Tag: #ESG

Constructing Social Portfolios: A Quantitative versus Screening Approach

By Alina Hofer, Lea Katharina Kasper & Dr. Kristjan Jespersen 

◦ 5 min read ◦

When we talk about ESG, one could argue that there is a strong bias focused on climate investing, reaching net zero targets as well as good corporate governance and diversity themes. But there is much more to ESG. The “Social” dimension of ESG is hugely under explored and developed and covers under studied issues such as how companies treat their employees and care for the responsibility of their products. Still further, assessments linked to human rights codes and social impacts is only now receiving the attention it truly deserves. Although the importance of these topics is undisputed, we see that attention to particularly address the social dimension has been lacking, whereas awareness of other ESG risks has been rising immensely during the past years. 

Not only is the general knowledge and focus on the social dimension of ESG limited, its overall  implementation in portfolio management has not been sufficiently experimented with and addressed.

The delay to properly implement the “S” in ESG is often explained because of the challenges to quantify, assess, and integrate social factors generally.

However, this argument should not be a sufficient justification for neglecting the “S” in ESG and for investigating a possible relationship between a good social rating and superior financial performance. To tackle this lack of awareness, we constructed two portfolios which integrate Refinitiv’s Social ratings based on different integration strategies and test their performance towards the market between 2012-2021.

When integrating social – or other ESG – ratings into the investment process, we find there is often disagreement on how to best consider these factors in portfolio construction. Currently, it is most common to apply screening or best-in-class strategies. These approaches aim to remove assets that do not fulfill certain criteria from a defined investment universe. Negative screening would mean to remove those companies that perform worst from the pool of assets. Inversely, an investor could also only continue with those firms who at least have a certain minimum rating. For both approaches, the portfolio weights are then allocated to the assets that remain. This is done using conventional indicators such as value, size or expected risk-adjusted returns. In our study, we, however observe a clear shortcoming of this approach: After screening out the worst 10% “social performers” and allocating weights based on a risk-return trade-off, the portfolio does not necessarily promise a higher overall ESG score than a portfolio would reach which does not consider the ratings at all. Although the portfolio yields a solid financial performance, this raises the question whether any ESG-related impact has been made with this integration approach.

To make sure an investor can improve his exposure to assets that score well in the social dimension, we integrate the rating scores directly into the optimization problem of our second portfolio. This leads to a very different outcome on the social rating:

Looking closer at the mechanics of this approach, we extend the traditional Sharpe Ratio with the ESG factor, meaning to add by how much it a company “outscores” the market average. This results in the following “Social Sharpe Ratio”:

We add a fifty percent weight split, which can be flexibly adjusted towards investor preferences. And we now balance a risk-return-social trade-off. This explains why the second approach over 9 years constantly beats the market average in respect to the integrated Social factor without sacrificing any performance on the financial side. In fact, we find that in 5 out of 9 years, the second strategy would have also led to higher risk-adjusted returns measured by the Sharpe ratio. Moreover, returns were consistently higher compared to the market benchmark. This result is quite remarkable, given that it is often questioned whether investors need to sacrifice returns in order to make their investments more socially responsible. 

Lastly, our study resulted in one more unforeseen twist when it comes to integrating ESG ratings. That is, the question whether we can actually trust the rating scores. To answer this, we must first understand how scores are created. Rating providers look at an immense amount of publicly disclosed information, reports and policies. And based on what company’s report, rating scores are aggregated. However, it is clear that a firm would only report on things they do well. In fact, we observe that with increased reporting, ESG scores also improve. But what about the real-life actions and impacts? Some rating providers offer a combined score, which also considers media reports on the involvement in controversial actions. As these scores are only available at an aggregate level, we calculate them on a single-pillar level using Refinitiv’s methodology, which adjusts for firm size and industry. Looking at specific examples in our portfolios, we found that the impact of such controversy involvement on the overall score could still be larger. Nevertheless, we stress that in order to have a complete picture of a firm’s ESG behavior, the impact of these controversies needs to be reflected in investment decisions. 

To sum up, given the results of our research, there are three things we aim to highlight:

  • It is crucial to increase investors’ awareness of “Social” matters and provide a better landscape for impact investments in this specific dimension.
  • Integrating ESG ratings does not always promise a better ESG performance for the whole portfolio. Therefore, it is necessary to focus on strategies that lead to actual impact.
  • Third, looking beyond the information that is disclosed by companies themselves, more attention should also be addressed to “real life actions” when making investment decisions. 

About the Authors

Lea Kasper has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Her interest and enthusiasms about sustainability and how to more efficiently integrate non-financial factors in investment decision-making contributed to her choice to further investigate this topic throughout the master thesis. 

Alina Hofer has recently graduated with a MSc. in Finance and Investments (cand.merc.) from Copenhagen Business School. Being passionate about creating impact through ESG-aligned investments, she was excited to further focus on her interest in this field throughout the master thesis.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Image source: SustainIt

ESG investing in a changing regulatory environment: investing in active or passive ESG financial products?

By Marco Morazzoni and Dr. Kristjan Jespersen

◦ 8 min read ◦

The impending climate crisis emphasizes the need to mobilize large-scale investments to finance the transition towards a more sustainable and inclusive economy. The financial sector plays a pivotal role in this context, as it allocates capital from investors who wish to pursue financial and non-financial objectives to corporations and stakeholders who need these resources to empower the sustainability transition.

Over the past decades, individual investors have become aware of the risks inherent in unsustainable business practices, being increasingly interested in financial products that combine a competitive risk-adjusted return with Environmental, Social and Governance (ESG) criteria. Despite the increase in funds, indices and benchmarks that include ESG dimensions, the universe of ESG financial products remains difficult to navigate for individual investors due to the range of investment strategies that can be used to pursue ESG goals, such as negative and positive screening, best-in-class, ESG integration, impact investing and ESG engagement. In addition to ESG strategic considerations, investors ought to consider the level of active management inherent in their ESG products, since it has considerable implications for financial returns and the ESG objectives pursued.

In fact, while some financial products have an active investment approach, trying to beat a reference benchmark, others merely aim to replicate the ESG impact and financial performance of an index.

‘Active versus passive’ debate

The literature on conventional active and passive investing is almost unanimously in favour of long-term passive investing, due to active managers’ inability to consistently beat the market and to the lower fees charged by passive funds. However, the ‘active versus passive’ debate in the context of ESG investing is more nuanced.  This is because ESG investing entails the pursuit of intangible and hardly quantifiable goals that go beyond the achievement of mere financial returns. Furthermore, due to the different definitions and methodologies used in the assessment of ESG performance and the resulting unrealiablity of ESG data, the trade-off between impact and financial returns can be difficult to reconcile. 

A study conducted on 78 ESG active mutual funds and 15 ESG exchange-traded funds (ETFs) seeks to contribute to the debate by illuminating the financial and non-financial features that characterize these sustainable financial products. The funds were selected from Morningstar Direct according to specific criteria, such as: availability of an ESG rating, European domicile, invested in equity, active investment approach (for mutual funds) and passive investment approach (for ETFs).

By constructing an equally-weighted portfolio for the selected ESG active mutual funds and ESG ETFs, the study used the CAPM, three-factor, four-factor and five-factor model to compare the portfolios’ risk-adjusted perfromance before and after fees. To increase the robustness of the study, the regression analysis was conducted on various market benchmarks, such as MSCI World, STOXX Europe 600, MSCI World ESG Leaders and MSCI Europe ESG Leaders.  

The regression results indicated that the ESG active portfolio outperformed the ESG passive portfolio both before and after accounting for management fees. Controlling for the criteria used in the selection of the funds, the active outperformance could be attributed to the funds’ instrinsic characteristics, such as investment orientation, ESG investment approach and ESG scores. Accordingly, 77% of the ESG active portoflio had a global investment orientation compared to 27% of the ESG ETF portfolio. This entails that the active portolio covered more geographies, exhibiting higher diversification and improved risk-mitigation.

Further, 83% of the active portfolio practiced ESG engagment, a strategy that previous literature associates to superior financial returns and improved ESG impact.

By engaging with companies on ESG issues, ESG active funds may have been able to help ‘lagging’ firms improve their ESG performance, while enabling ‘leading’ firms to address their ESG issues. With respect to ESG scores (Morningstar and MSCI), the active portfolio displayed a lower overall ESG score compared to the ESG ETF portfolio. This finding could suggest that the active portfolio invested in lower rated companies on average, with the objective of helping them transform their ESG strategy and thus pursue higher risk-adjusted returns.

Insights to individual investors in ESG financial products

Recognizing the limitation derived from the small sample size and the fact that the active outperformance might be due to the specific funds selected, the findings were used to provide a set of insights to individual investors who wish to invest in ESG financial products.

Firstly, individual investors were categorised into ESG-unaware, ESG-aware and ESG-motivated, according to the investor labels used by Pedersen et al. (2021) “Responsible investing: The ESG-efficient frontier”. This categorization simplified reality to the extent that it became easier to derive actionable insights. Furthermore, it provided more granularity with respect to investors’ prerogatives regarding the trade-off between the pursuit of an ESG impact versus a risk-adjusted return.

Based on this categorization, investors who disregard ESG information (ESG-unaware) should invest passively in broad conventional ETFs or in a diversified portfolio of more specific conventional ETFs.

Investors who consider ESG information for risk-mitigation purposes (ESG-aware) ought to focus on the level of selectivity displayed by active managers in their stock-picking activity, measured in terms of high/low R-squared. If active managers are highly selective (low R-squared), ESG-aware investors may consider foregoing part of their return, due to the higher active management fees, and thus benefit from managers’ ability to pursue a greater ESG impact and potentially higher risk-adjusted returns.

Conversely, if active managers exhibit low selectivity with respect to a reference benchmark (high R-squared), investors would be better off investing passively in broad ESG ETFs or in a diversified portfolio of more specific ESG ETFs. Lastly, ESG-motivated investors may be better off investing in ESG active funds who practice ESG engagement, as the higher fees charged by these funds would worthwhile, given the superior ESG impact inherent in ESG engagment strategies.

Regulatory considerations

In addition to the empirical findings, the study also included regulatory considerations in the assessment of the suitability of active versus passive ESG financial products for individual investors. This was critical, since the new MiFID for sustainability preferences will come into force on the 2nd of August 2022.

According to this regulation (2021/1253), investment firms will be obliged to ask their clients about their sustainability preferences and find out whether they are interested in sustainable financial products. If the answer is affirmative, financial advisors will only be allowed to offer MiFID-aligned products to their clients. A MiFID-aligned product will have to include a minimum portion of ‘environmentally sustainable Investments’ (SFDR article 9), EU Taxonomy-aligned investments, or enhanced article 8 investments, consisting of article 8 investments (SFDR article 8) which also include Principal Adverse Impact (PAI) indicators.

Linking the new regulatory requirements to the findings of this empirical research, it is reasonable to expect that ESG-unaware investors will no longer exist, as investment firms will be legally required to inform these clients about the ESG implications inherent in their investments. This will give rise to an increase in supply of sustainable financial products (MiFID-aligned), as investment firms strive to keep up with the increased demand for these products. The rise in supply will most likely be larger than the increase in demand, since a portion of the new ESG-aware investors might continue disregarding ESG information, if ESG financial products are priced unreasonably (excessively high management fees). This will ultimately lead to higher competition among investment firms, with a consequent downward pressure on fees in the long-run. Lower investment costs could subvert individual investors’ incentives, as they decide on whether to invest in ESG active or passive funds. Accordingly, it might become desirable for ESG-aware investors to invest in ESG active funds who practice ESG engagement, as opposed to it being a strategy exclusively suitable for ESG-motivated investors.

The information contained in this blog post is not to be taken as constituting the giving of investment advice or recommendation. The reader is acting for its own account, and they will make their own independent decisions as to whether any investment is appropriate based upon their own judgment.

About the Author

Marco Morazzoni is a recent graduate in MSc Applied Economics and Finance from Copenhagen Business School. Having an interest in finance and ESG, he wrote his master’s thesis on “ESG exchange-traded funds versus ESG active funds: how can individual investors pursue ESG objectives while achieving competitive risk-adjusted returns?”

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo: Khanchit Khirisutchalual on iStock

Institutions matter: The importance of institutional quality when embedding sustainability within the capitalistic realm

By Lisa Bernt Elboth, Adrian Rudolf Doppler, & Dr. Kristjan Jespersen

◦ 5 min read ◦

Institutions not only structure any sort of social interaction [1], but are also essential in solving societal problems [2], such as climate change and the associated threat towards a fair and just future. It is not without reason that the United Nations particularly emphasized institutional progress within SDG 16 [3] to advance to a more effective, inclusive, and accountable society. In a recent study, it was found that institutions matter to a great extent when scrutinizing the relationship between corporate financial performance (CFP) and ESG performance. More specifically, the institutional environment a company finds itself in determines whether sustainable business practices get transformed into financial returns.

The claim that more sustainable companies are outperforming their not so sustainable peers is not new [4] and the consequent shift of investors’ preferences towards more sustainable companies has been taking place with increasing speed over the last decade [5]. Associated wake-up calls and the urge to take ESG into consideration are not surprising either. Besides the alleged desire of investors for a just and sustainable future, this shift is more likely based on the theory that sustainable finance delivers abnormal returns [6]. But is the relationship between sustainable behavior and financial performance as straightforward as it is disseminated? Are more sustainable corporations indeed more likely to achieve better financial results regardless of where they are and what they do?

In fact, when utilizing ESG scores, rankings, and performance as a proxy for sustainable behavior, two meta-analyses [7] [8] concluded that in most empirical studies the resulting relationship was not as simplistic, universal or linear as it is often propagated. In a corresponding literature review, the researchers also identified a large number of discrepancies among scholars in how to statistically model the relationship, what control variables to use and how to even quantify the dependent and independent variables of focus. Following these insights, the researchers uncovered a determining factor in establishing and shaping the emphasized relationship – institutional quality.

Key Findings

The final sample consisted of datapoints from 6,976 corporations, situated in 75 different countries over a period of eleven years or, specifically, from 2009 to 2020. Subsequently, these were analyzed applying fixed effects panel regression models. Both an accounting- and a market-based measure were used to quantify corporate financial performance, respectively, Return on Assets (ROA) and Tobin’s Q. Meanwhile, ESG performance was proxied by ESG scores from Refinitiv (former Thomson Reuters). The variables associated with institutional environment were split into 

  1. Institutional Quality, calculated through a factor analysis and based on the World Governance Indicators from the World Bank and 
  2. Industry Sensitivity, a dummy variable equal to 1 if the GICS industry of a firm was deemed sensitive towards ESG.
Institutions are among the determinantal factors for the link 

Interestingly, the general statistical analysis of ESG and CFP did not yield any significant results, however, when moderating effects stemming from the institutional environment were introduced, this changed. Under high institutional quality, the researchers found a positive relationship between ESG scores and financial performance. Contrarily, the relationship was negative under low institutional quality. Exemplified below by the case of Finland 2012, Argentina 2018 and Zimbabwe 2012, institutions can be seen as the determining factor for direction of the focal link. Furthermore, the industrial environment a corporation finds itself in was found to affect the relationship ambiguously. Generally, sensitive firms seem to receive relatively less financial gain for improved ESG performance, and it may even be negative.

Possible explanations for such dynamics
  • Legal institutions, such as environmental regulations, labor laws or health and safety requirements, can serve as the means of reflecting sustainable behavior inside a company’s balance sheet. Finland was for instance the first country to introduce a carbon tax capturing corporate pollution by giving it a price and hence affecting accounting profits.
  • In highly corruptive settings, where the trust of the general public is lacking, the likelihood of sustainable activities being perceived as greenwashing and thus not rewarded by investors, could be another reason for an inverse relationship in low institutionally developed regions. 
  • In line with the previous, when accountability is low, and corporate entities can disclose information without third party verification, it could be relatively easy to stay focused on short-term profits through unsustainable practices but still receive a better ESG rating.  
  • In environments with low institutional quality, banks tend to only give out short-term loans in order to reduce their own risks. This can lead to a vicious cycle of corporate lenders also only focusing on short-term profit maximization which then again decreases their access to capital, constraining their ability to engage in long-term sustainable practices.
Putting the SO WHAT into practice

When setting out for systemic change, it is important to ensure the necessary institutional environment in order to encourage individuals, as well as corporate entities to act in the best interest of the entire society and the planet. Thereby, a bottom-up approach focusing on incentivizing every individual and a top-down approach, fostering legal macro-level change can be synthesized, leading to the best possible outcome. These institutions should seek to maximize accountability, transparency, and mechanisms to internalize negative externalities. Corporations within such environments should fully leverage opportunities associated with sustainable practices, such as cheaper access to capital, in order to incrementally advance the progress towards a just space for humankind. Corporations, which are especially sensitive towards ESG related elements irrespective of their ESG scores, should aspire to enhance their own credibility, as this might award them with a competitive advantage. Lastly, societies with high institutional quality should strive for teaching about their institutions and the associated benefits to everyone else, as a global problem can only be solved on a global level. 

References

Doppler, A.R., & Elboth, L.B. (2022). Institutional Quality, Industry Sensitivity and ESG: An Empirical Study of the Moderating Effects onto the Relationship between ESG Performance and Corporate Financial Performance (Unpublished master’s thesis). 22098. Copenhagen Business School, Denmark.

About the Authors

Lisa Bernt Elboth recently graduated with an M.Sc. in Applied Economics and Finance as well as a CEMS Master’s in International Management from Copenhagen Business School and Bocconi University. Her interest in global matters and sustainability has flourished during her studies impacting the choice of master thesis topic and this subsequent blog contribution.

Adrian Rudolf Doppler works as a research assistant for the Department of International Economics, Government and Business at Copenhagen Business School and had just graduated with a Master’s in Applied Economics & Finance and the CEMS Master’s in International Management after a two-year journey. He had always been passionate about ESG, Sustainability and the existing links with the capital markets, as well as the complex system dynamics arising form it.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo credit: Galeanu Mihai on iStock

How do we think about sustainable investing? Suggestions from an exploratory study

By Margherita Massazza & Dr. Kristjan Jespersen

◦ 4 min read ◦

From the outset, this blog post takes the perspective that behavioral finance is required to assess the perceived tension in sustainable investing (SI). Our work investigates the extent to which sustainability considerations are included in investment decisions, and the drivers behind SI approaches.

Sustainability is increasingly integrated in financial markets, with the acronym “ESG” (Environment, Social, Governance) becoming an all-encompassing term widely used in all phases of the investment process. According to a recent global review, sustainable assets [1] reached USD 35.3 trillion at the end of 2019, representing 35% of total professionally managed assets, and they are set to grow further in the coming years. Yet, despite its growth and the positive sentiment associated with it, there is an inherent tension in sustainable investing.

This tension stems from the apparent disconnect between the theoretical assumptions of classical financial models, focused on risk and financial returns as the predominant determinants of investment decisions (e.g., Capital Asset Pricing Model, Modern Portfolio Theory, etc.), and the empirical evidence of SI, where portfolio allocations are affected by non-financial aspects like personal values and social pressures. How can we make sense of this tension? 

Usually, the contradiction is formulated in terms of a tradeoff between financial returns and ESG impact: in order to achieve one, investors must forego the other. However, this view is still rooted in a traditional finance perspective, according to which including ESG considerations or seeking a non-monetary impact comes at the expenses of returns.

There needs to be more nuance in how sustainable investing decisions are investigated and assessed. Given the pervasive and engaging nature of ESG issues, sustainable investing is likely shaped by internal and external forces that go beyond the financial-vs-impact debate. By acknowledging the role that cognitive limitations, biases, and the external context play for investments, behavioral finance allows to capture the financial impact of factors that tend to be overlooked in mainstream financial theories. 

Under this perspective, the authors carried out a study based on primary data from European retail and professional investors. It focused on two main questions:

To what extent are sustainability considerations included in investment decisions?

Firstly our analysis broke down the relative importance of four attributes for the investment choice, i.e. the relative weight (expressed in percentage) that each characteristic exert on the investment decision. Sustainability attributes carry a relative importance of about 38%, with ESG score displaying a 26% relevance, and the investment’s end objective a 12% relevance. Taken together, these parameters display a larger role than standard financial attributes of risk level (relative importance of 33%) and expected returns (relative importance of 29%) (Figure 1). The results confirm the significance of ESG aspects for a well-rounded assessment of an investment, arguing against the traditional perspective of risk and returns as the sole determinants of investment choices.

Figure 1 – Relative importance of investment attributes for investment choice, by investor type
What drives investors to invest sustainably?

Secondly, we identified the main tendencies leading investors to engage in SI. Starting from a set of 16 heterogeneous motives, 4 main drivers emerged: a desire for self-expression, a financial-strategic rationale, the influence of the external context, and an opportunistic motive (Table 1). These drivers depict SI as a multifaceted phenomenon that unfolds along various dimensions, and not only on the financial and impact layers. They propose a novel perspective to think about SI, which takes into consideration how endogenous (e.g., alignment with values) and exogenous (e.g., role of regulation) forces may affect investments. 

Table 1 – Drivers of Sustainable Investing
How can the findings help us better assess sustainable investing?

This analysis shows the extent to which ESG aspects are integrated in investments, confirming their importance for investment choices. It also shows the multidimensionality of SI drivers, which eschews the rigid perspective of traditional finance and accounts for the impact of relevant internal and external factors. 

With this understanding, it is possible to formulate practical insights for industry participants to address the current challenges of SI. In fact, there are concerns related to the over-inclusion of sustainability in investment decisions at the expenses of fundamental financial analysis, which may lead to mispricing, inflated asset evaluation, and potentially an “ESG bubble”.

  • Standardize definitions and improve sustainability communication. Social context emerged as one of the drivers of SI, and regulators have a strong role to play in harmonizing the meaning of sustainability in finance. Legislative and non-governmental bodies are working to overcome the lack of standard definition and frameworks in SI – e.g., via the European Union’s Sustainable Finance strategy. Their effort to create a common vocabulary and shared understanding of what SI entails will help to align incentives, concepts, and strategies. In parallel, the financial-asset supply side (e.g., fund providers, financial advisors, etc.) should communicate clearly and extensively on the sustainability aspects of financial products. Given the importance of ESG characteristics for investment choices, this will ensure investors have reliable and trustworthy information to guide their investments. Together, the agreement in terminology and the availability of sustainability information will reduce the possibility for misinformation and opportunistic tendencies to sway investment decisions.
  • Recognize the existence of complex drivers behind sustainable investment decisions. Investors, both professional and retail, should evaluate how different motives affect their investment choices. Knowing that multiple drivers exist will ensure that investment are aligned with goals, limiting the influence of irrationality and misinformation. This will not only benefit investment strategies, but also curb counter-productive results such as the emergence of an ESG price bubble. To explore what drives investor’s decisions, an ad-hoc survey could be submitted ahead of opening investment accounts, mirroring the logic of the MiFID directive. This may have positive effects, such as involving more retail investors in sustainable investing [2].
  • Finally, consider adopting a behavioral approach when studying sustainable investing. The flexibility of behavioral finance may allow to grasp further insights and help to think about this timely topic in a novel way.

References

[1] The Global Sustainable Investing Alliance (GSIA) considers defines “Sustainable” all assets that integrate ESG factors in the analysis and selection of securities. More detail in their latest global report.

[2] Retail investors still face barriers to fully engage in SI: the topic is investigated in the paper “Investment Barriers and Labeling Schemes for Socially Responsible Investments” by Gutsche and Zwergel (2020).

About the Authors

Margherita Massazza is a CBS and Bocconi graduate in Economics of Innovation, with a focus on Sustainability. Her research investigates the links between traditional investments and behavioral finance to understand how sustainability decisions unfold. She is currently working in the Foresight team of AXA, an insurance company, where she studies the role that corporations will play in the future and how the concept of sustainability will evolve. 

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo by PiggyBank on Unsplash

How the EU Taxonomy Impacts Businesses Beyond Europe

By Andreas Rasche

◦ 4 min read ◦

In 2020, the EU launched its classification system for environmentally sustainable economic activities, the so-called “EU Taxonomy Regulation” (hereafter: the Taxonomy). The Taxonomy is part of an integrated system of new EU-wide sustainability regulations, including new disclosure requirements for investors. While the Taxonomy is based on EU regulation, it can be expected that it will also have effects on businesses beyond Europe. 

Basically, there are two ways in which the Taxonomy can affect non-EU companies. First, there are direct regulatory effects on non-EU companies. Because of the global nature of financial markets and the existence of global trade flows, non-EU companies will be directly exposed to the Taxonomy in different ways. Secondly, there will also be more indirect consequences, which I call “ripple effects”. Such effects exist because the Taxonomy raises the bar globally for how sustainability information should be disclosed, by whom it should be disclosed, and it which ways it can be disclosed. I briefly discuss both effects. 

Direct Effects 

In the short run, some non-EU companies will be exposed to the Taxonomy because of direct regulatory effects. Consider the following two examples: 

  • A non-EU investor or financial advisor that wants to offer products on the European markets will be exposed to the Sustainable Finance Disclosure Regulation (SFDR) which requires an alignment with the EU Taxonomy. To offer financial products on European markets non-EU investors will therefore have to align with SFDR and hence the Taxonomy.  
  • A non-EU company with EU-based investors is very likely to receive questions from these investors about the company’s alignment with the Taxonomy. Investors need this information to meet disclosure requirements under SFDR, for instance to classify their financial products in terms of their sustainability exposure. In other words, at least some non-EU companies will start disclosing more on Taxonomy-related indicators. 

I could list more examples here (e.g., non-EU asset managers wanting to raise money in the EU), but the message is clear: the effects of the Taxonomy are not limited to businesses located in Europe. Particularly, the Taxonomy’s interaction effects with SFDR will affected non-European companies as well as investors.  

Ripple Effects

Ripple effects are more indirect effects. They occur if an intervention, such as the introduction of a new regulation, creates further effects that reach beyond the system that was supposed to be influenced by the intervention. Such regulatory ripple effects can occur in different ways.

In the context of the Taxonomy, one important ripple effect is related to the practices of European businesses. Many of these businesses are global players, and they will apply the Taxonomy to their global operations regardless of whether these operations occur in a country that is legally covered by the Taxonomy. Sustainability reporting is usually done at the corporate level and therefore also includes firms’ non-European operations. The EU’s new disclosure regulation the Corporate Sustainability Reporting Directive (CSRD) will require that such reporting at the corporate level is taxonomy-aligned. In this way, European global players will “export” the Taxonomy to other parts of the world.

There are also ripple effects at the political level. The system of new EU legislation – including, the Taxonomy, SFDR, CSRD and other regulatory elements – is unique in the world. So far, no other region or country has a comparable system. However, the major economic regions in the world have also realized that future business will be difficult without sustainability-related regulations that enhance transparency and prevent greenwashing.

Consider two recent examples: In June 2021, the UK announced the creation of a Green Technical Advisory Group. This Group is supposed to develop and implement a UK green taxonomy, which is expected to be based in part on the EU Taxonomy system (e.g., in terms of metrics). In the US, President Biden signed Executive Order (EO) 14008 during his first days in The White House. While this EO does not aim at creating a US-based taxonomy, it has created a National Climate Task Force across different federal departments, which at least some see as an important step into the direction of more rigorous ESG-related regulation. 

Other countries and regions are likely to look to Europe when thinking about how to design a workable taxonomy regulation, as the challenges that have driven the creation of the EU Taxonomy are the same throughout the world: we need more transparency around sustainable economic activities, we need to better benchmark firms’ sustainable activities, and we we need to prevent greenwashing.

It is too early to say whether there will be convergence among the taxonomies developed by different countries and regions, but one thing is for sure: they are here to stay… 

About the Author

Andreas Rasche is Professor of Business in Society and Associate Dean for the Full-Time MBA Program at Copenhagen Business School. More at: www.arasche.com. 

Photo by Krzysztof Hepner on Unsplash

Unaccounted Risk: The Case of Sulfur Hexafluoride (SF6) in Offshore Wind Energy

By Esben Holst & Dr. Kristjan Jespersen

◦ 5 min read ◦

Carbon accounting provides a science-based measurement of greenhouse gas (GHG) emissions, achieving greater accountability of companies’ emissions causing global warming. GHGs are reported in CO2 equivalents (CO2e), meaning GHGs with widely different chemical qualities and environmental impact can be presented in a single understandable metric. However, the underlying methodology is debatable. This article questions whether the CO2e of Sulfur Hexafluoride (SF6) is misreported.

What is SF6 and why is it a hurdle for a green energy transition?

SF6 is used as an insulator in a wide variety of electrical equipment, mainly to prevent fires in incidents of short circuits. It is found in transformers inside windmills, offshore and onshore substations, and in power cables.

(Illustration to the left shows a sideview of a windmill turbine – Source: CAT-Engines. Right: an offshore wind energy system – Source: Nordsee One GmbH)

SF6 is a synthetic man-made GHG and cannot be reabsorbed naturally like CO2, meaning once emitted, it does irreversible damage. Most GHGs remain in the atmosphere around 100 years – SF6 remains for 3,200 years. These numbers are given by the Greenhouse Gas Protocol (GGP) based on calculations by the Intergovernmental Panel on Climate Change (IPCC). 

The IPCC’s metric Global Warming Potential (GWP), reveals environmental harm of a given GHG in CO2e. What then, makes SF6 problematic when converted into CO2e? SF6 has a GWP 23,500 times higher than CO2 – a value that is difficult to comprehend. The GWP metric is calculated using a 100-year timeframe based on GHG’s environmental harm. Yet, SF6 has an atmospheric lifetime of 3,200 years, essentially leaving 3,100 years of environmental harm unaccounted for. Using a simple logarithmic function incorporating IPCC data accounting for the missing 3,100 years, the GWP almost doubles. As illustrated below, this indicates how SF6 may be misrepresented in terms of environmental harm in CO2e emissions reporting.

As found by AGAGE – MIT & NASA, other worrying trends are observed. The atmospheric concentration of SF6 has more than doubled in the past 20 years. Luckily, its current concentration in the atmosphere remains low relative to other GHGs such as Methane or Nitrous Oxide.

Source: AGAGE

Regardless, the GWP of these two GHGs pales in comparison to the mindboggling detrimental effect of SF6 on the environment. Emitting this gas should therefore be strictly regulated.

Greenhouse Gas Emissions Reporting – Diverging Approaches

It only takes a little digging into offshore wind energy players to uncover diverging conversion methods of SF6 into CO2 equivalents (CO2e). The GHG emissions reporting methodologies of industry leaders use different emissions factors to convert SF6 into CO2e. An example of underreporting is illustrated by Vattenfall in their 2019 sustainability report, reporting SF6 as 15,000 times more potent than CO2. The emissions factor given by the GGP is 23,500. Ørsted uses a GGP emissions factor for the same gas in their 2019 ESG report. Yet, while Energinet also states it uses the GGP reporting framework in their 2020 CSR report, it uses an emissions factor of 22,800. The ownership distribution between Vattenfall and Ørsted in the Danish wind farm Horns Rev 1 of 40% and 60% respectively, thus blurs accountability and severity of reported emissions. As highlighted by the BBC, atmospheric concentration of SF6 is ten times the reported amount by countries. The IPCC and GGP are also aware of this.

During the past decade…actual SF6 emissions from developed countries are at least twice the reported values. (Fifth Assessment Report of the IPPC)

Measuring Impact of SF6 Leaks by Offshore Wind Players

SF6 emissions will rise exponentially alongside expanding electrified energy infrastructure using equipment containing this gas. This, together with repeated SF6 leaks, perpetuates the worryingly steep upward trend in atmospheric content of SF6 shown above. In 2020, Energinet reported a leak of 763.84kg SF6, or 17,950,240kg CO2e. The environmental impact of this leak is about the same as the emissions of 53 SpaceX rocket launches. Energinet has since admitted to years of underreporting of SF6, leading to amended SF6 emissions related to normal operations doubling.

Leaks of SF6 are too common. In Ørsted’s 2020 ESG report, a major leak at Asnæs Power Station was mentioned without disclosing the actual amount – withholding important risk-related data from investors. However, Energinet disclosed an SF6 leak of 527kg at that same facility in their 2020 CSR report. The leak for which Ørsted is responsible, yet feels is not material to disclose, is therefore potentially around 12,384,500kg CO2e. Indicating light at the end of the tunnel, Vestas has included SF6 on their Restricted Materials list since 2017, as well as introducing a take-back scheme for infrastructure containing this gas – setting a better example for business models of our green energy transition leaders.

Strengthening the Global Response to Climate Change Risk

It is vital that we understand SF6 is so detrimental to fighting climate change beyond 2100 that it has no place in sustainable business models today. Even if CO2 emissions are reduced in alignment with 2100 Paris Agreement goals, reporting in a 100-year timeframe will not save a planet billions of years old. GHG reporting must be better regulated and scrutinised in order to deliver a truly green energy transition. Releasing a gas causing irreversible damage cannot be an acceptable trade-off for a short-term “green” transition. While most company reports claim no alternatives exist, this is not true. Therefore, SF6-free equipment must be mandatorily installed.

A green transition goes beyond 2100, yet poor regulation enables energy companies to present SF6-CO2e favourably by using lower emission factors. Offshore wind energy players have not provided comparable, accountable, and transparent reporting – indicating stricter regulations on GHG reporting are necessary.

The Way Forward: Better Regulation

In 2014, an EU regulation banned the use of SF6 in all applications except energy after lobbyists argued no alternatives exist. The EU acknowledges the environmental harm of SF6, yet EU action has been described as inadequate. Asset managers, institutional and retail investors are exposed to hidden environmental risks related to SF6 in terms of double materiality. Double materiality referring to the financial costs related to management of SF6 incurred once completely banned. Non-financial reporting of GHG emissions and CO2e needs to be regulated far more than current global regulations. Investors, society, and most of all our environment deserves better protection.

NOTE: This article is based on a Copenhagen Business School (CBS) research paper in the course ‘ESG, Sustainable & Impact Investment’ taught by Kristjan Jespersen – Associate Professor at CBS – as part of the newly introduced Minor in ESG. The paper questions the greenness of wind energy by using the case of three large offshore wind energy farms in Denmark: Horns Rev 1 & 2 and Kriegers Flak. The findings are based on ESG, sustainability & annual reports from 2015-2019 of all involved OEMs, manufacturers, operators, and energy grid providers. Implications of the findings point to a coming hurdle within the electrification of a global green energy infrastructure transition. 

About the Authors

Esben Holst, an SDG and CSR research intern at Sustainify, is a Danish-Luxembourgish masters student at Copenhagen Business School. Besides attending the newly introduced Minor in ESG at CBS, his past studies focus on international business in Asia and business development studies.

Kristjan Jespersen is an Associate Professor at the Copenhagen Business School. He studies on the growing development and management of Ecosystem Services in developing countries. Within the field, Kristjan focuses his attention on the institutional legitimacy of such initiatives and the overall compensation tools used to ensure compliance.

Photo by Karyatid on Unsplash

Aspirational talk for a challenging walk

Professor Mette Morsing takes over the UN PRME  

By Jeremy Moon

The CBS Sustainability Centre and the Department of Management, Society & Communication (MSC) recently held a Panel Discussion to farewell Mette Morsing as she becomes the new Head of PRME (Principles for Responsible Management) based at the UN Global Compact office in New York.

This is clearly a challenge. Mette will be a rare academic in a world of international officials. She will lead a small team that supports the PRME initiative. PRME is intended to transform business and management education through research and leadership. It consists of 800+ business and management schools that have signed up to implement six principles concerning responsible and sustainable business education.  

Of course, the 800+ schools reflect very different educational and business cultures, and may have very different understandings of responsible and sustainable business. Doubtless the schools have other concerns so they may prioritize these differently… not least in these troubled times.

So in order to help – as well as challenge – Mette, we designed the Panel around the question: “What Should Business Schools Know and Do about Sustainability?”  The Panel duly raised challenges for Mette, reflecting their various vantage points around business and management education. The Panel members were:

  • Lise Kingo, Independent Board Member and former CEO & Executive Director, United Nations Global Compact (by video)
  • Florence Villeséche, Co-Director of the Diversity and Difference Platform and Associate Professor at Dept. of Management, Politics and Philosophy
  • Gregor Halff, CBS Dean of Education
  • Caroline Aggestam Pontoppidan, Academic Director of CBS PRME & Associate Professor at Dept. of Accounting
  • Claus Meyer, food entrepreneur and Adjunct Professor at the Department of Management, Society & Communication.

Mette Morsing responded to the perspectives raised by the Panelists and other participants were drawn into the conversation. This covered a range of issues and approaches to the sustainability challenges:

From the role of the ethic of care for people in business, to the role of data in sustainability; from how to integrate and govern environmental, social and governance responsibilities to forms of business school engagement for sustainability; and of course, strategies for green transformations.

I was particularly struck by the way that Claus Meyer contextualized his own work in the state of the food business which he described as being characterized by greed, obesity and other recipes for ill-health, over-supply, and starvation among other things. So, Claus takes a big picture and identifies and develops his responsibilities in his bakeries, restaurants and philanthropic work in this light.

How should Deans of Business Schools regard ‘their business’?

On the one hand, they could refer to the market for business management education, demand and supply; vital assets; competitors and collaborators; the impact of and influence upon regulators. But what I get from Claus is the big picture thinking.

So should the Deans bring into their strategic thinking the circumstances from which their students come – and don’t come, and the state of the businesses that their graduates enter (the distributions, resource uses, the dominant values)?

Isn’t this what they need to know for understanding and developing their impact on sustainability?  Is this the logic of a stakeholder approach to sustainability?

OK, Jeremy this is just talk… but as Mette reminded us in one of her most significant papers, aspirational CSR talk may be an important resource for social change … and thus part of the walk [1]. So, my parting advice to Mette is to try and get Business School Deans to better understand and connect with their wider context in order to act for sustainability.

References

[1] L.T. Christensen, M. Morsing & O. Thyssen (2013). CSR as aspirational talk. Organization, 20(3), 372-393.

About the author

Jeremy Moon is Professor at Copenhagen Business School, Chair of Sustainability Governance Group and Director of CBS Sustainability. Jeremy has written widely about the rise, context, dynamics and impact of CSR.  He is particularly interested in corporations’ political roles and in the regulation of CSR and corporate sustainability.