ESG Essentials for Corporates: The environmental angle #1 - Green commitments and green legislation

While businesses already have had to comply with environmental law and regulations for the past 25 years governments started expanding their climate change policies considerably since 2015, when 195 countries signed the Paris Agreement, committing to ambitious climate action.

Jargon buster

Paris Agreement: The Paris Agreement marks the most comprehensive and binding initiative, instructing all signatories to put forward their best efforts – the so-called nationally determined contributions (NDCs) – to keep the global temperature rise this century well below 2oCelsius above pre-industrial levels, and to pursue efforts to limit the temperature increase even further to 1.5oCelsius.

GHGs: Greenhouse gases trap the sun’s heat, causing the global average temperature to rise and resulting in changes to our climate.  GHGs include carbon dioxide, methane, nitrogen oxide and chlorofluorocarbons.

SDGs: In 2015, all United Nations members adopted 17 Sustainable Development Goals as part of the 2030 Agenda for Sustainable Development, a blueprint to achieve an inclusive, sustainable and resilient society and planet.

Emissions intensity:  Emission intensity is the volume of emissions per unit of gross domestic product (GDP). Reducing emission intensity means that less pollution is being created per unit of GDP.

CCC: The Committee on Climate Change is an independent, statutory body established under the UK Climate Change Act 2008 with the purpose to advise the UK and devolved governments on emissions targets and to report to Parliament on progress made in reducing greenhouse gas emissions and on preparations to help with adaptation to the impacts of climate change.

EPE: Environmental protection expenditure constitutes company spending aimed at reducing the environmental impact of business operations.

Paris Agreement highlights need for more stringent national climate policies

The global scale of the Paris Agreement and its GHG emissions reduction targets haven’t only led to more than a doubling in countries – from 70 to 160 – with climate policies in place, but have also firmly put the focus on accelerating national climate policy development.

While only certain provisions of the Paris agreement are legally binding – such as the requirements to maintain successive NDCs and to report on progress in implementing them – and there are no penalties for non-compliance, countries are expected to take ownership of achieving the deal’s targets.

With estimates showing that GHG emissions have to decline globally by about 40% – from 50 billion tons to around 30 billion tons in 2030 – in order to limit the increase in the global temperature to below 2oC, policy makers are up against the challenge to change corporate and public behaviour sufficiently to reduce their national emissions intensity on average by more than 4% per year.  Historically, the most effective climate change policies have improved average annual emissions intensity by less than 2% – these numbers indicate the need to fill the green policy gap and firm-up existing regulations.

From Climate Change Act to Environment Bill – the UK’s policy approach

While companies in the UK have had to comply with a set of domestic environmental rules – covering pollution, waste management and recycling, water management, hazardous substances and conservation and biodiversity issues – for decades, the UK’s Climate Change Act in 2008 marked the worldwide first, legally binding national framework for tackling climate change.

Two key aspects of the Climate Act were: 1) the introduction of “carbon budgets”, set every five years, which put limits on the amount of GHG the UK can emit; and 2) setting-up the Committee on Climate Change (CCC), an independent panel of experts advising the government. The Act led to the implementation of numerous new policies with the purpose of reducing emissions across a wide range of sectors.

In June last year, the UK went one step further, enshrining zero-carbon emissions into law, the first G7 nation to do so. Apart from accelerating the cut of GHG emissions in order to achieve the Paris Agreement targets, a major motivation for the new law was the CCC’s estimate that drawing down emissions to net-zero would still keep costs at 1-2% of the country’s GDP each year until 2050, the same cost bracket that had been calculated for the less ambitious Climate Act goals.

Lastly, to establish a new framework for environmental governance once the UK leaves the EU, the government introduced the Environmental Bill in January this year, which sets out even more stringent measures on air quality, protection of landscapes, wildlife, waste and water management. Annual costs from measures required by the Bill are estimated to total £220.7 million, with businesses facing the lion’s share; approximately £196.6 million.

The European Green Deal – the EU’s climate policy path

Going back to the early 1990s, the EU’s climate policy development was shaped by a number of considerations. EU policy makers wanted to avoid national policy differences, which could cause distortions of the EU’s internal market, improve energy security and increase the EU market’s competitiveness through green modernisation.

Despite various challenges to unify climate policies of its member states, the EU became a driving force behind international climate agreements:  In the negotiations on the Kyoto Protocol in 1997, the EU proposed the deepest emission cuts and accepted the highest reduction target among the major industrialised countries (-8%).

Fast forward to 2019 when the European Commission presented its European Green Deal, aiming for zero net GHG emissions by 2050, restoring biodiversity and decoupling economic growth from resource use by moving to a new, circular economy.  To ensure funding is in place to achieve its ambitious goals, the Green Deal provides three sources of funding under the “Just Transition Mechanism”:

  1. a Just Transition Fund with €7.5 billion of fresh EU funds, 2) a dedicated just transition scheme to mobilise up to €45 billion of private investments ,and 3) a public sector loan facility with the European Investment Bank to mobilise between €25 and €30 billion of investments.

To underpin and make the European Green Deal legally binding, the European Commission proposed a European Climate Law in March this year.

Disclosure on environmental protection as part of the EU’s NFRD

As part of the European Green Deal, the European Commission committed to complete a review of its Non-Financial Reporting Directive (NFRD) in the fourth quarter of 2020, which has now been moved the first quarter of 2021 due to the pandemic.

The EU introduced the directive to help investors, consumers, policy makers and other stakeholders to evaluate the non-financial performance of large companies and encourages these companies to develop a responsible approach to business. It requires the disclosure of non-financial information, such as reports on the policies businesses implement in relation to environmental protection, and diversity information to be published in the annual reports of large public-interest companies with more than 500 employees, from 2018 onwards.

Looking ahead - the EU Taxonomy

The EU Taxonomy is one of the most significant developments in sustainable finance and will be a key policy, if not the most wide-ranging policy for investors and issuers. While its focus is on helping companies to access green financing to improve their environmental performance, the performance thresholds the taxonomy introduces can help any business to identify which of its activities are already environmentally friendly.

Under the EU Taxonomy, environmentally sustainable activities must:

  1. Make a substantive contribution to one of six environmental objectives or be enabling transitional activities. The six environmental objectives are:
  • Climate change mitigation
  • Climate change adaptation
  • Sustainable use and protection of water and marine resources
  • Transition to a circular economy
  • Pollution prevention and control
  • Protection and restoration of biodiversity and ecosystems

       2. Do “no significant harm” to the other five environmental objectives, where relevant;

       3. Meet minimum safeguards, including OECD Guidelines on Multinational Enterprises and the UN Guiding Principles on Business and Human Rights.

Financial market participants and companies will be required to complete their first set of taxonomy disclosures, covering activities that substantially contribute to climate change mitigation and adaptation, by 31 December 2021.

We’ll be looking at the elements of the EU taxonomy and how they impact businesses in the Sustainable Finance articles of our “ESG Essentials for Corporate” series.

Fiscal and monetary stimulus measures turning greener

The Green Finance Measures Database, a library of policy and regulatory measures across 60 developed and developing countries, implemented by public authorities, including governments, central banks, financial regulators and public financial institutions, counted 391 national and sub-national policy and regulatory measures in place by the end of 2019, with nearly 80 new measures announced between January and October last year.

Apart from green regulations, what are the key measures in the governmental (and the public’s) green toolbox?

Fiscal stimulus measures

Companies of any sizes, as well as other organisations and private households can benefit from a plethora of environmental grants and other funding in the EU, with further country-specific green grants available, too. In the UK, the GOV.UK business finance and support finder provides an overview for environmental grants as do specialist sites such as GRANTFinder and Grants Online, offering databases of local, regional, national and EU-wide environmental schemes.

The activities of the Directorate-General for Environment (DG ENV) are financed mainly through the LIFE programme, the European Union’s €3.4 billion programme supporting environment, biodiversity and nature throughout the Union, and through the European Maritime and Fisheries Fund for marine environment projects. In addition, a growing number of foundations are handing out environmental grants: In 2016, 87 foundations in Europe approved 4,093 grant applications, totalling €583 million (PDF). Similarly, in the UK, The Environmental Funders Network is a network of over 170 foundations, family offices and individual donors supporting environmental causes of start-ups, smaller businesses and other organisations.

At the same time, rather than adding new environmental subsidy or grants programmes, governments are starting to green existing subsidies, demanding environmental practices from subsidy benefactors in order to continue receiving funding. The UK government, for example, announced in January this year that it plans to change the criteria for its annual £3 billion agricultural subsidy budget:  Farmers will obtain funding not simply for cultivating land, as currently under EU law, but for delivering “public goods”, such as sequestering carbon in trees or soil or planting pollinator-friendly flowers.

Green(er) recovery packages

Post COVID-19, there have been widespread calls globally to integrate green elements into pandemic recovery packages, or even entirely ‘greening’ fiscal stimulus programmes. Governments faced similar expectations in the wake of the 2007-08 global financial crisis; and hence, the green stimulus programmes implemented more than a decade ago can provide useful lessons for the design of current green stimulus efforts. 

At that time, components of rescue packages included renewable electricity production, building retrofits, efficiency technology upgrades as well as incentive schemes for low-carbon vehicles (such as scrapping schemes), energy network expansion and investments in green transport infrastructure and clean energy research. China launched the largest single green stimulus programme after 2008, spending almost $100 billion for rail infrastructure development in the country. The €200 billion strong European Economic Recovery Plan in 2008 and the separate European Energy Programme for Recovery, worth nearly €4 billion, came with a substantial green stimulus, including measures to improve energy efficiency and boost innovation in clean technologies.

Evaluations of the various green tools within the stimulus package after the financial crisis showed that, overall, green stimuli in Europe and the US only contributed temporarily to an increase in GDP between 0.1-0.5%, however, there’s evidence that energy efficiency programmes for buildings, vehicle scrappage schemes and the introduction of smart meters helped to significantly cut carbon emissions since 2008.

Post COVID-19, the EU leaders agreed on an overall budget of US$2.1 trillion/€1.824 trillion, which includes the 2021-2027 budget of €1.074 trillion, and an additional recovery plan, “Next Generation EU” of €750 billion. For the first time, the EU stipulated that part of the budget, 30%, should be allocated to climate-related projects and advancing the energy transition; measures include doubling the annual renovation rate of the existing building stock, support for cities and companies in updating their vehicle fleets with low-carbon options, and, in this context, installing one million electric vehicle charging points in the EU, compared to less than 200,000 today.

Green monetary stimulus measures

Central banks, collaborating in the “Central Banks and Supervisors Network for Greening the Financial System”, are involved in many international working groups aimed at enhancing the pricing of climate change and transition risks and promoting the financial flows towards sustainable investment products.  However, a growing number of market observers as well as central bank members themselves, are calling for central banks to ‘practice what they preach’ and incorporate green principles into their own activities, in particular their asset purchasing programmes (APPs) .

If central banks started to buy green assets for their asset portfolios, they would significantly propel green investment volumes: The European Central Bank (ECB) alone spends €20 billion monthly on its assets buying programme, nearly as much as the monthly average of €23.5 billion in clean energy investments globally in 2019. And questions have also been raised about a possible green component of the €750 billion Pandemic Emergency Purchase Programme (PEPP), agreed in March this year.

Amidst on-going discussions amongst central banks, with some arguing that their institutions shouldn’t “address topics outside their primary remit”, Christine Lagarde, head of the ECB, has confirmed that the “discussion on whether, and if so how, central banks and banking supervisors can contribute to mitigating climate change is at an early stage but should be seen as a priority”, while also pledging to “continue to look at …how the ECB can be an actor in this.”

Green taxes

Environmental taxes, designed to tax corporate and private behaviour that is harmful to the environment, are another crucial element of countries’ efforts to transform to zero-carbon societies. Environmental taxes, which cover energy, transport, pollution and resource, amounted to £51,678 billion in the UK last year, with almost three quarters coming from energy taxes.

In the EU, environmental tax revenue amounted to €324.6 billion in 2018, accounting for 6.0% of total government revenue from taxes and social contributions (TSC) and 2.4 % of the EU GDP. Between 2002-18, environmental taxes grew by 49% (€107.0 billion) in nominal terms, however, over the same period, the share of environmental tax revenue in total government TSC revenue decreased by 0.6 percentage points, from 6.6% to 6.0%.

Against this backdrop, and with UK revenues from environmental taxes only ranging in the middle of all EU countries, calls here have become louder to rethink the current structure of environmental taxes in order to more strongly discourage harmful environmental behaviours and to align the green tax system with the government’s  environmental objectives.

Tax experts are advocating for a radical approach, which could bring green considerations into mainstream tax, and as such, for example, offer lower corporation tax rates for 'environmentally friendly' companies and lower income tax even for employees of these companies. They also recommend making environmental taxes more visible, pointing to the fact that taxes can only act as an agent of change if businesses and consumers are much more aware of the overall level of environmental taxation they’re exposed to unless they adapt their environmental practices. One way could be to apply different VAT rates for foods and other products depending on their environmental impact.

While it will be a tricky task to determine what an environmentally-friendly business looks like and to retrieve the necessary data to apply environmental impact scores to products, the first step towards a darker green UK tax system has been made: The Chartered Institute of Taxation (CIOT) is currently in the process of forming a climate change working group to consider the implications of climate change for UK tax policy.

The role of the courts

Private climate litigations started to gain momentum in 2005 and were mainly concentrated in the United States. However, this first generation of green lawsuits didn’t see much success for the plaintiffs due to the lack of sufficient evidence of the causal links between climate harm and corporate conduct. In recent years new climate change science and the historical Paris Agreement – with national climate change policies being introduced in its wake – have brought the fight against global warming back into the courtrooms, and have increased the likelihood of positive outcomes for the plaintiffs.

Prominent climate change advocates, such as former NASA scientist James Hansen, US economist Jeffrey Sachs, director of the Earth Institute at Columbia University, or dedicated green legal groups such as ClientEarth have fuelled this second wave of lawsuits, urging citizens to pursue major polluters and negligent governments for liability and damages and to demand the right to a safe and clean environment.

This year, ClientEarth won two cases against energy company Enea, resulting in the firm suspending financing and construction of a new coal plant in Poland, and in May, ClientEarth lawyers launched a legal challenge against the German government to increase air pollution reduction measures.

Whether being held accountable or acquitted, companies finding themselves in the courtroom for alleged green breaches will in any case face legal costs, reputational damage and heightened public scrutiny as well as pressure to disclose climate change risk. Furthermore, company executives may be directly sued for breach of their fiduciary duties and obligations to consider and disclose climate change risk.

Turning environmental compliance into business opportunities

UK businesses spent an estimated £2.5 billion on environmental protection in 2017, compared with £2.1 billion in 2016, and costs for environmental compliance will further increase with the Environmental Bill. The majority, 70%, of environmental protection expenditure (EPE) by UK businesses relates to operating expenditure (OpEx), which accounted for £1.8 billion and £1.6 billion in 2017 and 2016 respectively.

So, are green compliance costs negatively affecting the competitiveness of businesses, in particular in countries with ambitious climate policies? A number of studies have given a clear answer and delivered further evidence that the well-known ‘induced innovation’ hypothesis holds true: More stringent policies trigger greater investment in innovations; in this context pollution-preventing, clean technologies, which in return can offset compliance costs as well as reduce other production costs.

And the effects of climate policies are reaching even further, starting to transform companies and markets, with companies acknowledging that they need to take a more proactive stance in seizing business opportunities that arise while taking the necessary steps to comply with environmental regulations.

Developing “greener” products and services that help enter new markets and target new customer groups, streamlining supply chains to reduce transport emissions and changing material sourcing to equally lower the carbon footprint and manufacturing costs present just a few options for corporates to improve their top- and bottom line.

A survey of senior executives in key industries confirms the positive green sentiment: The majority stated that the impact of environmental regulation on the competitiveness of their business is positive overall, and compliance costs are more than offset by gains in improved quality, performance and competitiveness or are absorbed in some other way within their business models.

In our next article of this series we’ll further outline the business case for corporate environmental action.

Key elements of the Environment Bill for businesses

  • Establish a new independent Office for Environmental Protection to scrutinise environmental policy and law, investigate complaints and take enforcement action against public authorities.
  • Introduce charges for a number of single use plastic
  • Introduce powers that require producers to take more responsibility for the products and materials they place on the market, including when they become waste, introducing a consistent approach to recycling, tackling waste crime, creating powers to introduce bottle deposit return schemes and having more effective litter enforcement.
  • Introduce a power to stop the export of polluting plastic waste to less developed countries.
  • Set an ambitious, legally-binding target to reduce fine particulate matter.
  • Mandate that manufacturers recall vehicles and machinery when they do not meet the relevant environmental standards.
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