Climate Change and Incentivizing Private Investment

Edward B. Aparis |

Even as climate change and environmental issues become increasingly salient in contemporary public discourse, regulation of the private sector remains one of the toughest pieces of the policy puzzle. What can be done to get the private sector to align itself with the United Nations (UN) Sustainable Development Goals (SDGs), and what incentives can policy-makers offer?

In this brief study, we will examine the idea of utilizing a new framework for investors in the private sector to help realign private sector companies’ priorities towards the SDGs, particularly Goal 13: Climate Action, associated with the issues of climate change.

We will examine only Goal 13 and focus on the role of the private sector investor reporting requirements in developed countries, using the United States as one example. In examination of this situation, we will aim to provide insight on how policy makers can nudge or drive the realignment of the private sector towards the SDGs, such as Goal 13.

Even though there are other equally important related topics that need to be examined, such as Goals 15 and 16, the role of regulation by government in “Public Private Partnerships” (PPP), “Small Medium Enterprises” (SMEs), and the role of “Nationally Appropriate Mitigation Action” (NAMA) plans in developing countries, the focus will be kept narrow for the following reasons:

• Goal 13 substantially highlights the role of “developed country parties” in garnering a substantial amount of funds to meet its targets

• The expansion of the Sustainable Development Goals to include private sector indicates the need to focus on private sector parties, especially from the developed world

Background

In 25 September 2015, the United Nations General Assembly through its member countries adopted the Sustainable Development Goals that aimed to “end poverty, protect the planet, and ensure prosperity for all”. The “17 SDGs”, as they are known, introduced a new “sustainable development agenda” that aimed to encompass civil society, the private sector, the “individual”, as well as the government sector.

The SDGs became the successor agenda to the “Millennium Development Goals” (MDGs) that were part of the UN Millennium Project that aimed to address multiple dimensions of poverty, hunger, disease, inadequate shelter, and exclusion. The MDGs also raised and promoted issues of gender equality, education, and environmental sustainability. As predecessors to the current sustainable development agenda (i.e. SDGs), the MDGs targeted quantified deliverables, with 2015 being the initiative’s deadline. These targets included social and economic disparities, gaps between rich and poor households, and disparities between rural and urban populations.

To a certain degree the successor sustainable development agenda, the SDGs, are an expansion of the predecessor MDGs. Yet, what makes the SDGs distinct is the expanded focus into areas that include spatial (urban) development, economic consumption and production, supply chain, energy, climate change, conservation and sustainable use of the oceans, as well as, land degradation and biodiversity loss, just to name a few.

Goal 13: Climate Action

Under SDG 13 (i.e. Goal 13), taking urgent action to climate change and its impacts, prioritizes climate change as a key prominent issue for upper, middle, and lower income countries, as well as the larger sustainable development agenda. This was solidified in 12 December 2015 in the adoption of the Paris Agreement at the UN Climate Change Conference Paris 2015. Coming into force on 4 November 2016, signatory countries agreed to work towards limiting the rise of global temperatures below 2 degrees Celsius and to strive towards 1.5 degrees Celsius. The implementation of the Paris Agreement, through the UN Framework Convention on Climate Change (UNFCCC), now serves as the primary vehicle for Goal 13.

Among one of five Goal 13 targets, the commitment of “developed country parties” plays a vital role, which is the joint mobilization of at least $100 Billion USD annually by 2020 undertaken by these parties from “all sources”. These mobilized funds are aimed to address developing countries’ needs towards creating effective (“meaningful”) mitigation actions and transparency on implementation. Also, the full operationalization of the “Green Climate Fund” through its capitalization is also critical to the successful implementation of Goal 13.

What is interesting about Goal 13 is the role for private sector participation in being a source for financial flows and investment. From the SDG perspective, private and public financial flows and investment is seen as going “hand in hand”. The role for private sector and the creation of incentives to stimulate these financial flows and investments from “all sources” (e.g. investors) are critical for long term sustainability and managing with the magnitude or amount of funds required that goes beyond government sector resources.

Even earlier reports before ratification of the Paris Agreement, reports by UNFCCC, calculated between $200-210 Billion USD annually for mitigation measures alone to return global greenhouse emissions to acceptable levels by 2030. Suffice to say, private sector participation is necessary for Goal 13 to be fulfilled and implemented.

There are important tools that policy makers can utilize in creating the incentives for private sector entities to align their roles and motivations with SDGs, especially for Goal 13. It is the general premise for Goal 13 to create incentives for the private sector to infuse the necessary financial flows and investments into mitigation measures and frameworks, such as the Green Climate Fund, which serves as the primary financial vehicle for the UNFCCC and hence for Goal 13. Policy makers can delve into the mechanisms and tools at their disposal to incentivize the private sector.

“Environmental, Social, and Governance” (ESG)

There is an accepted trend and growing interests among financiers, investors, and CEOs towards the idea of shifting capital into developing economies tied to practices and themes of “environmental, social, and governance” (ESGs), as well as, sustainability and long-term thinking. The premise is rooted in the concept of shifting capital into developing economies that translate into profits which in fact can translate into sustained economic growth, social inclusion, and environmental protection in the long run. ESGs has been increasingly adopted into the reporting cycle and business models of companies on an individual non-mandated voluntary basis. To a certain extent, the investment into a developing economy for a large transnational company is better served in long term sustainable practices that can yield continuous profits and stave off non-financial risks.

Already, private sector companies’ (i.e. CEOs) sentiments have recognized that solving “societal challenges as a core element in the search for competitive advantage” is essential. Despite the intangible quality of ESGs and how it may not translate to traditional risk and investment assessments of viability or profitability, there is an emerging sentiment among investors “across the board” of understanding, as well as, the reporting of a companies’ non-financial disclosures to “inform and underpin” their investment decisions. This goes along with the demand for non-financial reports where data that highlights “environmental, social and economic sustainability” is disclosed, according to an Ernst & Young report published in 2015.

Stranded Assets

Investors’ interests of ESG information is significantly motivated by the increase frequency of “stranded assets” and the risk involved with such a situation. A stranded asset is defined as something that has become obsolete or non-performing well ahead of its useful life and recorded as a loss of profit, according to the Grantham Research Institute on Climate Change and the Environment at the London School of Economics. The “obsolete” condition of an asset, for example fossil fuels, may lose its value to the investor (e.g. shareholder) of a company devoted to the extraction, refining, and distribution of fossil fuels, as well as, using fossil fuels as production inputs. This value loss can be caused by several factors such as a societal shift towards renewable energy, government regulations limiting fossil fuels, and climate change legislation. Profit loss of such assets can have serious repercussion to individual investors, hedge funds, and banks, as well as, asset management institutions tied to pension funds or universities, just to name a few examples.

Stranded Assets

There is a growing concern from investors regarding stranded assets which has increased investor demand for non-financial reporting of risks and data associated with ESGs, since environmental, social, and governance risks could impact a company’s current business model in the near or long term future in terms of government regulation or even societal shifts towards other forms of energy, just to name a few.

Aligning priorities: ESG framework and the SDGs

The investor fear of the stranded assets which can impact a company’s value finds some common ground in relation with the SDGs’ mission and values, especially Goal 13. There are already efforts being conducted between the United Nations and private sector entities to create platforms financing SDGs. This is particularly important for Goal 13, as well as, other SDG endeavors that require large scaling up of investment that public sector cannot provide alone.

Policy makers can take measure to respond to investors’ needs and demands for ESG reporting frameworks and effectively align such investors preferences with SDGs, such as Goal 13. Given the magnitude of the task in effectively coordinating ESGs and SDGs, policy makers are in the position to implement a new ESG framework that aligns with the SDGs. From the investor perspective, such mandated reporting frameworks already meet their growing sentiment of having non-financial, ESG information and data. Investor preferences for such reporting of companies, once mandated by policy makers, can require companies to report on non-financial data, risks, and information, creating the incentive for such companies to realign their business and financial priorities with the SDGs while addressing the growing concern for investor demands.

Policy makers can mandate such rules and reporting requirements on financial and asset-management institutions (i.e. investors) and those institutions in turn can provide positive incentives to private sector companies to realign their interests towards SDGs through an ESG framework.

Integration of ESG considerations could help investments outperform expectations given the growing investor preference of ESG / non-financial reporting. ESG frameworks, once aligned with SDGs, can attract substantial amounts of capital from the private sector and finance SDG initiatives, such as Goal 13’s Green Climate Fund. What is key for policy makers is to establish transparent and “sound data” measures for an ESG framework to be effective in aligning and attracting investors. Having such sound data and transparent information is essential in promoting progress for investors to be aligned with SDGs.

In other words, an investor needs (as required by business and financial disclosure requirements enacted by policy makers) to know whether their company is aligning towards the goals of the SDGs, through comprehensive reporting that combines the traditional financial information and non-financial reporting (e.g. environmental, social, governance, and other sustainable matters - ESGs).

Example: U.S. Securities and Exchange and Requirements for Disclosure – Concept Release and Public Comment

Since Goal 13 specifies the role of developed country parties, it is essential that policy makers in developed countries pursue these measures in order for Goal 13 to be successful. Such measures have been initiated in the United States through the US Securities and Exchange Commission (SEC) in garnering public comment concerning the disclosure of non-financial information that extends to sustainability and mitigation of risk reporting.

In terms of the SEC, sustainability disclosure encompasses a range of topics, including climate change, resource scarcity, corporate social responsibility, and good corporate citizenship. In regard to the SEC’s concept release document of such proposed reporting requirements, these topics often are characterized broadly as environmental, social, or governance, which fall under the ESG framework.

The public comments provided to the SEC concept release document of including ESG framework type of disclosure requirements yielded insightful perspectives for other policy makers to potential design a policy to incentivized and align private sector parties to SDGs. It was noted by the SEC report and public comment that there was a considerable number of commentators with a growing interest in ESG disclosure from investors, some recommended a further expansion of the proposed reporting requirements around ESG, while others noted that the current regime of reporting is primarily voluntary and hence a standard requirement by the SEC can resolve information gaps and resolve inconsistencies between private sector entities that pursue such reporting on their own incentive.

A lot of the comments that favored required standard ESG reporting noted that mitigation of risk was the top priority, particularly in deciding on investing on potential companies that are not transparent in their information.

On the other end of the debate in terms of the SEC concept release document was that some if not a considerable number of commentators opposed the mandatory disclosure of sustainability risks and did not see the connection between the “societal issues” and “investor protection” in periodic filings. Many noted in this camp that they see the value of such reporting of information but did not understand how they are connected to a company’s financial performance. There was also a concern from the same camp that a push on the SEC to have such information required to be disclosed served special interests by having “federal securities law” to address non-financial/social concerns.

In the duration of the SEC garnering public comment, issues of climate change and the lack of information associated with stranded assets and regulatory risk emerged. Some commentators suggested the SEC to adopt a “new line-item” disclosure requirement for climate change matters. The specified interests to address stranded assets seemed to be reflected in many studies by financial and asset management institutions and perhaps indicate a growing real concern of investors.

Conclusion and Recommendations: Lessons from the SEC public comment process

There are polarizing camps surrounding the SEC concept release document regarding the proposed requirement for business and financial disclosure of non-financial information that correspond with a ESG framework, as well as, the issue of climate change. The lessons yielded from the public comment process revealed that there is a growing segment of private sector investors, ranging from individual investors to asset management institutions, which have growing concern and demand of information from companies in certain sectors that impact directly climate change to be open and transparent on the profitability of their products/goods and production inputs that may devolve into stranded assets, hence, losing value to the investor.

Policy makers can utilize the current investor sentiment as an opportunity to shape business and financial disclosure laws that can incorporate an ESG framework that meets Goal 13 of the SDGs. Of course, re-modifying such disclosure laws may differ from one developed country to the next, but overall, there is a growing investor preference for such information to be disclosed from their companies, where an ESG framework that corresponds to Goal 13 can be integrated and utilized.

Original Authorship Date: 10 April 2017

Re-posted: 2 February 2019

Updated: 4 March 2019

For referenced sources, please contact the author.

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