified, ESG fixed-income instruments,” said Flammer. “Doing so, we likely have made environmental and social economic systems more resilient and decrease overall systemic risk.”