The rise of ESG is an excellent opportunity for financial markets to shake off their 2008 financial crisis legacy and help solve some of the most pressing issues of the day.
However, while voluntary efforts and the work of the ESG frontrunners are laudable, change will only become truly mainstream when policymakers put their full weight behind the movement.
Left to their own devices, many financial firms – which are profit-driven entities in a profit driven system – are likely to continue a business-as-usual approach. Stuart Kirk, HSBC Asset Management’s former head of responsible investment, recently implied just this when he declared that firms don’t or shouldn’t care about whether Miami sinks under water since risk is measured only in short-term chunks (the average length of an HSBC loan is six years). Although Kirk was having a swipe at the climate risk agenda, he also succeeded in articulating the default position of financial markets. Under the current system, he’s right. Legally and economically, there is often little reason for financial firms to care about the long-term impact of their business decisions so long as the returns in the short-term are decent. The point is that policymakers need to start making them care.
Expecting financial firms “to be good” without changing the fundamental rules of the game is unrealistic. Imagine a game of chess in which one party is told off for using their queen. It doesn’t matter if the way the queen moves is unsustainable, a queen is still a powerful piece on the board, and it would be unreasonable for firms to be put at a disadvantage for choosing not to use it. Either everybody stops using their queens or no one does. And to make sure people stop using their queens – which in this case translates as investing in or financing dirty yet profitable industries without a clear, science-based transition plan – policy change is crucial.
So yes, financial markets, as capital allocation machines, can help save the world, or at least play a key role in the efforts thereof, but only if the legal and economic frameworks of the system in which they operate undergo substantial transformation.
So far policymaking has been lukewarm, with a flurry of complicated initiatives but little fundamental change. Take the EU and its push to bolster the integrity of green markets via labels such as “taxonomy compliant”. The complexity of the EU taxonomy along with its apparently miraculous appearance – common green definitions agreed upon by 27 different member states each with their own unique geopolitics – has helped create an atmosphere of progress. Only on closer inspection does the progress itself reveal its potential for being illusory.
The reason for that is simple. One banker, who would probably self-identify as an “ESG purist”, recently told me that he felt as though the sustainable transition architecture was being built upside down, or worse, missing the point. Why, he said, should firms that are doing their best to make ESG core to their business models have to face additional compliance costs and challenges when firms that continue their business-as-usual approach do not? On one hand, the “greenium” is a real phenomenon, as firms can benefit from attaching ESG labels to their products. On the other hand, the absence of brown punishing factors means the business-as-usual approach can still happily co-exist with the new labels system.
In other words, policymakers are still shying away from more radical measures. The irony here is that anti-greenwashing legislation like the EU taxonomy has the potential for being a tool for greenwashing itself, insofar as it can be held up as a proof of progress (look, we policymakers are doing something, something big!) while diverting attention from the lack of more radical measures, such as brown punishing factors. And that’s not even mentioning the recent vote in the European Parliament that has enabled the controversial inclusion of gas and nuclear into the taxonomy.
It’s as though we have the Torah but without the 10 commandments. The Torah contains a total of 613 commandments, the most important of which are the 10 famous ones. “Thou shall not murder” (one of the 10), seems fundamental, whereas others, such as “Men must not shave their beards with a razor” is arguably of secondary importance. Similarly, Chapter II of the EU Taxonomy Regulation lays out detailed and stringent criteria for environmentally sustainable economic activities. Yet nowhere does EU law say, “Thou shall not destroy the planet” and here is a list of unsustainable economic activities that need to be phased out.
Complications: consumer costs and jurisdictional differences
It is unreasonable to expect financial market participants not to follow the rules of a game that has been created by policymakers. The primary focus should be on the policymakers themselves and attempts to reform the rules of the game. And to be fair to the policymakers, they have an exceptionally hard task in front of them.
Firstly, they need to ensure a timely and orderly energy transition without increasing costs for electorates. In the context of a severe inflation period and an energy crisis fuelled by the Russia-Ukraine war, an increase in living costs for already struggling citizens could result in significant civil disobedience and governments being voted out of office. While it is lovely to assume there’s popular support for weening economies off fossil fuels, short-term, individual self-interest is a powerful force when it comes to election day. Just look at the impact of the gilets jaunes (yellow vests) protests in France, which were triggered by a planned increase in the tax on diesel and petrol but then morphed into a wider anti-government movement.
Governments that do enact more stringent measures, such as carbon taxes, risk taking one step forward, but two steps backward, for if they are subsequently voted out of office, the next administration could reverse policy direction in a bid to win the populist vote. Macron’s would-be successor Marine Le Pen, for example, has defended a position that is widely seen as a setback in the fight against global heating. Then, on the other side of the Atlantic, the spectre of climate-change-denier Donald Trump still looms large. The political risk is all too real.
Jurisdictional differences also complicate the work of policymakers. Broadly speaking, the world falls into three main groups: those who commit to net-zero and do something, those who commit to net- zero and do nothing, and those who commit to nothing and do nothing. Given that we live in a patchwork of nation-states where short-term national interest often trumps the greater good, it is hard to draw a line between the first and the second groups, especially in this early period, as good intentions can still be watered down or shelved as states focus on what they consider more immediate concerns. Moreover, multilateral diplomacy is painfully slow and often produces questionable results. In short, human civilization in its current form is just not designed to tackle these kinds of crises, which require collective action and co-operation.
In an ideal world, there would be common, enforceable laws that apply to all jurisdictions, with aid given by the richer countries to the poorer ones to help them either off-set their emissions or work on their own energy transitions. There would probably have to be a degree of green technology transfer to make this happen. Yet all of this is thorny territory. Each jurisdiction in the nation-state patchwork has its own geopolitical constraints, which makes global agreements challenging, and green technology transfer goes against grain of information capitalism that leans heavily on the sanctity of intellectual property rights. Why should investors and developers work on green technologies if the fruit of their labour and investment is handed out free to all those who need it?
While I don’t wish to play the role of Cassandra, it’s quite hard to feel optimistic, given the immense scale of the structural challenges that policymakers need to overcome to mitigate the climate crisis. And it’s not just the climate crisis, of course. There is also the biodiversity crisis, which many say pose as great a systemic risk as climate change. One hopes that policy makers will be able to transform economies without causing unnecessary harm to ordinary citizens as part of a just transition. And financial markets can certainly play an essential role in this process.