How enhancing ESG scores can boost climate finance

ESG has taken a lot of heat recently. Between the ire it elicits from US Republicans, and ongoing disagreements about assessment models, you could be forgiven for thinking it was falling out of favour. In reality, ESG related funds continue to see strong interest, with $26bn flowing into them in Q1 of this year, according to Refinitiv Lipper data.

PwC estimates that ESG-related assets under management will reach $34tn by 2026 or roughly $1 in every $5 under management globally. This dynamic has been driving markets in recent years, with MSCI estimating back in 2020 that the difference in the cost of capital between the highest ESG bucket and the lowest was almost 0.5%. It’s becoming increasingly expensive for corporates to ignore.

ESG ratings are purposefully broad. They are designed to measure the non-monetary performance of a business. A key issue this poses is the lack of a consistent metric; how is a unit of biodiversity traded off against gender diversity? While these challenges are well documented and heavily debated, they have not stopped the continued adoption of ESG in the market.

ESG ratings provide the best proxy for climate action

Indeed, for an investor looking for a single metric to assess a corporate’s alignment with net zero, ESG ratings arguably offer the closest measure, and have broad availability across different markets. While regulation is evolving to tackle the lack of standardised reporting of climate action, it remains some way off providing a consistent metric with comparable coverage to ESG.

ESG ratings currently provide the best proxy for climate action in the market and are increasingly driving capital flows. For this reason, it is critical that they are made to work a lot harder.

At present, ESG ratings providers cover most elements of a corporate’s emissions over time but still miss out on several key parts of the picture. Few, if any, provide information on ‘beyond value chain’ actions. None provides a meaningful assessment of the quality of carbon credits used towards a corporate’s climate claims.

The point here is important: the most influential non-monetary metric in markets is not capturing the full extent of companies' climate performance.

This may not be surprising. Carbon credits are complex and cannot be simplified into a single unit. The diversity of climate solutions underlying each one means they need an ongoing risk assessment to gauge how they compare to a corporate’s liabilities.

This is a key area in which carbon ratings can add value, in assessing both individual projects and overall carbon credit portfolios.

Corporations should approach their climate strategy in the same way that they approach their treasury functions. The bigger they are, the more sophisticated they need to be and the more important diversification becomes. This is applicable to internal decarbonisation, decarbonising supply chains and contributing to beyond value chain decarbonisation via carbon credits.

Markets trade on risk and carbon markets are no different

Ensuring all these elements are fully captured in ESG scores will enable market pricing to do more of the heavy lifting. Markets trade on risk, and carbon markets – which sit at the core of thousands of businesses’ ESG strategies – are no different. Ratings facilitate a better risk evaluation of individual projects and overall carbon credit portfolios. The carbon element of a corporate’s environment score must assess total emissions and carbon credits – both individually and in aggregate – ensuring both are aligned with top down targets. In turn, ratings encourage companies to manage the risk of their carbon credit portfolios in a more informed way.

Climate leaders will be recognised by the market with a lower cost of capital, while laggards will be penalised.

In conclusion

Market mechanisms have a key role to play in tackling climate change. There is a tidal wave of capital ready to be put to work investing in climate solutions. We must build active and vibrant markets in order to unleash them, with robust information and tools to enable efficient pricing and risk allocation. ESG ratings must work harder to enable this. Including independent carbon ratings offers a powerful way to support this process.

This article is also published on BeZero. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability & Energy writers, their opinions do not necessarily represent those of illuminem.