By Dr. Ingrida Kerusauskaite, Portfolio Lead, Anti-Corruption and Illicit Financial Flows, Palladium
Environmental, social and governance (ESG) criteria have been gaining prominence in recent years, as investors increasingly focus on other metrics beyond profit. For example, in the United States, investors by the end of 2019 were considering ESG factors “across $17 trillion of professionally managed assets, a 42 percent increase since 2018”.1
The E part of the equation recently received a boost through the COP26 (2021 United Nations Climate Change Conference), with countries and companies pledging to do more to limit climate change. This resulted in more than $130 trillion of finance being committed by the financial sector to “transform… the economy for net zero” over the next 30 years.2 A range of other major finance initiatives focus on transforming the financial sector by mainstreaming and scaling climate-related reporting, climate-risk management and climate-related investment returns.3 Nevertheless, even these pledges are considered insufficient to limit global warming to 1.5 degrees; however, countries are set to reconvene at the end of 2022.4
In this article, I argue that companies should build on recent commitments to environmental action by adding anti-corruption commitments alongside environmental ones, which would help them deliver on social and governance goals and achieve environmental pledges.
ESG is gaining momentum, but challenges in ESG ratings remain.
Significant challenges exist in measuring how well companies are doing on ESG, which means that a company can be rated as market-leading by one rating agency, only to receive low scores by another. For example, Monica Billio and colleagues5 observed how Nissan Motor Company received a low score from Sustainalytics and MSCI while being rated among the best by RobecoSAM and Refinitiv; they noted that the discrepancies were largely due to the former two agencies focusing on the firm’s management of their exposure to ESG risk. RobecoSAM, on the other hand, placed more weight on the environmental dimensions in the automotive industries and awarded Nissan for its cleantech-innovation work.
Some of the reasons behind different agencies providing conflicting ratings include varying definitions of ESG and what its elements consist of, meaning that rating agencies use different variables to measure each of the E, S and Gcomponents. For example, Refinitiv considers three categories under governance—CSR (corporate social responsibility) strategy (themes reviewed are CSR strategy and ESG reporting and transparency), management (structure—independence, diversity and committees—and compensation) and shareholders (shareholder rights and takeover defences).6 In contrast, MSCI considers two key themes: corporate governance (including ownership and control, board, pay and accounting) and corporate behaviour (looking at business ethics and tax transparency).7
Furthermore, ratings agencies assign varying weightings to the different issues and variables considered, depending on their own assessments of the materiality of risks and opportunities overall or in specific industries. Also, different data sources (for example, publicly available information or direct-approach questionnaires) and time horizons are used to measure and score each element.
Nevertheless, ESG mainstreaming can bring significant additional benefits to companies, including preparing for potential disruptions in their business-as-usual work (for example, needing to phase out environmentally harmful practices) and demonstrating to their shareholders and the public their abilities to manage complex ESG-related changes and programs within the company, which can also be put to use to pursue other company goals.
“Tagging on” anti-corruption
The COP26 led to several public and private organisations committing to do more to tackle climate change and environmental degradation. I invite you to consider the environmental commitments of one organisation and the potential to build on these to enhance anti-corruption and integrity measures. The ECB (European Central Bank) committed to focusing on three milestones relating to climate, as below.
The ECB’s environmental commitments
First milestone: Paving the way with reliable data
1. We will gather data needed for climate change risk analyses
Climate-related policies and measures depend on reliable data. That’s why we work on new indicators that help to assess banks’ carbon footprints. We will look at how to measure their vulnerability to climate-related physical risks and will work to improve our indicators, in line with progress at the EU level on environmental sustainability disclosure and reporting.
2. We will adapt our models and make them fit for climate change
Macroeconomic models are at the heart of our analyses and decisions. We will enhance our models to better take into account the effects of climate change. This will help us to assess the impact of climate change and related policies on the economy, on the financial system and on how our monetary policy feeds through to people and businesses.
The first milestone could very well apply to enhancing data on anti-corruption. Challenges, of course, exist—corruption tends to be more political within organisations, and there can be hesitation to report on incidences of it.
Measuring progress on reducing corruption is challenging, and indicators have to be carefully considered. For example, if the number of reported cases of crime increases in a given period, it could mean different things: anti-corruption mechanisms are working better and are well enough designed to identify corruption; people trust in the whistleblowing system and feel confident to report; or, indeed, corruption levels are going up.
Nevertheless, academic scholarship and investment in anti-corruption are resulting in new indicators being developed (for example, the recently updated Index of Public Integrity [IPI] and the Transparency Index [T-Index] developed by Professor Alina Mungiu-Pippidi of the Hertie School). Collaboration with researchers and anti-corruption specialists could help design better data-collection methods.
The ECB’s environmental commitments (continued)
Second milestone: Knowledge is the driving force
1. We will check our own exposure to climate risks
We will be carrying out stress tests of our own balance sheet in 2022 to check how exposed it is to climate risks.
2. We will check firms’ and banks’ exposures to climate risks
Our economy-wide climate stress test that was conducted in 2021 showed that the costs to banks and companies of adapting swiftly to green policies are much lower than the costs of doing nothing and dealing with severe natural disasters in the future. In 2022, we will carry out a separate supervisory climate stress test of individual banks to figure out how well they are prepared for climate risks that might materialise.
3. We will make disclosure of climate risks a priority
To effectively assess climate risks and how they could affect us as well as banks and businesses, we need to know much more about those risks. That’s why we will introduce climate-related disclosure requirements for using private sector assets as collateral in our monetary policy operations and for our private sector asset purchases. We will announce further details in 2022.
4. We will review how credit ratings reflect climate risks
Ratings provided by credit rating agencies are a key tool to understand the overall riskiness of assets. Therefore we are checking how ratings agencies include climate risks in their ratings. Additionally, we will consider developing minimum standards to ensure that those risks are consistently included in our own internal assessments.
Third milestone: Action based on reliable data and best knowledge
1. We will include climate risks in our collateral framework
We will consider climate risks when evaluating assets that banks want to use as collateral to get loans from us. This means that assets with higher climate risks could be treated differently than assets with lower climate risks. We will keep supporting innovation in the area of sustainable finance. Since the beginning of 2021, we have accepted certain sustainability-linked bonds as collateral and for our asset purchases.
2. We will make our asset purchases greener
We will further include climate-related criteria when guiding our corporate asset purchases. This could include looking at how issuers are complying with the Paris Agreement or how they are committed to similar goals. Additionally, as of 2023, we will start disclosing climate-related information on our corporate asset purchases.
No organisation is immune to crime, and ensuring that staff are aware of the potential ways their organisation could be exploited for illicit activities is essential. This includes assessing the corruption risks of working with supply chains and other partners globally. Many of the approaches taken to mitigate climate-change risks could be adapted to understanding and confronting corruption risks.
Conclusion
Environmental and climate-change-related factors have been gaining the public’s and investors’ attention, and frameworks are being put in place. While commitments do not always translate into action—this will require sustained focus—the trajectory is positive. An added focus on anti-corruption can directly bolster corporate-governance-related ESG metrics, helping companies achieve their other ESG and broader goals.
Concentrating on anti-corruption and integrity initiatives can not only boost social and governance commitments but also realize environmental goals. This can happen by reducing leakage in environmental initiatives and bolstering the robustness of reporting on environmental indicators.
References
1 US SIF: Trends Report 2020 Executive Summary: “Report on US Sustainable and Impact Investing Trends 2020.”
2 GFANZ (Glasgow Financial Alliance for Net Zero): “Amount of finance committed to achieving 1.5°C now at scale needed to deliver the transition,” November 3, 2021.
3 UN Climate Change Conference UK 2021 in Partnership with Italy: “Glasgow Financial Alliance for Net Zero’s COP26 Statement,” November 3, 2021.
4 World Resources Institute (WRI): “COP26: Key Outcomes From the UN Climate Talks in Glasgow,” Helen Mountford, David Waskow, Lorena Gonzalez, Chirag Gajjar, Nathan Cogswell, Mima Holt, Taryn Fransen, Molly Bergen and Rhys Gerholdt, November 17, 2021.
5 Corporate Social Responsibility and Environmental Management: “Inside the ESG ratings: (Dis)agreement and performance,” Monica Billio, Michele Costola, Iva Hristova, Carmelo Latino and Loriana Pelizzon, September 1, 2021, Volume 28, Issue 5, Pages 1426-1445.
6 Refinitiv: “Environmental, Social and Governance Scores from Refinitiv,” February 2021, Page 10.
7 MSCI: “MSCI ESG Ratings Methodology, Executive Summary,” MSCI ESG Research, December 2020.
8 European Central Bank (ECB)/Eurosystem: “What’s our roadmap to greening monetary policy?” 2022.