Investing in Scotland's Net Zero ambition: the ESG agenda

Our short series of green finance articles by Banking and Finance partner, Tony Cameron, kicks off with an overview of the rising significance of environmental, social, and governance (ESG) issues to investors and lenders.

Environmental, social, and governance topics are sitting firmly at the top of the agenda for an increasing number of organisations as the market sees a strong shift towards ESG-based decision making.

Non-financial performance criteria used to be a secondary consideration for most investors but an EY Climate Change and Sustainability Survey in 2021 reported that 91% of investors said ESG played a pivotal role in decision making on investments “frequently” or occasionally” in the previous 12 month period. The number who “frequently” based decisions on such metrics rose from 38% to 43% in the last two years.

These survey findings are borne out in practice as more money was invested into ESG focussed funds in Q2 2020 than in the whole of the previous five years. More than a trillion dollars is now invested in ESG funds worldwide and this growth is predicted to continue.

Regulation

ESG is also featuring more prominently in regulatory guidance. One of the core principles of the Financial Reporting Council’s UK Stewardship Code 2020 is the systematic integration of stewardship and investment to include material ESG issues and climate change, again signalling the significance of ESG.

This focus will only increase as the UK implements the recommendations of the Task Force on Climate Related Financial Disclosures (TCFD) to make climate related disclosures mandatory for UK companies. These recommendations are expected to be implemented, at least in part, by the end of 2022 but there is still some way to go in respect of speed of implementation and also the widely recognised need for improvement in the quality and consistency of data to properly inform investment decisions.

ESG and lenders

On the subject of transparency, we are continuing to see ESG reporting obligations appearing in loan documentation in the market and the Loan Market Association has published both Green Loan Principles and the Sustainability Linked Loan Principles.

Lenders are also beginning to place a greater focus on ESG related matters in credit appraisal and there is a wider acknowledgement that focusing on such factors will not harm financial performance but will essentially future proof companies by ensuring that they don’t become disconnected from customers or markets due to failure to align with how ESG will shape life and work going forward.

That said, the Governor of the Bank of England has observed that financial markets are still not properly pricing in the risk of entities with carbon intensive businesses or who are not meaningfully observing the ESG agenda.

Any real shift will a require a quicker move along the arc from ESG obligations to financial imperatives (such as margin ratchets) through to the necessary end game that debt funding will not be accessible at all in a meaningful way to entities which do not pursue an ESG agenda.