A new economic paradigm
Dr Kim Schumacher outlines the vital influence of environmental impact assessment frameworks on the sustainable finance sector
Finance is key when it comes to reaching climate targets and accelerating the low-carbon energy transition. Expanding renewable energy capacity, and sustainably managing natural resources, will require huge capital expenditure. It also means that environmental, social and governance (ESG) factors will have to be integrated into financial, political and regulatory decision-making. The importance of finance has been put forward by a plethora of publications and statements which aim to foster investment that takes account of ESG factors. In its 2018 Guide on Sustainable Finance, IEMA highlighted how sustainable finance can help manage climate-related risks and drive the transition to a net-zero emissions society. However, the 2019 UN Climate Action Summit highlighted a flaw in climate and sustainable finance activities: insufficient impact measurement.
Heralded as a primary solution to the climate crisis and flanked by regional and global investor commitments from businesses, governments and financial actors, green finance has become a sizeable element of the financial sector. They are seen as a way to mobilise global private and blended capital flows to achieve the Paris Climate Agreement and UN Sustainable Development Goals (SDGs), and are considered more climate-resilient. They have, however, been met with scepticism from some stakeholders, including researchers and regulators, who question whether they are as climate-aligned or ESG-compatible as advertised. And despite the rapid growth of this sector and the wider consensus around its role, the volume of climate-aligned investments falls short of limiting global warming to 2°C, or reaching the SDGs.
The quality of ESG data is preventing large institutional investors from expanding activities in this area. Measuring the impact of ESG investments is a challenge: many models and methodologies do not permit solid asset allocation or risk management. Several studies have illustrated the hampering effect of inconsistent data, and shown that differing methodologies are the cause of variations when assessing climate risk exposure for identical equity or bond portfolios.
Data gaps and the inconsistencies of proprietary assessment methodologies make it difficult to evaluate green financial products. Several indicators, including biodiversity and ecosystem services, pose particular challenges. The knowledge deficiencies and data gaps regarding the impacts of investments on natural capital, and vice versa, are among the largest across the ESG data landscape. These undermine the credibility of ESG scores for numerous asset holdings, leading to greenwashing concerns. Due to incomplete corporate disclosure and lack of granular multi-annual ESG datasets, ESG ratings for companies still differ between rating agencies.
The market for ESG data is projected to grow to almost $800m by 2020. This underscores the reliance of sustainable financial market actors on external data services. However, at the moment, all main data sources primarily rely on self-assessed company reporting or annual questionnaires sent by organisations such as the Carbon Disclosure Project or the UN Principles of Responsible Investment. In the absence of standardisation, these data sources vary in terms of consistency and granularity. The latter defines what constitutes a green project, what indicators and metrics to use, and how to benchmark best practice. Proper environmental management frameworks can alleviate greenwashing controversies by offering a tested template for reliable measurement, reporting and verification of project and policy-related ESG impacts.
EIA: a core tool
To strengthen emission pathways and ESG strategies, solid measurement, reporting and verification mechanisms need to be established. These assure proper accounting of climate and ESG-related impacts and enable proper disclosure with best practice frameworks such as the recommendations published by the Task Force on Climate-Related Financial Disclosure. Standardisation is being addressed on multiple fronts, such as by the Sustainability Accounting Standards Boards and the International Standardisation Organisation (ISO), which has established committees to develop standards dealing with the disclosure of climate-related investment activities (ISO 14097) and terminologies surrounding sustainable finance TC 322). IEMA is involved in ISO standard development, having joined the TC 322 as an organisational member.
The European Commission is leading the most advanced effort, having published legislative proposals dealing with different aspects such as establishment of a common taxonomy, a “unified classification system on what can be considered an environmentally sustainable economic activity”. Other proposals are on disclosure, benchmarks and the creation of a green bond standard.
In sustainable finance, Environmental Impact Assessment (EIA) is instrumental for the structuring of green bonds, given the project-based nature of this type of debt financing. The green bond market has multiplied in size, with cumulative issuance since 2007 standing at $521bn; 2017 and 2018 account for more than 50% of all issuances. Its most prominent role in the green bond segment notwithstanding, EIA will have a much larger impact on ESG data quality and standardisation of impact measurement methodologies.
The EU makes direct reference to EIA in the taxonomy technical report, a practical guidance document published in June 2019, to outline further details on how the taxonomy would be implemented. The report provides sample sectoral assessment procedures for sustainable finance practitioners in which they need to ensure an “EIA has been completed in accordance with the EU Directives on Environmental Impact Assessment (2014/52/EU) and Strategic Environmental Assessment (2001/42/EC)” to properly evaluate the potential risks on ecosystems.”
It evidences that existing EIA frameworks are an established tool to measure impacts ex-ante, with modern frameworks even containing ex-post monitoring obligations during an asset’s operation and decommissioning phases. Numerous EIA or strategic environmental assessment frameworks already require the systematic production and collection of asset-level or policy-level ESG data. This can be used to fill data gaps, complement existing databases and catalyse standardisation trends. This will not only render ESG scores and ratings more reliable, but also accelerate the transition towards better disclosure and render ESG impacts, as well as climate-related risk exposure, more comparable at asset and company level. EIA could thus play an important role in determining the future growth patterns of sustainable finance.
- The market for ESG data is projected to grow to almost $800m by 2020
- Cumulative issuance since 2007 stands at $521bn, with 2017 and 2018 accounting for more than 50% of all issuances
- Climate-aligned investments fall short of limiting warming to 2°C
Dr Kim SCHUMACHER CEnv MIEMA is an honorary research associate at the School of Geography and the Environment, University of Oxford.