Development of ESG Standards Globally: Which Direction Will We Take?

Canada is developing a green taxonomy for ESG, loosely based on the proposed European Sustainable Finance Taxonomy, but with a greater reflection of the countries resource-based economy. Concurrently the International Standards Organization (ISO) is developing its own Sustainable Finance Technical Standards. Used together these may provide a better road map for international ESG than the northern hemisphere approaches currently being driven by the US or European financial institutions and regulators. Does this tell us anything about the way ESG governance may develop globally?

 In an article by Linklaters LLP, an international law firm based in London, the contrast between the development of ESG practices in the United States and the European Union was examined. Their article shines a light on the differences that are evolving from different jurisdictions.

 In America, the pressure on lenders to cascade ESG requirements to their clients is internal, driven by the big financial heavyweights like BlackRock (an American global investment management corporation with $7.4 trillion in assets under management).

 In Europe, the drivers are external – the EU is regulating and enforcing change through its Sustainable Finance and Climate Change Agenda. The EU Taxonomy Regulation is one of the key pillars of that Agenda and forms part of a wider package of sustainable finance legislation, the ultimate aim of which is to encourage investment flows from the financial sector to companies engaged in or transitioning to more sustainable activities. The goal is for the EU to become carbon neutral by 2050 and meet its climate change objectives. In particular, the EU taxonomy is designed to combat greenwash and help identify what is or is not sustainable. Read more about the EU Taxonomy here [link to EU Taxonomy blog below]

 This dichotomy makes sense from a cultural perspective but poses several interesting questions. First, which of these two approaches, if any, will gain the larger foothold? Will the rest of the world follow the EU and adopt their taxonomy, or will market forces prevail as the main driver? Or could we end up with different approaches across different countries when defining ESG?

Second, what are the implications in the interim as people maneuver through these different approaches? Will it affect international trade, possibly favoring some locations over others?

A clue as to what the future may hold can be found in Canada, clearly heavily influenced by what happens in the United States, but still culturally distinct and often EU-aligned via trade agreements.

The Standards Council of Canada (SCC) is working on a green taxonomy which is based on the EU version but is different in some important ways, reflecting Canada’s resource-based economy which is shaped by the extractive industries, most notably oil and gas.

Nationally, there is a growing awareness of the need to encourage the “transitional economy” to reduce dependency upon oil and gas, but at the same time, there is a vocal lobby in the hydrocarbon rich western provinces to preserve the income and benefits from the exploitation of oil and gas for as long as possible. Also, Canada has first-hand experience with how ESG concerns can lead to political trials and tribulations, causing significant delays and even cancellations of mega projects, as evidenced through the troubled Trans Mountain Pipeline project and the SNC Lavalin scandal. With these challenges it is easy to see why Canada did not just copy the EU taxonomy, as there are nuances that demand development of a process which is tailored to domestic needs. 

There are other reasons why the EU taxonomy may not travel well. It is very “dark green” and so aligning economic activities with its criteria may be quite challenging for many companies and sectors. It could be considered by some to be over-prescribed and bureaucratic. At this stage, it also focusses heavily on the “E” of ESG, with social and governance requirements still to be fleshed out. For other parts of the world the Social and Governance factors are as, if not more, important. Indeed, there is much discussion around whether the E, S or G has more influence on value, which should be the starting point of any discussion around the usefulness of the EU taxonomy and its potential to gain popularity from the markets.

At this juncture, one outcome may be the emergence of jurisdiction-specific taxonomies, the result of which could be nothing short of confusing. If one ponders what must go into formulating an international trade agreement, alignment of standards is obviously something that takes time and diplomacy. 

So, what are the implications for cross-border investment considering different standards for ESG?  There is a school of thought that the markets will determine what works. This may be the case, but once any taxonomy is adopted, reversing out of national standards, particularly those defined in regulations, takes time and effort because it is politically difficult.  So, if the market is too slow to force ESG in one direction or another, we may end up with a regulatory framework that is inconsistent with the direction being suggested by commercial forces.

It would seem, therefore, that there is a strong argument to be made for international collaboration on this issue. The ideal would be to co-create a taxonomy that maintains common themes with benchmark standards adopted for the most important issues, allowing for local variation where it is only truly necessary.

The good news? For now, this framework of standards plus local variation already exists to a limited extent within the UN Sustainable Development Goals (SDGs) and IFC Performance-Standards. They may not be the right tools in some, if not most circumstances, particularly for non-project related and small-scale finance.  The SDGs are quite broad, aspirational goals, rather than standards; and the IFC Performance Standards are not applied very much outside the project finance space. Though it probably is correct to say that those businesses who have endeavored to align their activities with existing international sustainability frameworks and standards (such as the SDGs and IFC PSs) may well have a head-start on others in terms of aligning themselves with any taxonomy criteria.

Certainly, clarity on ESG protocol moving forward would be welcome as the current situation is confusing and ripe for a shake-down. One possible light at the end of the tunnel might be coming from the International Standards Organization (ISO), as they work to develop their first draft of Sustainable Finance Technical Standards. They offer hope for both clarity and continuity. ISO standards are, of course, not laws and need commercial adoption, but this move toward global standardization will be useful to drive consistency.