The transition to a sustainable economy: why it is relevant to everyone

The thing about humans, says Kelly Sporn, senior policy advisor in A&O’s Environment, Climate and Regulatory Law Group, is “we’re not good at looking down the road. We’re geared to a short-termist point of view.”

“With the challenges posed by climate change, biodiversity loss and ecosystem degradation, we need to act now to prevent catastrophic consequences in the future.”

Until relatively recently, actions addressing ESG (environment, social and governance) and sustainability tended to be seen in many quarters as a corporate social responsibility issue. “That is changing,” says Kelly.

Companies now have to navigate a “complex plethora of sustainability developments” from every direction – from new regulations and soft policy requirements, to market-led changes, investor demands and stakeholder engagement. Along with a raft of internal experts, Kelly works with clients from a variety of sectors and geographies to help them do just that.

The term ‘ESG’ has been around for more than a decade. It was coined in 2005 by the United Nations Environment Programme Finance Initiative (UNEP FI) in its ‘Who cares wins’ report that encouraged investment in strategies with non-financial objectives. “It was effectively a product label,” says Kelly.

“For many, ESG has related to an ethical choice – what’s good for the broader community, the planet and society – rather than being focused on financial returns.”

In recent years, the policy debate has moved from a collection of non-financial objectives to focusing on specific sustainability goals. The shift was galvanised at COP 21 in 2015 by the adoption of the Paris Agreement, which aims to limit average global warming to no more than two degrees , and the UN Sustainable Development Goals (SDGs), which broadened the focus to other environmental issues and social issues.

The concept of climate financial risk was highlighted by the establishment of the Task Force on Climate-Related Financial Disclosures (TCFD).

It drew attention to the financial risks arising from increased physical risks caused by climate change, and the risks related to the transition to a decarbonised policy.

An example of climate financial risk can be seen with a house that is built on land increasingly subject to flooding due to changes in climate and extreme weather. This physical risk will translate into credit risk for the bank that is using the house as security for a home loan; it may also make insurance unfeasible for insurers. “TCFD has recast the narrative on climate change as a systemic risk to our economy,” says Kelly.

Beyond climate change

The policy focus has centred on climate action following the Paris Agreement, particularly since a report by the UN Intergovernmental Panel on Climate Change indicated that we have to make significant emissions cuts by 2030 in order to meet the Paris targets.

But climate change is not the only strand to sustainability. “Biodiversity loss and natural system degradation is occurring at an unprecedented rate,” says Kelly, “with animal species declining by more than 60% on average since 1970 and more than 75% of land being impacted by human expansion.”

The topic has been of concern for some time, and the equivalent to COP 26 for biodiversity, CBD COP 15, was held in China in October 2021. Events such as Covid-19 are throwing sharper focus on the issue, with evidence of a link between the loss of biodiversity and climate change and a rise in pandemics.

The social aspect of ESG constitutes a set of objectives in their own right, such as gender equality, decent work and quality education, but its relationship to the climate and environmental goals means the transition to net zero will affect how our whole economy works.

“If you don’t take into account the social impact, you potentially risk having not only stranded assets but stranded communities.”

All of this has to be underpinned by good governance: accountable, transparent and embodying stewardship. “Governance is shifting from being an objective in its own right to something broader underpinning environmental and social objectives,” Kelly says.

Capital directed toward the goal

Recognition of the issue is a start, but it’s only the start. The big question remains how to achieve the Paris Agreement’s targets for limiting global warming, when it will take an investment in the order of USD3-5 trillion per year, as estimated by the Global Financial Markets Association and Boston Consulting Group.

Kelly says: “Governments don’t have enough to do it on their own. Private capital will be needed to meet decarbonisation and other sustainability goals.”

Banking partner Kate Sumpter agrees the transition to a sustainable economy requires enormous investment and the financial sector, as an intersection for capital allocation, “will play a major role” in promoting sustainability and sustainable management.

PSL counsel Oonagh Harrison adds: “The vast majority of governments, policymakers and regulators around the globe recognise that the financial services sector, as important global economic players, must contribute to sustainability. The UK’s Treasury, for example, believes that financial services will have a bigger role to play in tackling climate change than any other sector.”

A number of global and national initiatives are driving the transition towards carbon neutrality. The sheer volume and overlapping nature of these initiatives mean that our clients face significant strategic and operational challenges.

Kate says: “Those institutions that can get their arms around the requirements are likely to benefit from the opportunities that will flow from the changes and we need to be suitably immersed in the technical detail of the requirements to help clients spot those opportunities.”

‘Competency greenwashing’

While many new rules and requirements have been focused on financial services, the importance of integrating sustainability into corporate governance and strategy is gaining more attention from policymakers. Kelly supports moves to prevent “competency greenwashing”.

“Boards need to ensure that they are being properly advised on what they need to consider regarding sustainability,” she says.

“Reading a few articles on sustainability isn’t a qualification for advising on it,” she adds. “It is a multidisciplinary field with an academic foundation. It requires a complex web of expertise that rarely resides in one person.”

She observes that businesses’ approach to sustainability tends to fall into two camps: those which react to external developments such as regulation and activism on a piecemeal basis and those which are making the sustainability transition the centre of their strategy.

Some businesses are still seeing ESG as a collection of non-financial or ethical considerations, and not everyone is affected by the rising tide of developments to the same degree...yet.

“We’re seeing a fundamental systemic shift the likes of which we’ve never seen. It’s bigger than the credit crunch of 2008. And what we’ve seen so far is just the tip of the iceberg.”

Sea change in structured finance

Sustainability-focused structured financings have recently moved from niche to mainstream in the market. These mirror the growing global focus on the sustainability of investments, and investor interest in human rights considerations.

“We are on the cusp of a sea change,” said Tim Conduit, London-based Capital Markets partner. “Sustainability awareness and compliance is becoming simply a matter of good governance and risk management.”

Key milestones in this trend were the 1999 creation of the UN Global Compact, the UN Principles for Responsible Investing in 2006, the UN Sustainable Development Goals and the UNFCCC Paris Agreement in 2015, and now, with its renewed focus on climate finance, the Glasgow Climate Pact from COP 26.

“Changing investor sentiment, greater regulation and increased litigation and shareholder activism in the human rights and environmental space worldwide over the past decade have combined with these global initiatives to create a snowball effect,” he said. The pandemic has further focused the minds of governments, regulators and investors on sustainability and pushed the ‘S’ in ESG to the fore.

Sustainable finance products are increasingly varied and innovative. “Although in the past investors tended to focus on green investments, we have now seen, for example, the issuance of ‘blue’ bonds – the marine equivalent of ‘green’ – and diversity bonds recognising (for example) gender-balanced corporate boards,” said Tim.

It’s a fast-evolving landscape, but the implications for the market are significant. In particular, he said, the adoption of a ‘green supporting factor’ – a controversial proposal to lower capital requirements for products based on their perceived sustainability – could create a seismic shift in the markets.

‘I think about livelihoods’

Economic transition is a classic ‘one size does not fit all’; Chris Bishop, a Banking and Finance partner based in Singapore, sees crucial differences that make the European approach less appropriate in developing economies where the bulk of his work is focused.

“When I think about transitioning the economy, I think about livelihoods,” he says.

While developed markets face a challenge of “sustaining the status quo”, he says, achieving a basic modern standard of living is the difficult task facing countries such as Indonesia, Vietnam and Thailand with their widely dispersed populations.

Low-carbon energy is a key consideration. China, Laos and Vietnam are all developing hydroelectric projects on the Mekong River and its vast basin. The quandary is how to limit the environmental damage caused by damming the river and tributaries.

Chris would like to see “a more nuanced conversation” with less focus on financing through transition and more focus on people. For example, a community that may be 15 years away from replacing its coal-fired power station with alternative sources of electricity should be able to refinance the coal-burner in the interim, as that is part of a successful and managed transition.

“I don’t think regulations as contemplated in Europe allow for that in the developing market. But that’s what transition means in Asia.”

Business community under the spotlight

“I can’t remember a time when corporates and the business community have been under such a societal, stakeholder and regulatory spotlight,” says Matt Townsend, partner and co-head of the International Environmental, Climate and Regulatory Law Group.

“Corporates now recognise that climate and other sustainability factors have the potential for major negative impacts on their business prospects.”

People are engaging more, he notes, but to what effect? Historically, the challenge to getting action has been finding the connection into the topic.

Public outcry over a company’s poor ESG behaviour can precipitate a temporary fall in share price, but there appears to be little widespread appetite yet to boycott products.

At the moment, the bigger pressure on corporates is coming from a regulatory and compliance shift with “a massive policy engineering exercise from governments and central bankers like [former Bank of England governor] Mark Carney to redeploy private capital for green and sustainable purposes”.

Investors are pushing for greater transparency and “meaningful” data, and there’s a “hard edge behind that on how they deploy their capital”.

He sees transparency becoming an important aspect of “product”: where a clothing brand’s cotton is sourced; how investment opportunities are detailed; or the husbandry policies of farms supplying meat to a steakhouse.

“In my view,” says Matt, “there’s still a massive education process to make sure we all have a long-term horizon.

“We can’t look at sustainability in the abstract; we have to look at wider human impacts. There has to be a recalibration.

“I think it will take time. We may get to a result that the end-buyer isn’t going to like.”

China ‘somewhat of a leader’

Banking and Finance partner Xue Wang has extensive experience working with Chinese companies, financial institutions and policy banks. She says “people are not wrong” in their assessment of China as a huge energy consumer, but often fail to appreciate the country “is somewhat of a leader in some aspects, especially on energy transition”.

Much of China’s policy focus now is on transitioning to more green, sustainable sources of energy. Under its Paris Agreement NDCs, China has committed to reach carbon peak by 2030 and net zero by 2060, and its commitment to reaching these targets is reflected in its latest five-year plan and throughout national and regional policies.

While the transition will be difficult, Xue believes “there’s a huge amount of energy and policy drive in the economy to make it happen.”

She says China already has a “substantial penetration” of renewal energy which goes largely unreported because there is little foreign investment and big plans for new mega-scale renewables projects in coming years as part of the plan to meet their Paris Agreement commitments. China is already the world’s third-largest market for offshore wind.

Japan is also seeing a drive to develop offshore wind, along with onshore wind and solar, to transition from its reliance on imported natural gas. Xue says, “a huge thing here is transitioning to hydrogen and ammonia. There’s a lot of talk not just in the transport sector but also in terms of introducing ammonia into the energy mix to decarbonize power generation.”