Over the last three years, we have faced growing regulation in the sustainable investment industry. More recently, this regulation has shifted from an emphasis on disclosure to more specific definitions and thresholds. We also see investors and sustainability certifications, such as the ISR Label, taking similar steps.
This approach makes sense in its application; it is not feasible for an outsider to assess each and every investment, so rules need to be applied that a third party can check and verify. However, for active investors who evaluate companies on a case-by-case basis, these rules may be overly restrictive. The unintended consequence may be the exclusion of companies that are attractive financial investments and highly impactful from a sustainability perspective.
A good example of this is the ESMA name rule, which will come into full effect in May 2025. To include certain terms in a fund’s name, sector and activity exclusions need to be applied. If you want to include ESG or any ‘environmental’ term in the fund’s name, the fund must adhere to the exclusions of the Paris-Aligned Benchmark, originally designed by the EU for benchmarking purposes. One of the required exclusions is:
“Companies that derive 50% or more of their revenues from electricity generation with a GHG intensity of more than 100 g CO2e/kWh[1].”
The motivation behind these rules is understandable; a fund marketed as environmental, social, or sustainable must qualify how it meets these characteristics. However, this 100g threshold is based on what is required within the EU to meet its decarbonization targets and excludes any fossil fuel-powered generation. It does not account for the agreed and required trajectories in other countries, which may result in the exclusion of companies operating well within the national commitments to the Paris Agreement in their respective countries.
The rule also fails to consider the nuances of different companies. How do we compare a company with 45% fossil fuel-powered electricity production and no intention to decarbonize further against a company with 51% fossil fuel-powered electricity production but a significant and rapid decarbonization plan? What about comparing a company with 51% coal-powered electricity generation to one with 51% natural gas-powered electricity generation?
For example, at Quaero Capital, we recently reviewed the US utility sector to analyze whether companies in this sector align with our own net-zero commitments and exclusion policies, as well as how they are evaluated under the ESMA name rules.
NextEra, one of the US utilities, would need to be excluded by a fund wanting to include ‘ESG’ or other environmental terms in its name. NextEra is one of the largest developers of renewable energy in the US and globally. Historically, the company relied heavily on fossil fuels, but it is now retiring these as significant investments in renewables are being added to the grid.
As shown through the Transition Pathway Initiative (TPI) tool, NextEra already operates well below the carbon intensity required to meet the 1.5°C target of the Paris Agreement. Despite retiring all coal- and oil-fired power plants, the company still operates significant natural gas power plants alongside its renewable energy sources.
Source: https://www.transitionpathwayinitiative.org/sectors
The Transition Pathway Initiative tool, a valuable collaboration between asset owners, asset managers, the London School of Economics (LSE), and the Grantham Research Institute on Climate Change and the Environment, maps a company’s committed emission reduction plans against the required decarbonization pathways for its sector and geography, according to the Sectoral Decarbonization Approach created by CDP, WWF, and the WRI in 2005. The main source of data for these scenarios is the International Energy Agency.
The output is an assessment of whether a company is doing enough and has sufficiently committed to decarbonize. It is a respected and useful tool for assessing how well a company is managing its transition.
Based on this assessment and our own understanding of the company, we disagree with the notion that NextEra is not impactful, environmentally focused, or low ESG risk simply because more than 50% of its revenue comes from fossil fuel electricity generation. We are, therefore, concerned that new regulations will require excluding this company from ESG or environmentally focused funds.
This type of rule encourages investors to focus on younger companies that are 100% dedicated to renewable technologies, rather than older companies undergoing a significant and costly transition. Both are critical for the overall energy transition, and capital should not be encouraged to favor one over the other.
Market reactions over the last quarter suggest another unintended consequence: investors may simply move their money out of funds required to track the Paris-Aligned Benchmark (PAB) and into the less restrictive Climate Transition Benchmark (CTB). This could, in turn, lead to changes in fund names, away from terms requiring adherence to the PAB and toward terms that fit the CTB.
Regulation is essential and has played a vital role in curbing greenwashing and hype within the industry in recent years. However, as active managers in this field, we support maintaining the freedom to think critically about what belongs in an ESG or sustainable fund.
[1] https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32020R1818&from=EN