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Future of capital markets

Time to get serious about the role of finance in climate change

By July 11, 2022May 4th, 2023No Comments

(This blog was originally written for the FT Climate Capital Council’s event, “Energy Efficiency: How to Get to Net Zero at a Time of Crisis.” Learn more about the event here.)

To read the headlines, you could easily be forgiven for thinking that climate change and ESG are the number one issue in capital markets. When it comes to equity markets, ESG integration does seem to be fully underway, as the value of global assets applying environmental, social and governance data to drive investment decisions has soared to $40.5tn, representing more than a third of the $95tn equity market in 2020. Whether ESG integration is having a meaningful impact on climate change, however, is currently a matter of serious debate, with many critics saying this is having little impact and, in many cases, is simply greenwashing. In fairness to the investment management industry, however, most equity analysts will tell you that the goal of ESG integration is to minimize social and climate-related financial risks, not to save the planet, despite what their marketing teams may claim.

Turning to credit markets, we find an even bigger challenge. While a 2020 BBVA Global Markets Research report estimated that the current size of the green and sustainable bond market is now approaching $1tn, this is a drop in the bucket in the $128tn bond market that services private firms and sovereign debt and where some of the world’s largest sustainability challenges reside.

For example, when it comes to climate, a 2017 study by the Carbon Disclosure Project notes that over 70 percent of greenhouse gasses are emitted by just 100 companies. Of these 100, 38 are private or state-owned companies that account for 41.07 percent of emissions globally, while 62 publicly traded companies, including familiar public companies like Exxon and Shell, account for 27.93 percent of emissions. The private or state-owned corporations, while not participating in equity markets, are active participants in credit markets that have little or no ESG consideration or oversight. As a senior investment manager for a global bank’s equity business noted, engaging a portfolio company on setting climate change goals led the company to divest some of its most problematic greenhouse gas-producing subsidiaries. He later discovered these subsidiaries were then bought by a private equity firm using debt financing through the credit window of his own firm.

To address these challenges, capital markets leaders and managers now need to move beyond analyzing ESG issues through the lens of a single materiality framework focused on financial risk (sustainable finance 2.0) to a double materiality model (sustainable finance 3.0) that also measures social and environmental impacts of financial products across all asset classes, from equity investing to credit markets.

As with the struggle to define ESG standards, defining and disclosing data on non-material societal impacts is complicated by the lack of widely agreed upon impact measurement frameworks and disclosure standards. At the same time, we see signs that these challenges are beginning to be addressed by both markets and public policy. Recent initiatives like the Capitals Coalition and the Impact-Weighed Accounts Initiative are creating new pathways and frameworks for impact integration, while the recent EU Corporate Sustainability Reporting Directive (CSRD) will support the Sustainable Finance Disclosure Regulation (SFDR) built around a double materiality framework.

While in many ways an even more challenging journey than the move to sustainable finance 2.0, the urgent need to move to sustainable finance 3.0 is clear and may surprise us with how quickly impact becomes an integrated part of mainstream capital market management.