Introduction
The phrase Environmental, Social and Governance (ESG) is everywhere at the moment. It is a C suite agenda issue and the market is flooded with diagnostic tools and reporting options. But what does “ESG” actually mean, and how is it relevant to the energy transition?
ESG is an umbrella term used to describe three key areas of importance when measuring the sustainable and ethical impact of a business. The Cambridge English dictionary tells us it is “a way of judging a company by things other than its financial performance”. So far, so vague. In fact, the meaning of ESG is continually evolving and along with such evolution, the impact on finance and the energy transition is constantly changing.
The “E” in ESG is more developed and relates to a company’s environmental performance, including GHG emissions, energy efficiency, resource management and environmental impacts. The “S” is less developed and includes human rights issues such as health and safety policies, working conditions, prevention of modern slavery/child labour, plus employee well-being, diversity and inclusion policies, charitable initiatives and engagement with the local community. The “G” includes a consideration of the corporate structure, Board composition, reporting lines, management systems, internal and external reporting, compliance records, procurement processes, investment decisions and management of supply chains.
Together, ESG is a broad ranging concept which is exercising Boards in how to collate, assimilate and report verifiable ESG data, how to use this in driving business forward and how to position themselves to seek investment/funding for projects which meet their ESG aspirations. How does this impact the energy transition?
Global initiatives and voluntary standards
The United Nations Framework Convention on Climate Change entered into force in 1994 with the aim of stabilising greenhouse gas (GHG) concentrations. However, it is only since the signature of the Paris Climate Agreement in 2015 at the 21st United Nations Conference of the Parties on Climate Change (COP21) that climate change and the imperative to decarbonise has moved into the mainstream of public and political consciousness. The Paris Agreement aims to limit global warming to well below a rise of 2, preferably 1.5, degrees Celsius, compared to pre-industrial levels. A global collective effort to decarbonise is required, with energy transition at its heart.
The UK was the first major economy to announce a commitment to reaching net zero by 2050, and has been joined by the US, Japan, Korea, the UAE and many others. Some smaller nations have committed to achieving this more rapidly, e.g. Finland is targeting 2035, whereas Russia, China, Saudi Arabia and a handful of others have also made commitments but are lagging behind, setting a 2060 target instead. In total, 137 countries have pledged to reach net zero, which between them cover 73% of global emissions, but so far only 66 have put a target year on their policies. Setting a goal is important but the real challenge is committing to that in law and making tangible progress towards it. To achieve these targets, rapid and widespread changes in policy, investment and behaviours will be required.
For nations to achieve a reduction in GHG emissions, enterprises which are domiciled in those countries will need to contribute to their efforts by decarbonising businesses and public sector initiatives, and different States are considering different ways to achieve this via regulation, financial incentives or voluntary guidance. However, it requires concerted efforts at a global level and a number of international bodies are leading the way, publishing various voluntary standards to guide business.
Financial institutions are increasingly recognising the need to take action and when the UN published a set of principles to guide responsible investing – the UN Principles for Responsible Investment (UNPRI) – in 2019, there were 132 founding members. There are now 290 signatories which is equal to 45% of the global banking sector (by assets) who hold total assets to the value of USD84 trillion. The UNPRI were developed by investors, for investors, to guide the incorporation of ESG issues into good investment practice, and can be broadly summarised as acting in the best interests of beneficiaries whilst giving regard to ESG principles. However, the principles are very high level and operate alongside more detailed guidance from the International Sustainability Standards Board (ISSB). The ISSB was established at COP26, and is an independent private sector body based in Frankfurt tasked with developing a comprehensive global baseline of sustainability-related disclosure standards that will provide investors with information about companies’ sustainability-related risks and opportunities to help them make informed decisions. The intention is that the standards, and the language used, will be aligned with the EU Taxonomy (see below) to enable investors to compare apples with apples, a problem which has long hampered corporate reporting in this area. The ISSB builds on the work of the Sustainability Accounting Standards Board, which focused on quantifying and reporting the outward ESG impacts and risks of an organisation's performance across 77 different industry standards, looking at profitability, potential liabilities and long-term impacts across a broad range of ESG perspectives (not just an environmental lens, as the name might suggest, but considering social and governance issues too).
Taken together, these global agreements and voluntary standards have had an impact on the thinking of investors, and have helped to drive interest in and commitment to offering sustainable finance for the energy transition.
How is ESG developing?
In the early stages, the focus for any capital earmarked for ESG investments was very much on the “E” aspect and today, the environmental side of ESG is well developed. There are a number of international environmental conventions, and prescribed regulatory frameworks in many jurisdictions, and well established ways of setting and measuring targets which will include demonstrated compliance with these laws, for example TCFD reporting (see below), UN Sustainable Development Goal alignment and science based target reporting initiatives.
Governance requirements, which underpin both the environmental and social aspects of ESG, are well developed and many voluntary codes of practice are being reviewed by governments with a view to making them mandatory. For example, in the UK in January 2022, two sets of Regulations were introduced requiring publicly quoted companies, large private companies and limited liability partnerships (LLPs) to make climate-related financial disclosures in their annual reports, and non-binding guidance was issued in February to assist companies and LLPs in understanding and complying with these new obligations.1 The regulations were based on the voluntary four-pillar framework established by the Task Force on Climate-related Financial Disclosures (TCFD), a body created by the international Financial Stability Board to improve and increase reporting of climate-related financial information and address how climate change might impact an organization's ability to create value. These four pillars represent core elements of how companies should operate – governance, strategy, risk management, metrics and targets – and are dealt with in the UK regulations by an obligation on companies to publish a Non-Financial and Sustainability Information Statement (for LLPs the information can be covered in an energy and carbon report within the Directors Report, or within a Strategic Report if one if published). Such statements/reports must disclose how climate change is addressed in corporate governance, the impacts on strategy, how climate-related risks and opportunities are managed, and the performance measures and targets applied in managing these issues.
The “S” of ESG, however, remain problematic. “Social purpose” is a fluid, vague term which can be more subjective than the principles of good environmental or governance practices, although many energy companies have long been aware of local content requirements such as training up a local workforce and technology transfer to host governments, and integrated these provisions into their project documents – policies which today would be capable of being classed as ESG-compliant. There is currently a focus amongst the international community on further developing the social aspect of ESG criteria, which can be witnessed in the passing of anti-slavery legislation in recent years (for example the Modern Slavery Acts in the UK in 2015, and Australia in 2018), the Transparency Act in Norway (which came into force in July of this year), and numerous reporting requirements being proposed across the EU. The most significant of these is the Draft Directive on Corporate Sustainability Due Diligence, which will impose mandatory human rights and environmental due diligence obligations on certain large EU businesses, as well as some non-EU businesses that do business in the EU single market. This provides that businesses must conduct due diligence to identify – and then cease or mitigate – the actual and potential human rights and environmental impacts of their operations, subsidiaries and business relationships in the value chain. As such, the Directive will enshrine in EU law binding due diligence requirements that draw heavily from the UN Guiding Principles on Business and Human Rights.2
Equator Principles
The Equator Principles (EPs) are a voluntary set of guidelines originally developed by the International Finance Corporation (an arm of the World Bank) and launched in 2003. Most recently updated in 20193, a matter on which Norton Rose Fulbright advised the Equator Principles Association, they provide a common framework for lenders to assess and manage the social and environmental risks and effects of a “Project” in recognition of the responsibility that financial institutions and their clients have to human rights and the environment when financing or running a Project. As of the start of July 2022, 134 financial institutions (the EPFIs) in 38 countries have officially adopted the EPs.
By incorporating the EPs within the terms of a loan, it helps to ensure that the Projects the institutions are financing are developed in a manner that is socially responsible, and reflects sound environmental management practices. A Project is defined as a development (including an expansion or upgrade) in any sector, with some common examples including power plants, mines, oil and gas development Projects, chemical plants, infrastructure development, manufacturing plant, large scale real estate development, real estate development in an environmentally sensitive area, or any other Project that creates significant environmental and/or social risks and impacts. EPFIs believe that the adoption of and adherence to the EPs offers significant benefits to them, their borrowers and local stakeholders through their borrowers’ engagement with locally affected communities. Adopters should be able to better assess, mitigate, document and monitor the credit and reputation risk associated with financing development projects. In the context of the energy transition, the early adoption of these principles (which today would be considered to represent “ESG” values) means that many of those seeking finance for energy projects are used to operating within a framework similar to the principles now in place for loans described as “green”, “social” or “sustainability-linked”. EP4 is the current iteration and a global team from Norton Rose Fulbright worked on the revision and update of EP4.
Sustainable finance and the energy transition
Many leading financial institutions have made public declarations in support of ESG principles. At COP26 the GFANZ4 initiative was announced comprising 450 member firms from the global financial sector representing USD130 trillion in assets under management pledge support for a net zero future. There are large amounts of ring-fenced capital looking for investment partners, which is good news for the energy transition. These are not small amounts – hundreds of billions are being set aside for sustainable finance in the form of loans, bonds and advisory work. For example, Societe Generale, a long-time investor in energy projects, has set a target to invest USD120 billion by 2023 in energy transition projects using a range of sustainable finance solutions (loans, bonds, advisory)5. Morgan Stanley has supported green, social, sustainability-linked and blue6 bond transactions valued at approximately $83 billion, with an overall target of USD 1 trillion7 for investment in projects that help prevent and mitigate climate change.
According to KPMG, virtually every large global bank has made some sort of commitment — both financial and otherwise: “What is notable about these announcements is not just the sheer size of the commitments. It is who is making the statements. The Goldman Sachs pledge was made by David Solomon (the global CEO). At the Bank of America it was the Vice Chairman of the global bank. The point is that the leaders are making ESG a CEO-level and Board-level mandate; they are elevating the issue to the highest levels of the organization.”
A growing number of lenders are offering loans which can only be used for ESG purposes (in keeping with their own ESG reporting requirements), opening up a wider pool of investors for project developers to approach. These products can be broken down into three main categories – green loans, social loans and sustainability linked loans. All of these might be suitable for energy transition projects, depending on the specifics of the project, leading to increased opportunities for funding. Green and Social Loans are similar in that they are both “purpose-based” – that is, the funds must be applied to specific “green” or “social” purposes, and the borrowers will need to demonstrate compliance with published standards such as the Green Loan Principles or Social Loan Principles (developed by a working party of representatives from leading financial institutions and supported by the Loan Market Association, the Asia Pacific Loan Market Association, and the Loan Syndications and Trading Association). To give an example of how these loans might help support an energy transition project, the developers of a combined solar and storage project could apply for a green loan (the purpose being clean energy and emission reductions), but when that project is in an emerging market and includes support for the local community as part of the project contracts, it could also be in receipt of a social loan. In August 2022, global energy and electricity provider Iberdrola announced a new EURO 550 million green loan agreement with the European Investment Bank to help fund the development of a portfolio of wind farms and photovoltaic parks in Spain, with a projected capacity of 1.8 GW. Other examples where green loans may play a role might be large-scale, long duration energy storage for renewables to help solve the intermittency problem (i.e. avoiding the need for fossil fuels as baseload), investment in electrolytic hydrogen production, or perhaps industrial carbon capture and storage projects, or CCS which facilitates a low carbon hydrogen project during the transition phase.
In contrast, sustainability-linked loans are loans which are structured in order to incentivise the borrower to achieve pre-agreed sustainability-linked targets (commonly known as Sustainability Performance Targets) (the SPTs) and support environmentally and socially sustainable economic activity and growth by offering a margin reduction if those targets are achieved. The borrower’s performance in achieving the agreed SPTs is measured through selected sustainability Key Performance Indicators that can be external and/or internal. To help achieve standardisation and enable borrowers to compare products, sustainability-linked loans are based on Sustainability Linked Loan Principles (SLLP) again developed by the working party mentioned above. In an energy transition context, examples of SPTs include reducing GHG emissions and improving energy efficiency, but these targets must be “ambitious and meaningful”. The SLLPs detail that SPTs should be “ambitious” in that they should (i) represent a material improvement in the respective KPIs and be beyond a “Business as Usual” trajectory; (ii) where possible be compared to a benchmark or an external reference; (iii) be consistent with the borrower’s overall sustainability/ESG strategy; and (iv) be determined on a predefined timeline, set before or concurrently with the origination of the loan. These loans can help progress the energy transition, albeit on a smaller scale, by incentivising individual companies to improve their carbon footprint within their operations and throughout their supply chains.
A well-structured, well-documented renewable energy project could benefit from any one of these types of loans and, providing such projects can prove their bankability in the long-term, the effect of an increase in ESG investments can only be a good thing for energy transition projects seeking investors, particularly those in well-developed sectors such as the wind and solar industry. Hurdles remain for the development and financing of “green gas” projects, such as hydrogen or ammonia production, but these relate to issues around stimulating demand and scaling-up of transport infrastructure, rather than production itself. Methane, of course, is more problematic – recognised as a transition fuel, but still a fossil fuel with high levels of GHG emissions. However Russia’s invasion of Ukraine has highlighted energy security as a key issue, and now methane (along with certain nuclear activities) is set to be included within the EU’s list of officially sanctioned decarbonisation investments as part of its EU Taxonomy (see below), due to come in to force at the start of 2023.
Mirroring the language used in the loan markets, the International Capital Markets Association (ICMA) has recently published voluntary process guidelines for issuing green, social, sustainable or sustainability-linked bonds within the frameworks of the Green Bond Principles, Social Bond Principles, Sustainability Bond Guidelines and Sustainability-Linked Bond Principles, with the aim of standardising the bond market and developing the role that debt markets can play in funding new and existing projects with environmental and social benefits. However green bonds have been around for many years – for example, ENEL has issued green bonds since 2017 using the Green Bond Principles to fund green projects including projects for the development of renewable generation plants, the construction and management of transmission and distribution networks, smart metering systems, the development of sustainable mobility projects, and demand response initiatives.8
Green, social and sustainable bonds are all purpose-based instruments where the proceeds will be exclusively applied to eligible environmental or social projects, whereas sustainability-linked bonds can be used for general corporate purposes and are tied to sustainability objectives of the issuer. It is green bonds which are of most relevance to financing the energy transition as many renewable energy or energy efficiency projects will fit the criteria. The ICMA principles provide useful guidance to the market and have been readily applied, with USD 1 trillion in value of green bond issuances in 2021. In May of this year, the Japanese government announced9 plans to issue 20 million yen (approx. USD 157 billion) in “green transition” bonds to help finance investment in clean energy, with Prime Minister Kishida calling for the need to shift to a carbon-neutral society from one dependent on fossil fuel, and no doubt more announcements will follow from other big importers looking to diversify supplies, particularly in light of the instability facing oil and gas markets since Russia’s invasion of Ukraine.
At the end of January this year, BloombergNEF issued its investment trends report10 which reported that global investment in the energy transition totalled a new record of USD 755 billion in 2021, a rise of 27% from 2020, attributing this to rising climate ambition and policy action from countries around the world. Geographically, China and the US were the big hitters, investing USD 266 billion and USD 114 billion respectively, plus the EU as a bloc made investments which total USD 219 billion. It is clear that the funding is being made available, and for the right projects, with the right regulatory and policy frameworks in place, there will be a growing amount of potential capital available which shows no sign of slowing down.
What is the EU Taxonomy and how is it relevant?
The EU has set a target of climate neutrality by 2050. In order to facilitate sustainable investment in projects that will help achieve this, it has introduced the Taxonomy Regulation, which is intended to guide investors on the types of economic activities which can be considered environmentally sustainable via a unified classification system, and also to prevent “greenwashing” by companies of their activities. The Regulation sets out a “green taxonomy” which establishes criteria for determining whether an economic activity qualifies as environmentally sustainable for investment purposes. Using detailed criteria that each “green” investment must meet – such as emissions limits or energy efficiency – the taxonomy aims to make climate-friendly projects more visible and attractive to private capital, and help guide and encourage investment from the financial sector to companies engaged in or transitioning to more sustainable activities. It also aims to stop organisations from overstating their environmental credentials.
The regulation also obliges companies based in the EU to report their level of taxonomy-aligned activities. In order for green or sustainability-linked loans to be branded as “Taxonomy aligned” they must be used for/substantially contribute to one of the six environmental objectives identified by the regulation: climate change mitigation or adaptation, the sustainable use and protection of water and marine resources, prevention/control of pollution, protection and restoration of biodiversity and healthy ecosystems, or the transition to a circular economy. Clearly, energy transition projects will meet a number of these objectives.
Recently, and somewhat controversially, plans to expand the scope of the regulation to include gas and nuclear investments within the group of financing activities which can be labelled as “green” rather than “transition” activities have been approved, although this will be subject to certain conditions. This was highly controversial and criticised by green lobby groups and NGOs. However it highlights a growing pragmatism that in order to meet climate change targets, traditional energy companies will be needed to move the energy transition onward.
The role of carbon markets
Voluntary carbon markets are growing at pace – for example, at COP26 in November 2021, the London Stock Exchange announced plans to develop a market offering to support publicly traded carbon funds, and is working on developing a new market solution to accelerate the availability of financing for projects that will support a just transition to a low-carbon economy. The goal would be to address two major challenges: access to capital at scale for the development of new projects that reduce or remove carbon worldwide; and primary market access to a long-term supply of high-quality carbon credits for corporates and investors.
It is important to note the role of voluntary carbon markets here, and to distinguish them (along with mandatory emissions trading schemes) from ESG investment. Carbon markets certainly help facilitate the decarbonisation agenda of many countries and companies, by offering credits for projects focussed on emission reduction or removal, but these are not necessarily energy transition projects – rather, they are projects either undertaken or invested in by big emitters, as a way of counter-balancing the emissions of an energy intensive project. While renewable energy projects can be eligible for carbon credits, such as the Bokhol Senegal Solar Project11, most projects tend to be nature-based solutions such as reforestation or afforestation, restoration of peatlands (for carbon storage) or improving access to clean, safe water (thereby removing the need to boil it and reducing the associated emissions). Some are projects that would not otherwise be profitable such as a direct air capture project. Where emissions trading schemes are targeting a reduction in emissions overall rather than providing investment in the energy transition, carbon markets are playing an important role in bridging the gap where the technology does not yet exist to remove emissions completely by creating a value for climate projects. Providing the net in the net zero, if you will.
Energy security or energy transition – why can’t we have both?
This time last year, the public mood seemed to be very much against any kind of ESG investment in more traditional oil and gas projects. BlackRock, most famously, announced a divestment of thermal coal investments and the launch of new funds which would screen fossil fuels in early 2020, and going further said in a letter to its investors “one of the most important questions we will face is the scale and scope of government action on climate change, which will generally define the speed with which we move to a low-carbon economy… While government must lead the way in this transition, companies and investors also have a meaningful role to play… Investors are increasingly reckoning with these questions and recognizing that climate risk is investment risk.”12
The perhaps more pragmatic assertion that fossil fuels remain an essential and resilient part of the mix and required continued investment to decarbonise during the energy transition fell on deaf ears in some quarters. Tragically, it has taken the Russian invasion of Ukraine to stimulate rational debate on the role of gas, in particular, during the transition and in light of the need for resilient and reasonably priced supplies. With governments struggling to balance ethical considerations (not buying Russian oil and gas) with providing energy to their populations, whilst scrambling to boost investment in renewables and fast track legislation and fiscal policies to encourage the private sector to join them, the discussion on the role of hydrocarbons during the transition has moved centre stage. The inclusion of certain gas and nuclear activities within the EU Taxonomy (as “green” activities), CCUS-enabled gas projects now accepted as a valid use of ESG capital, and more ESG-branded funds investing in the energy majors means that ESG investments can really help to increase the pace and scale of transition. This change of mood is reflected in recent reports of shareholder voting behaviour. Again looking at BlackRock, the Financial Times reported that “by this year’s annual meeting season support for US shareholder proposals on environmental and social issues fell by nearly half, voting for just 24 per cent of them” and the picture was the same at State Street Global Advisors, where “support for environmental and social proposals … fell from above 25 per cent last year to roughly 20 per cent this year”.13 It is clear that we are entering a more pragmatic period where funds must not be directed from those seeking to make the transition happen, but must be directed and invested to make that change happen on an acceptable basis, which is where ESG reporting will be essential.
Looking ahead to COP27
In early November of this year, Egypt will host the 27th UN Climate Change Conference (COP27). The priorities have been announced as climate finance and climate adaptation and there will be a drive for technological and financial support to be provided by the wealthier nations to developing economies, as pledged at COP26, when developed countries undertook to raise at least USD100 billion in climate finance per year. With a focus on finance, this could be a win for energy transition projects.
Conclusion
There is clearly a need for policy makers to balance energy security and resilience of supply against the extreme climate situation. Developed economies need a resilient energy supply to weather the impending forecasts of global recession and inflating price rises, and developing nations urgently need the provision of clean energy supplies alongside investment to enable adaptation. Firm action must be taken by the heaviest polluters to decarbonise quickly. Given the current cost and supply challenges in global energy markets, there needs to be an integrated approach and restricting access to capital is likely to be harmful.
A combination of mandatory reporting requirements, standardised assessment criteria applied on a global scale, and the huge amount of capital committed to ESG funds are all positive steps which can only be of benefit to the energy transition. There are great opportunities for renewable and low-carbon energy projects to secure funding, scale up and start delivering the clean energy we all so desperately need. The direction of travel is set, and there can be no turning back. There is a role for energy companies to play in ensuring a just transition, but to do so will need a concerted effort from governments, policy holders, financiers and energy companies to deliver that change – and they will need to be held to account for the progress made. The future depends upon it.
This article was initially published for Gastech Conference 2022
