Handbook of Sustainable Finance

Thierry Roncalli

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Distributed under a Creative Commons Attribution 4.0 International License
Handbook of
Sustainable Finance

Thierry Roncalli

Université Paris-Saclay
Copyright © 2022–2024 by Thierry Roncalli

<figure><img src="image_2.png" /></figure>

This book is published under a CC BY license (Creative Commons Attribution 4.0 International License)

https://creativecommons.org/licenses/by/4.0

This version: October 6, 2025.
# Contents

<table><tr><td>Contents</td><td>vii</td></tr><tr><td>Preface</td><td>ix</td></tr><tr><td>List of Symbols and Notations</td><td>xi</td></tr><tr><td>Abbreviations</td><td>xix</td></tr><tr><td>1 Introduction</td><td>1</td></tr><tr><td>1.1 Definition</td><td>1</td></tr><tr><td>1.2 Short history of responsible and ethical investing</td><td>2</td></tr><tr><td>1.3 The ESG ecosystem</td><td>6</td></tr><tr><td>1.3.1 Sustainable investment forum</td><td>7</td></tr><tr><td>1.3.2 Initiatives</td><td>7</td></tr><tr><td>1.3.3 Regulators</td><td>13</td></tr><tr><td>1.3.4 Reporting frameworks</td><td>18</td></tr><tr><td>1.3.5 Rating agencies and data providers</td><td>25</td></tr><tr><td>1.4 Regulatory framework</td><td>28</td></tr><tr><td>1.4.1 EU taxonomy regulation</td><td>33</td></tr><tr><td>1.4.2 Climate benchmarks</td><td>36</td></tr><tr><td>1.4.3 Sustainable finance disclosure regulation</td><td>36</td></tr><tr><td>1.4.4 MiFID II and sustainable preferences</td><td>38</td></tr><tr><td>1.4.5 Corporate sustainability reporting directive</td><td>39</td></tr><tr><td>1.5 The market of ESG investing</td><td>42</td></tr><tr><td>1.5.1 ESG strategies</td><td>42</td></tr><tr><td>1.5.2 The market share of ESG investing</td><td>45</td></tr><tr><td>1.6 Conclusion</td><td>48</td></tr><tr><td>I ESG Risk</td><td>51</td></tr><tr><td>2 ESG Scoring</td><td>53</td></tr><tr><td>2.1 Data and variables</td><td>54</td></tr><tr><td>2.1.1 Sovereign ESG data</td><td>54</td></tr><tr><td>2.1.2 Corporate ESG data</td><td>65</td></tr><tr><td>2.2 Scoring system</td><td>75</td></tr><tr><td>2.2.1 ESG and scoring theory</td><td>76</td></tr><tr><td>2.2.2 Tree-based scoring methods</td><td>77</td></tr></table>
<table><tbody><tr><td>2.2.3</td><td>Other statistical methods</td><td>93</td></tr><tr><td>2.2.4</td><td>Performance evaluation criteria</td><td>93</td></tr><tr><td>2.3</td><td>Rating system</td><td>112</td></tr><tr><td>2.3.1</td><td>Definition</td><td>112</td></tr><tr><td>2.3.2</td><td>ESG rating process</td><td>113</td></tr><tr><td>2.3.3</td><td>Rating migration matrix</td><td>117</td></tr><tr><td>2.3.4</td><td>Comparison with credit ratings</td><td>131</td></tr><tr><td>2.4</td><td>Exercises</td><td>132</td></tr><tr><td>2.4.1</td><td>Score normalization when the features are independent</td><td>132</td></tr><tr><td>2.4.2</td><td>Probability distribution of an ESG score</td><td>134</td></tr><tr><td>3</td><td>Impact of ESG Investing on Asset Prices and Portfolio Returns</td><td>137</td></tr><tr><td>3.1</td><td>Theoretical models</td><td>138</td></tr><tr><td>3.1.1</td><td>An introduction to modern portfolio theory</td><td>138</td></tr><tr><td>3.1.2</td><td>ESG risk premium</td><td>151</td></tr><tr><td>3.1.3</td><td>ESG efficient frontier</td><td>169</td></tr><tr><td>3.2</td><td>Empirical results</td><td>178</td></tr><tr><td>3.2.1</td><td>Equity markets</td><td>178</td></tr><tr><td>3.2.2</td><td>Fixed-income markets</td><td>199</td></tr><tr><td>3.3</td><td>Cost of capital</td><td>209</td></tr><tr><td>3.3.1</td><td>Cost of equity</td><td>209</td></tr><tr><td>3.3.2</td><td>Cost of debt</td><td>213</td></tr><tr><td>3.3.3</td><td>The case of sovereign issuers</td><td>217</td></tr><tr><td>3.4</td><td>Exercises</td><td>227</td></tr><tr><td>3.4.1</td><td>Equity portfolio optimization with ESG scores</td><td>227</td></tr><tr><td>4</td><td>Sustainable Financial Products</td><td>229</td></tr><tr><td>4.1</td><td>ESG mutual funds</td><td>229</td></tr><tr><td>4.1.1</td><td>Regulation</td><td>230</td></tr><tr><td>4.1.2</td><td>Sustainable labels</td><td>246</td></tr><tr><td>4.1.3</td><td>The market of ESG funds</td><td>257</td></tr><tr><td>4.2</td><td>Green and social bonds</td><td>266</td></tr><tr><td>4.2.1</td><td>Green bonds</td><td>267</td></tr><tr><td>4.2.2</td><td>Social bonds</td><td>281</td></tr><tr><td>4.2.3</td><td>Other sustainability-related instruments</td><td>285</td></tr><tr><td>4.3</td><td>Sustainable alternative assets</td><td>287</td></tr><tr><td>4.3.1</td><td>ESG private equity and debt funds</td><td>292</td></tr><tr><td>4.3.2</td><td>Sustainable infrastructure</td><td>294</td></tr><tr><td>4.3.3</td><td>Sustainable real estate</td><td>296</td></tr><tr><td>5</td><td>Impact Investing</td><td>297</td></tr><tr><td>5.1</td><td>Definition</td><td>299</td></tr><tr><td>5.1.1</td><td>Impact investing frameworks</td><td>300</td></tr><tr><td>5.1.2</td><td>Historical perspectives</td><td>307</td></tr><tr><td>5.1.3</td><td>Investing FOR impact vs. investing WITH impact</td><td>315</td></tr><tr><td>5.1.4</td><td>Impact measurement</td><td>320</td></tr><tr><td>5.2</td><td>Sustainable Development Goals</td><td>325</td></tr><tr><td>5.2.1</td><td>Where we stand with the SDGs</td><td>326</td></tr></tbody></table>
<table><tbody><tr><td>5.2.2</td><td>SDGs and impact investing</td><td>333</td></tr><tr><td>5.2.3</td><td>SDG funds</td><td>335</td></tr><tr><td>5.3</td><td>The market of impact investing</td><td>342</td></tr><tr><td>5.3.1</td><td>Market size</td><td>342</td></tr><tr><td>5.3.2</td><td>Market products</td><td>348</td></tr><tr><td>5.4</td><td>An example with the biodiversity risk</td><td>365</td></tr><tr><td>5.4.1</td><td>Definition</td><td>366</td></tr><tr><td>5.4.2</td><td>Ecosystem functions and services</td><td>394</td></tr><tr><td>5.4.3</td><td>Biodiversity threats and risks</td><td>428</td></tr><tr><td>5.4.4</td><td>Biodiversity measurement</td><td>539</td></tr><tr><td>5.4.5</td><td>Biodiversity governance and regulation</td><td>549</td></tr><tr><td>5.4.6</td><td>Investment approaches</td><td>559</td></tr><tr><td>5.5</td><td>Exercises</td><td>564</td></tr><tr><td>5.5.1</td><td>Calculating the prevalence of undernourishment</td><td>564</td></tr><tr><td>5.5.2</td><td>Calculating the species-area relationship using the theory of island biogeography</td><td>566</td></tr><tr><td>5.5.3</td><td>Species abundance models</td><td>568</td></tr><tr><td>5.5.4</td><td>Valuation of risks to life and health</td><td>569</td></tr><tr><td><b>6</b></td><td><b>Engagement &amp; Voting Policy</b></td><td><b>573</b></td></tr><tr><td>6.1</td><td>Active ownership</td><td>574</td></tr><tr><td>6.1.1</td><td>Definition</td><td>574</td></tr><tr><td>6.1.2</td><td>The various forms of active ownership</td><td>575</td></tr><tr><td>6.1.3</td><td>Individual versus collective engagement</td><td>586</td></tr><tr><td>6.1.4</td><td>The role of institutional investors</td><td>588</td></tr><tr><td>6.1.5</td><td>Performance of active ownership</td><td>592</td></tr><tr><td>6.2</td><td>ESG voting</td><td>593</td></tr><tr><td>6.2.1</td><td>Voting process</td><td>593</td></tr><tr><td>6.2.2</td><td>Proxy voting</td><td>593</td></tr><tr><td>6.2.3</td><td>Defining a voting policy</td><td>595</td></tr><tr><td>6.2.4</td><td>Statistics about ESG voting</td><td>597</td></tr><tr><td><b>7</b></td><td><b>Extra-financial Accounting</b></td><td><b>609</b></td></tr><tr><td>7.1</td><td>Historical perspectives</td><td>609</td></tr><tr><td>7.2</td><td>Single vs. double materiality</td><td>609</td></tr><tr><td>7.3</td><td>Environmental accounting</td><td>609</td></tr><tr><td>7.3.1</td><td>National environmental accounts</td><td>609</td></tr><tr><td>7.3.2</td><td>Corporate environmental accounts</td><td>609</td></tr><tr><td>7.4</td><td>Sustainability accounting</td><td>609</td></tr><tr><td>7.4.1</td><td>Social issues</td><td>609</td></tr><tr><td>7.4.2</td><td>Governance factors</td><td>609</td></tr><tr><td><b>II</b></td><td><b>Climate Risk</b></td><td><b>611</b></td></tr><tr><td><b>8</b></td><td><b>The Physics and Economics of Climate Change</b></td><td><b>613</b></td></tr><tr><td>8.1</td><td>Awareness of climate change impacts</td><td>614</td></tr><tr><td>8.1.1</td><td>Scientific evidence of global warming</td><td>614</td></tr><tr><td>8.1.2</td><td>From the Holocene to the Anthropocene?</td><td>624</td></tr></tbody></table>
<table><tbody><tr><td>8.1.3</td><td>The physics of climate change</td><td>659</td></tr><tr><td>8.2</td><td>The ecosystem of climate change</td><td>710</td></tr><tr><td>8.2.1</td><td>Scientists</td><td>710</td></tr><tr><td>8.2.2</td><td>Conferences of the Parties</td><td>723</td></tr><tr><td>8.2.3</td><td>Regulation policies</td><td>739</td></tr><tr><td>8.3</td><td>Integrated assessment models</td><td>750</td></tr><tr><td>8.3.1</td><td>The DICE model</td><td>750</td></tr><tr><td>8.3.2</td><td>Other models</td><td>774</td></tr><tr><td>8.3.3</td><td>Scenarios</td><td>781</td></tr><tr><td>8.4</td><td>Environmentally-extended input-output model</td><td>807</td></tr><tr><td>8.4.1</td><td>Input-output analysis</td><td>807</td></tr><tr><td>8.4.2</td><td>Application to environmental problems</td><td>819</td></tr><tr><td>8.4.3</td><td>Estimation of first-tier and indirect emissions</td><td>823</td></tr><tr><td>8.4.4</td><td>Imported and exported carbon emissions</td><td>836</td></tr><tr><td>8.4.5</td><td>Taxation, pass-through and price dynamics</td><td>846</td></tr><tr><td>8.5</td><td>Exercises</td><td>867</td></tr><tr><td>9</td><td>Climate Risk Measures</td><td>869</td></tr><tr><td>9.1</td><td>Carbon emissions</td><td>870</td></tr><tr><td>9.1.1</td><td>Global warming potential</td><td>870</td></tr><tr><td>9.1.2</td><td>Consolidation accounting at the company level</td><td>876</td></tr><tr><td>9.1.3</td><td>Scope 1, 2 and 3 emissions</td><td>878</td></tr><tr><td>9.1.4</td><td>Carbon emissions of investment portfolios</td><td>894</td></tr><tr><td>9.1.5</td><td>Statistics</td><td>896</td></tr><tr><td>9.1.6</td><td>Negative emissions, avoided emissions, and carbon offsetting</td><td>899</td></tr><tr><td>9.2</td><td>Carbon intensity</td><td>907</td></tr><tr><td>9.2.1</td><td>Physical intensity ratios</td><td>907</td></tr><tr><td>9.2.2</td><td>Monetary intensity ratios</td><td>908</td></tr><tr><td>9.2.3</td><td>Statistics</td><td>911</td></tr><tr><td>9.3</td><td>Dynamic risk measures</td><td>914</td></tr><tr><td>9.3.1</td><td>Carbon budget</td><td>914</td></tr><tr><td>9.3.2</td><td>Carbon trend</td><td>920</td></tr><tr><td>9.3.3</td><td>Participation, ambition and credibility for an alignment strategy</td><td>929</td></tr><tr><td>9.3.4</td><td>Illustration</td><td>934</td></tr><tr><td>9.4</td><td>Greenness measures</td><td>938</td></tr><tr><td>9.4.1</td><td>Green taxonomy</td><td>938</td></tr><tr><td>9.4.2</td><td>Green revenue share</td><td>939</td></tr><tr><td>9.4.3</td><td>Green capex</td><td>942</td></tr><tr><td>9.4.4</td><td>Green intensity versus carbon intensity</td><td>942</td></tr><tr><td>9.5</td><td>Exercises</td><td>943</td></tr><tr><td>10</td><td>Transition Risk Modeling</td><td>945</td></tr><tr><td>10.1</td><td>Economic analysis of negative externalities</td><td>946</td></tr><tr><td>10.1.1</td><td>Welfare analysis of negative externalities</td><td>946</td></tr><tr><td>10.1.2</td><td>Solutions to negative externalities</td><td>951</td></tr><tr><td>10.1.3</td><td>Cost-benefit analysis</td><td>965</td></tr><tr><td>10.2</td><td>Carbon pricing mechanisms</td><td>985</td></tr><tr><td>10.2.1</td><td>Definition</td><td>986</td></tr></tbody></table>
<table><tbody><tr><td>10.2.2 Panorama of existing direct pricing mechanisms</td><td>994</td></tr><tr><td>10.2.3 Internal carbon price</td><td>1003</td></tr><tr><td>10.3 Stranded assets</td><td>1009</td></tr><tr><td>10.3.1 Definition</td><td>1009</td></tr><tr><td>10.3.2 Drivers of asset stranding</td><td>1012</td></tr><tr><td>10.3.3 Scope and sector analysis</td><td>1012</td></tr><tr><td>10.3.4 Measurement of financial risks</td><td>1015</td></tr><tr><td>10.4 Decarbonization pathway</td><td>1026</td></tr><tr><td>10.4.1 Global analysis</td><td>1027</td></tr><tr><td>10.4.2 Sector analysis</td><td>1031</td></tr><tr><td>10.4.3 Tracking net-zero progress</td><td>1034</td></tr><tr><td>10.5 Exercises</td><td>1038</td></tr><tr><td>10.5.1 Compensating and equivalent variation</td><td>1038</td></tr><tr><td><strong>11 Climate Portfolio Construction</strong></td><td><strong>1039</strong></td></tr><tr><td>11.1 Portfolio optimization in practice</td><td>1040</td></tr><tr><td>11.1.1 Equity portfolios</td><td>1040</td></tr><tr><td>11.1.2 Bond portfolios</td><td>1046</td></tr><tr><td>11.1.3 Advanced optimization problems</td><td>1053</td></tr><tr><td>11.2 Portfolio decarbonization</td><td>1059</td></tr><tr><td>11.2.1 Global reduction of the carbon footprint</td><td>1059</td></tr><tr><td>11.2.2 Sector-specific constraints</td><td>1065</td></tr><tr><td>11.2.3 Empirical results</td><td>1071</td></tr><tr><td>11.3 Net-zero investing</td><td>1083</td></tr><tr><td>11.3.1 Integrated approach</td><td>1083</td></tr><tr><td>11.3.2 Core-satellite approach</td><td>1109</td></tr><tr><td>11.4 Exercise</td><td>1121</td></tr><tr><td>11.4.1 Equity and bond portfolio optimization with green preferences</td><td>1121</td></tr><tr><td>11.4.2 Monotonicity property of the order-statistic and naive approaches</td><td>1124</td></tr><tr><td><strong>12 Physical Risk Modeling</strong></td><td><strong>1125</strong></td></tr><tr><td>12.1 General circulation model</td><td>1126</td></tr><tr><td>12.1.1 Carbon cycle</td><td>1126</td></tr><tr><td>12.1.2 Greenhouse gas chemistry</td><td>1126</td></tr><tr><td>12.1.3 Horizontal and vertical heat transport</td><td>1126</td></tr><tr><td>12.1.4 Oceans</td><td>1126</td></tr><tr><td>12.1.5 Carbon sinks</td><td>1126</td></tr><tr><td>12.2 Statistical modeling of climate hazards</td><td>1126</td></tr><tr><td>12.2.1 Chronic risk</td><td>1126</td></tr><tr><td>12.2.2 Acute risk</td><td>1126</td></tr><tr><td>12.3 Geolocation</td><td>1127</td></tr><tr><td>12.3.1 Climate hazard location</td><td>1127</td></tr><tr><td>12.3.2 Asset location</td><td>1127</td></tr><tr><td>12.4 Applications</td><td>1128</td></tr><tr><td>12.4.1 Cyclones and hurricanes</td><td>1128</td></tr><tr><td>12.4.2 Drought</td><td>1128</td></tr><tr><td>12.4.3 Floods</td><td>1128</td></tr><tr><td>12.4.4 Extreme heat</td><td>1128</td></tr></tbody></table>
<table><tbody><tr><td>12.4.5 Water stress</td><td>1128</td></tr><tr><td>12.4.6 Wildfire</td><td>1128</td></tr><tr><td>12.5 Exercises</td><td>1128</td></tr><tr><td><strong>13 Climate Stress Testing and Risk Management</strong></td><td><strong>1129</strong></td></tr><tr><td>13.1 Transmission channels</td><td>1130</td></tr><tr><td>13.1.1 Direct and indirect transmission</td><td>1130</td></tr><tr><td>13.1.2 Credit transmission channel</td><td>1130</td></tr><tr><td>13.1.3 Market transmission channel</td><td>1130</td></tr><tr><td>13.1.4 Systemic risk</td><td>1130</td></tr><tr><td>13.2 Climate risk hedging</td><td>1131</td></tr><tr><td>13.3 Climate value-at-risk</td><td>1131</td></tr><tr><td>13.4 Climate stress testing</td><td>1131</td></tr><tr><td>13.5 Exercises</td><td>1131</td></tr><tr><td><strong>Conclusion</strong></td><td><strong>1133</strong></td></tr><tr><td><strong>A Technical Appendix</strong></td><td><strong>1137</strong></td></tr><tr><td>A.1 Mathematical tools</td><td>1137</td></tr><tr><td>A.1.1 Linear algebra</td><td>1137</td></tr><tr><td>A.1.2 Optimization</td><td>1139</td></tr><tr><td>A.1.3 Quadratic form</td><td>1146</td></tr><tr><td>A.1.4 Nonnegative matrix</td><td>1148</td></tr><tr><td>A.2 Statistical and probability analysis</td><td>1149</td></tr><tr><td>A.2.1 Probability distributions</td><td>1149</td></tr><tr><td>A.2.2 Copula functions</td><td>1158</td></tr><tr><td>A.2.3 Estimation methods</td><td>1169</td></tr><tr><td>A.3 Stochastic analysis</td><td>1178</td></tr><tr><td>A.3.1 Stochastic optimal control</td><td>1178</td></tr><tr><td>A.3.2 Jump-diffusion processes</td><td>1178</td></tr><tr><td>A.4 Spatial data</td><td>1178</td></tr><tr><td>A.4.1 Spherical coordinates</td><td>1178</td></tr><tr><td>A.4.2 Geographic coordinate systems</td><td>1178</td></tr><tr><td>A.4.3 Network common data form</td><td>1178</td></tr><tr><td><strong>B Solutions to the Tutorial Exercises</strong></td><td><strong>1179</strong></td></tr><tr><td>B.1 Exercises related to ESG risk</td><td>1179</td></tr><tr><td>B.1.1 Score normalization when the features are independent (Exercise 2.4.1)</td><td>1179</td></tr><tr><td>B.1.2 Probability distribution of ESG scores (Exercise 2.4.4)</td><td>1179</td></tr><tr><td>B.1.3 Equity Portfolio optimization with ESG scores (Exercise 3.4.1)</td><td>1189</td></tr><tr><td>B.1.4 Calculating the prevalence of undernourishment (Exercise 5.5.1)</td><td>1199</td></tr><tr><td>B.1.5 Calculating the species-area relationship using the theory of island biogeography (Exercise 5.5.2)</td><td>1206</td></tr><tr><td>B.1.6 Species abundance models (Exercise 5.5.3)</td><td>1216</td></tr><tr><td>B.1.7 Valuation of risks to life and health (Exercise 5.5.4)</td><td>1221</td></tr><tr><td>B.2 Exercises related to climate risk</td><td>1228</td></tr><tr><td>B.2.1 Compensating and equivalent variation (Exercise 10.6.1)</td><td>1228</td></tr><tr><td>B.2.2 Equity and bond portfolio optimization with green preferences (Exercise 11.4.1)</td><td>1233</td></tr></tbody></table>
Bibliography 1245

Subject Index 1313

Author Index 1327
<figure><img src="image_3.png" /></figure>
# Preface

## Teaching sustainable finance

I started teaching finance at the University of Bordeaux in 1995. My first course was called *Stochastic Finance* and was dedicated to option pricing and stochastic calculus. At that time I was also working as a consultant for a bank to develop numerical methods for some exotic payoffs. I realized that this academic course could benefit from this professional position. Indeed, I learnt that the main problem of traders is not the calculation of the option price, but the definition of the hedging strategy. Combining academic theory with professional practice has been a constant theme of my teaching career. In the 2000s, my risk management courses made extensive use of the risk management knowledge acquired at the Groupe de Recherche Opérationnelle (GRO) at Crédit Lyonnais and Crédit Agricole between 1999 and 2005. In the 2010s, my courses in asset management were largely based on the professional experience developed at SGAM AI and Lyxor Asset Management between 2005 and 2016. This sustainable finance course follows the same path. It is largely based on the ESG and climate investing research I have conducted at Amundi Asset Management since 2018.

Although this course has many features in common with the previous ones, sustainable finance is not as mature as option pricing, risk management and asset management. In particular, regulation is in its infancy and not yet stabilized, academic models are still in their infancy, data are noisy, biased and of poor quality, and even concepts are not well defined. In this context, all actors (investors, issuers, financial institutions, regulators, etc.) are adopting a *learning-by-doing* approach. This has important implications for the development of a training course. Each year, the course needs to be updated by incorporating new advances in modeling, adjusting definitions, changing the structure of the lecture notes, removing obsolete sections and adding new paragraphs. Since its inception, the course has been a continuous work in progress.

The issue of sustainable economic growth is a major change in the way economics and finance are taught. However, most academic models do not take climate change into account because they were developed in the 19th and 20th centuries. Taking climate change into account requires a complete overhaul of economic theory and many related concepts: economic growth, negative externality, moral hazard, labor productivity, economic rationality, consumption maximization, social welfare, Pareto optimality, invisible hand, market efficiency, utility function, homo economicus, capital allocation, risk theory, golden rule, overlapping generations model, steady state, non-cooperative games, etc. As teachers, it is difficult to adapt to this new world because we lack distance and cannot benefit from well-established textbooks. However, we cannot wait because time is running out. Therefore, we have a heavy responsibility to educate students about these important issues without adequate tools and a normative framework. This explains why there are thousands of ways to teach sustainable finance. It is not a science. Then be careful about the content, because it necessarily reflects our personal beliefs and experiences. And so I claim the right to be biased.
## About these lecture notes

In January 2019, I started to introduce some elements of ESG and climate investing in my course *Advanced Asset Management*. At that time, it was only about portfolio optimization with ESG scores and carbon footprints. Over the years, the part dedicated to sustainable finance has increased and now makes up 25% of the course. In 2021, we had some discussions at the University of Paris-Saclay about the future development of the Masters in Finance. We decided to create a full and comprehensive course in sustainability finance, going beyond portfolio allocation. For the 2021/2022 academic year, I then put together a set of 770 slides for the first course at Paris-Saclay University. During the year, Peter Tankov also offered to share his course *Green Finance* at ENSAE Paris. Today, sustainable finance is taught in four master's programs: *Master in Risk and Asset Management* (Paris-Saclay University), *Master in Quantitative Finance* (Paris-Saclay University), *Master in Banking & Finance* (Paris-Saclay University), *Master in Statistics, Finance and Actuarial Science* (ENSAE Paris and Paris Cité University). These three courses differ in the number of hours and the scientific approach (qualitative/quantitative and economics/mathematics). Unfortunately, creating three different lecture notes was not effective because there was a lot of overlap between them. Therefore, I decided to write a single set of lecture notes and use them for each course. This explains why some parts of this handbook are very descriptive, but other parts are technical and require a mathematical background in probability, statistics, machine learning, linear algebra, optimization and stochastic analysis.

The publication of my previous lecture notes on risk management (Roncalli, 2020a, Handbook of Financial Risk Management) was a great disappointment. In fact, the publisher has set a high price that is prohibitive for my students. Therefore, I have decided to publish this manual for free. Whatever happens, the electronic version of this manual is and will remain free for my students and everyone else. It is available at the following web site:

http://www.thierry-roncalli.com/SustainableFinanceBook.html

## Acknowledgments

I would like to thank the various people who helped me organize these academic courses, in alphabetical order: Michel Guillard, Eleni Iliopulos, Claire Loupias, Fabrice Pansard, Peter Tankov and Fabien Tripier. I would also like to thank all the Masters students who participated in my Sustainable Finance courses.

I would also like to thank all my co-authors at Amundi Asset Management, in particular Inès Barahhou, Mohamed Ben Slimane, Leila Bennani, Amina Cherief, Baptiste Desnos, Angelo Drei, Théo Le Guenedal, Frédéric Lepetit, Edmond Lezmi, Dorianne Lucius, François Lombard, Nouredine Oulid Azouz, Théo Roncalli, Raphaël Semet, Lauren Stagnol, Takaya Sekine and Jiali Xu. I have been learning about the practice of sustainable finance since I joined Amundi's quantitative research team. The writing of these lecture notes is therefore heavily influenced by the materials and models developed at Amundi.

I would also like to thank Mohamed Ben Slimane, Amina Cherief, Frédéric Lepetit, Wassim Le Lann, Théo Roncalli and Jiali Xu for helping with the data, reading and commenting on some parts of this book, or testing the exercises.
# List of Symbols and Notations

## Symbol Description

$\times$ Arithmetic multiplication

$\cdot$ Scalar, vector and matrix multiplication

* Convolution

$\circ$ Hadamard product $(x \circ y)_i = x_i y_i$

$\otimes$ Kronecker product $A \otimes B$

$|\mathcal{E}|$ Cardinality of the set $\mathcal{E}$

$\succeq$ (or $\preceq$) Preference ordering

$\succ$ (or $\prec$) Strict preference ordering

$\langle x, x' \rangle$ Inner product of $x$ and $x'$

$\mathbf{0}$ (or $\mathbf{0}_n$) Vector of zeros

$\mathbf{1}$ (or $\mathbf{1}_n$) Vector of ones

$1\{\mathcal{A}\}$ The indicator function is equal to 1 if $\mathcal{A}$ is true, 0 otherwise

$1_A\{x\}$ The characteristic function is equal to 1 if $x \in \mathcal{A}$, 0 otherwise

$a$ Subarea $a \subseteq A$

$A$ Area $A$

$(A_{i,j})$ Matrix $A$ with entry $A_{i,j}$ in row $i$ and column $j$

$A^{-1}$ Inverse of the matrix $A$

$A^{\top}$ Transpose of the matrix $A$

$A^{+}$ Moore-Penrose pseudo-inverse of the matrix $A$

$\mathcal{A}\mathcal{E}$ Avoided emissions

$\text{AS}(w | b)$ Asset-based active share

$\text{AS}_{\text{sector}}(w | b)$ Sector-based active share

$\alpha_p$ Planetary albedo (default value = 0.29)

$b$ Vector of weights $(b_1, \dots, b_n)$ for the benchmark $b$

$b$-score (or Beta score)

$B_{\lambda}(\lambda, \mathcal{T})$ Planck radiation law

$\mathcal{B}(p)$ Bernoulli distribution with parameter $p$

$\mathcal{B}(n, p)$ Binomial distribution with parameters $n$ and $p$

$\mathcal{B}(n, p)$ Bates distribution with parameter $n$

$\mathcal{B}(\alpha, \beta)$ Beta distribution with parameters $\alpha$ and $\beta$

$\beta_i$ Beta of asset $i$ with respect to portfolio $w$

$\beta_i(w)$ Another notation for the symbol $\beta_i$

$\beta(w | b)$ Beta of portfolio $w$ when the benchmark is $b$

$c$ Specific heat capacity

$\text{cov}(X)$ Covariance of the random vector $X$

$C_i$ Carry of bond $i$
<table><tr><td>C (or ρ)</td><td>Correlation matrix</td></tr><tr><td>C<sub>n</sub> (ρ)</td><td>Constant correlation matrix of size n with uniform correlation ρ</td></tr><tr><td>[C]</td><td>Concentration</td></tr><tr><td>CB (t<sub>1</sub>, t<sub>2</sub>)</td><td>Carbon budget between t<sub>1</sub> and t<sub>2</sub></td></tr><tr><td>CC</td><td>Concentration rate</td></tr><tr><td>CE</td><td>Carbon emissions</td></tr><tr><td>CI</td><td>Carbon intensity</td></tr><tr><td>CI*</td><td>Maximum carbon intensity value or threshold</td></tr><tr><td>CM</td><td>Carbon momentum</td></tr><tr><td>CM<sup>Long</sup></td><td>Long-term carbon momentum</td></tr><tr><td>CM<sup>Short</sup></td><td>Short-term carbon momentum</td></tr><tr><td>CPI</td><td>Consumer price index</td></tr></table>

<table><tr><td>d</td><td>Distance</td></tr><tr><td>det (A)</td><td>Determinant of the matrix A</td></tr><tr><td>diag (a)</td><td>Diagonal matrix with elements (a<sub>1</sub>, ..., a<sub>n</sub>)</td></tr><tr><td>D</td><td>Covariance matrix of idiosyncratic risks</td></tr><tr><td>D<sup>η</sup> (p)</td><td>Hill number (or diversity index of order η)</td></tr><tr><td>D (x)</td><td>Discriminant curve</td></tr><tr><td>D (a)</td><td>Diagonal matrix D (a) = diag (a) with elements (a<sub>1</sub>, ..., a<sub>n</sub>)</td></tr><tr><td>DTS<sub>i</sub></td><td>Duration-times-spread factor of bond i</td></tr><tr><td>DTS (w)</td><td>Duration-times-spread factor of portfolio w</td></tr><tr><td>δ (t)</td><td>Net diversification rate</td></tr><tr><td>δD</td><td>Deuterium isotope ratio (²H/¹H)</td></tr><tr><td>δ<sup>13</sup>C</td><td>Carbon isotope ratio (¹³C/¹²C)</td></tr><tr><td>δ<sup>18</sup>O</td><td>Oxygen isotope ratio (¹⁸O/¹⁶O)</td></tr></table>

<table><tr><td>e<sub>i</sub></td><td>The value of the vector is 1 for the row i and 0 elsewhere</td></tr><tr><td>E<sub>a</sub></td><td>Expected number of species endemic to the subarea a ⊆ A</td></tr><tr><td>exp (A)</td><td>Exponential of the matrix A</td></tr><tr><td>E [X]</td><td>Mathematical expectation of the random variable X</td></tr><tr><td>E</td><td>Set of edges in a graph</td></tr><tr><td>E (λ)</td><td>Exponential probability distribution with parameter λ</td></tr><tr><td>E</td><td>Energy flux (or radiation flux)</td></tr><tr><td>EAR (a)</td><td>Endemics-area relationship in subarea a ⊆ A</td></tr><tr><td>EF</td><td>Emission factor</td></tr><tr><td>ε</td><td>Emissivity</td></tr></table>

<table><tr><td>f (x)</td><td>Probability density function</td></tr><tr><td>F</td><td>Climate forcing</td></tr><tr><td>F<sub>solar</sub></td><td>Incoming solar radiation (default value = 242.82 W/m²)</td></tr><tr><td>F (x)</td><td>Cumulative distribution function</td></tr><tr><td>F<sup>-1</sup> (α)</td><td>Quantile function</td></tr><tr><td>F</td><td>Vector of risk factors (F<sub>1</sub>, ..., F<sub>m</sub>)</td></tr><tr><td>F<sub>j</sub></td><td>Risk factor j</td></tr><tr><td>F<sub>t</sub></td><td>Filtration</td></tr></table>

<table><tr><td>g</td><td>Greenium</td></tr><tr><td>G</td><td>Greenness measure</td></tr><tr><td>G (p)</td><td>Geometric distribution with parameter p</td></tr><tr><td>G = (V, E)</td><td>Graph with vertices V and edges E</td></tr><tr><td>GI</td><td>Green intensity</td></tr><tr><td>Gini</td><td>Gini coefficient</td></tr><tr><td>GRS</td><td>Green revenue share</td></tr></table>
$\gamma$ Risk-tolerance coefficient

$\bar{\gamma}$ Risk-aversion coefficient

$\gamma_1$ Skewness

$\gamma_2$ Excess kurtosis

$\mathcal{H}(p)$ Herfindahl index

$i$ Asset (or component) $i$

$I_n$ Identity matrix of dimension $n$

$\mathcal{I}(p)$ Shannon entropy of the distribution $p$

$\mathcal{I}(X)$ Shannon entropy of the random variable $X$

$\mathcal{I}(X, Y)$ Shannon entropy of the random vector $(X, Y)$

$\mathcal{I}(X \cap Y)$ Mutual information of the random vector $(X, Y)$

$\mathcal{I}^*(p)$ Shannon diversity index

$\mathcal{IG}(\mu, \lambda)$ Inverse Gaussian distribution with parameters $\mu$ and $\lambda$

$\text{IR}(w | b)$ Information ratio of portfolio $w$ with respect to the benchmark $b$

$\mathbb{K}$ State space $(1, \dots, K)$

$\kappa_j^{\text{up}}$ Upstreamness index of sector $j$

$\kappa_j^{\text{down}}$ Downstreamness index of sector $j$

$\text{LE}(t; \varrho)$ Discounted lifetime expectancy

$\ln(A)$ Logarithm of the matrix $A$

$\ell(\theta)$ Log-likelihood function with $\theta$ the vector of parameters to estimate

$\ell_t$ Log-likelihood function for the observation $t$

$\mathcal{L}(x; \lambda)$ Lagrange function, whose Lagrange multiplier is $\lambda$

$\mathcal{L}$ Leontief inverse matrix

$\tilde{\mathcal{L}}$ Dual inverse matrix (or upstream multiplier matrix)

$\tilde{\mathcal{L}}$ Downstream multiplier matrix

$\lambda(t)$ Origination (or speciation) rate

$\lambda(p)$ Simpson index

$m$ $m$-score (or min-max score)

$\mathcal{M}^p$ Map function

$\text{MD}_i$ Modified duration of bond $i$

$\text{MD}(w)$ Modified duration of portfolio $w$

$\mu$ Vector of expected returns $(\mu_1, \dots, \mu_n)$

$\mu_i$ Expected return of asset $i$

$\mu_m$ Expected return of the market portfolio

$\hat{\mu}$ Empirical mean

$\mu(w)$ Expected return of portfolio $w$

$\mu(X)$ Mean of the random vector $X$

$\mu_m(X)$ $m$-th centered moment of the random vector $X$

$\mu'_m(X)$ $m$-th moment of the random vector $X$

$\mu(t)$ Extinction rate

$n_i$ Abundance (number of individuals) of species $i$ (rank abundance distribution)

$n_S$ Number of scenarios or simulations

$\mathcal{N}(\mu, \sigma^2)$ Normal distribution with mean $\mu$ and standard deviation $\sigma$

$\mathcal{N}(\mu, \Sigma)$ Multivariate normal distribution with mean $\mu$ and covariance matrix $\Sigma$

$\mathcal{NRD}(\mu_x, \sigma_x^2, \mu_y, \sigma_y^2)$ Ratio distribution of $Z = X/Y$ where $X \sim \mathcal{N}(\mu_x, \sigma_x^2)$ and $Y \sim \mathcal{N}(\mu_y, \sigma_y^2)$

$\Omega$ Covariance matrix of risk factors

$p(k)$ Probability mass function of an integer-valued random variable
<table>
  <tr>
    <td>P</td>
    <td>Markov transition matrix</td>
  </tr>
  <tr>
    <td>P(t)</td>
    <td>Transition matrix at time t</td>
  </tr>
  <tr>
    <td>P(Σ)</td>
    <td>Cholesky decomposition of Σ</td>
  </tr>
  <tr>
    <td>P(λ)</td>
    <td>Poisson distribution with parameter λ</td>
  </tr>
  <tr>
    <td>P(x)</td>
    <td>Performance curve</td>
  </tr>
  <tr>
    <td>PPI</td>
    <td>Producer price index</td>
  </tr>
  <tr>
    <td>π</td>
    <td>Vector of risk premia</td>
  </tr>
  <tr>
    <td>π*</td>
    <td>Stationary distribution</td>
  </tr>
  <tr>
    <td>π<sub>cpi</sub></td>
    <td>Inflation rate (consumer price index)</td>
  </tr>
  <tr>
    <td>π<sub>m</sub></td>
    <td>Market risk premium</td>
  </tr>
  <tr>
    <td>π<sub>n</sub><sup>-</sup></td>
    <td>1-diversity distribution</td>
  </tr>
  <tr>
    <td>π<sub>n</sub><sup>+</sup></td>
    <td>n-diversity distribution</td>
  </tr>
  <tr>
    <td>π<sub>ppi</sub></td>
    <td>Inflation rate (producer price index)</td>
  </tr>
  <tr>
    <td>φ(x)</td>
    <td>Probability density function of the standardized normal distribution</td>
  </tr>
  <tr>
    <td>φ<sub>2</sub>(x<sub>1</sub>, x<sub>2</sub>; ρ)</td>
    <td>Probability density function of the bivariate normal distribution with correlation ρ</td>
  </tr>
  <tr>
    <td>φ<sub>n</sub>(x; Σ)</td>
    <td>Probability density function of the multivariate normal distribution with covariance matrix Σ</td>
  </tr>
  <tr>
    <td>Φ(x)</td>
    <td>Cumulative density function of the standardized normal distribution</td>
  </tr>
  <tr>
    <td>Φ<sup>-1</sup>(α)</td>
    <td>Inverse of the cdf of the standardized normal distribution</td>
  </tr>
  <tr>
    <td>Φ<sub>2</sub>(x<sub>1</sub>, x<sub>2</sub>; ρ)</td>
    <td>Cumulative density function of the bivariate normal distribution with correlation ρ</td>
  </tr>
  <tr>
    <td>Φ<sub>n</sub>(x; Σ)</td>
    <td>Cumulative density function of the multivariate normal distribution with covariance matrix Σ</td>
  </tr>
  <tr>
    <td>q</td>
    <td>q-score (or quantile score)</td>
  </tr>
  <tr>
    <td>QALE (t; q)</td>
    <td>Value of per statistical life year</td>
  </tr>
  <tr>
    <td>QF (x; Q, R, c)</td>
    <td>Quality-adjusted life expectancy</td>
  </tr>
  <tr>
    <td>r</td>
    <td>Radius</td>
  </tr>
  <tr>
    <td>r</td>
    <td>Return of the risk-free asset</td>
  </tr>
  <tr>
    <td>R</td>
    <td>Vector of asset returns (R<sub>1</sub>, ..., R<sub>n</sub>)</td>
  </tr>
  <tr>
    <td>R<sub>i</sub></td>
    <td>Return of asset i</td>
  </tr>
  <tr>
    <td>R<sub>i,t</sub></td>
    <td>Return of asset i at time t</td>
  </tr>
  <tr>
    <td>R<sub>m,t</sub></td>
    <td>Return of the market portfolio at time t</td>
  </tr>
  <tr>
    <td>R(w)</td>
    <td>Return of portfolio w</td>
  </tr>
  <tr>
    <td>R(t)</td>
    <td>Rating of the entity at time t</td>
  </tr>
  <tr>
    <td>R(w)</td>
    <td>Risk measure of portfolio w</td>
  </tr>
  <tr>
    <td>R</td>
    <td>Reduction rate of carbon emissions</td>
  </tr>
  <tr>
    <td>R(w | b)</td>
    <td>Carbon footprint reduction rate of portfolio w wrt benchmark b</td>
  </tr>
  <tr>
    <td>R<sup>2</sup></td>
    <td>Coefficient of determination</td>
  </tr>
  <tr>
    <td>RN (μ, σ<sup>2</sup>)</td>
    <td>Reciprocal normal distribution of Y = 1/X where X ~ N(μ, σ<sup>2</sup>)</td>
  </tr>
  <tr>
    <td>q</td>
    <td>Discount rate</td>
  </tr>
  <tr>
    <td>ρ (or C)</td>
    <td>Correlation matrix of asset returns</td>
  </tr>
  <tr>
    <td>ρ<sub>i,j</sub></td>
    <td>Correlation between asset returns i and j</td>
  </tr>
  <tr>
    <td>ρ(x, y)</td>
    <td>Correlation between portfolios x and y</td>
  </tr>
  <tr>
    <td>s</td>
    <td>Credit spread</td>
  </tr>
  <tr>
    <td>s(j)</td>
    <td>Number of species with exactly j individuals (species abundance distribution)</td>
  </tr>
  <tr>
    <td>s<sub>j</sub></td>
    <td>Mapping vector of sector j</td>
  </tr>
  <tr>
    <td>Sector<sub>j</sub></td>
    <td>Sector j</td>
  </tr>
  <tr>
    <td>S</td>
    <td>Number of species</td>
  </tr>
  <tr>
    <td>S</td>
    <td>ESG score</td>
  </tr>
  <tr>
    <td>S*</td>
    <td>Minimum ESG score or threshold</td>
  </tr>
  <tr>
    <td>S<sub>0</sub></td>
    <td>Total solar irradiance or solar constant (default value = 1368 W/m<sup>2</sup>)</td>
  </tr>
  <tr>
    <td>S(x)</td>
    <td>Selection curve</td>
  </tr>
</table>
<table>
  <tr>
    <td>S(t)</td>
    <td>Survival function</td>
  </tr>
  <tr>
    <td>S<sub>a</sub></td>
    <td>Expected number of species in subarea a &sub; A &mdash; S<sub>a</sub> = E [S&#x0303;<sub>a</sub>]</td>
  </tr>
  <tr>
    <td>S&#x0303;<sub>a</sub></td>
    <td>Random number of species in subarea a &sub; A</td>
  </tr>
  <tr>
    <td>SAR (a)</td>
    <td>Species-area relationship in subarea a &sub; A</td>
  </tr>
  <tr>
    <td>SC<sub>1</sub></td>
    <td>Scope 1</td>
  </tr>
  <tr>
    <td>SC<sub>2</sub></td>
    <td>Scope 2</td>
  </tr>
  <tr>
    <td>SC<sub>3</sub><sup>up</sup></td>
    <td>Upstream scope 3</td>
  </tr>
  <tr>
    <td>SC<sub>3</sub><sup>down</sup></td>
    <td>Downstream scope 3</td>
  </tr>
  <tr>
    <td>SC<sub>3</sub></td>
    <td>Scope 3 (= SC<sub>3</sub><sup>up</sup> + SC<sub>3</sub><sup>down</sup>)</td>
  </tr>
  <tr>
    <td>SC<sub>1-2</sub></td>
    <td>Scope 1 and 2</td>
  </tr>
  <tr>
    <td>SC<sub>1-3</sub><sup>up</sup></td>
    <td>Scope 1, 2 and upstream 3 (= SC<sub>1</sub> + SC<sub>2</sub> + SC<sub>3</sub><sup>up</sup>)</td>
  </tr>
  <tr>
    <td>SC<sub>1-3</sub></td>
    <td>Scope 1, 2 and 3</td>
  </tr>
  <tr>
    <td>SR (w | r)</td>
    <td>Sharpe ratio of portfolio w when the risk-free rate is equal to r</td>
  </tr>
  <tr>
    <td>&sigma;</td>
    <td>Stefan-Boltzmann constant (default value = 5.67 &times; 10<sup>-8</sup> W/m<sup>2</sup> K<sup>-4</sup>)</td>
  </tr>
  <tr>
    <td>&sigma;<sub>i</sub></td>
    <td>Volatility of asset i</td>
  </tr>
  <tr>
    <td>&sigma;<sub>m</sub></td>
    <td>Volatility of the market portfolio</td>
  </tr>
  <tr>
    <td>&sigma;&#x0303;<sub>i</sub></td>
    <td>Idiosyncratic volatility of asset i</td>
  </tr>
  <tr>
    <td>&sigma;&#x0303;</td>
    <td>Empirical volatility</td>
  </tr>
  <tr>
    <td>&sigma;(w)</td>
    <td>Volatility of portfolio w</td>
  </tr>
  <tr>
    <td>&sigma;(w | b)</td>
    <td>Tracking error volatility of portfolio w wrt benchmark b</td>
  </tr>
  <tr>
    <td>&sigma;<sub>AS</sub>(w | b)</td>
    <td>Active share active risk of portfolio w wrt benchmark b</td>
  </tr>
  <tr>
    <td>&sigma;<sub>MD</sub>(w | b)</td>
    <td>Duration active risk of portfolio w wrt benchmark b</td>
  </tr>
  <tr>
    <td>&sigma;<sub>DTS</sub>(w | b)</td>
    <td>DTS active risk of portfolio w wrt benchmark b</td>
  </tr>
  <tr>
    <td>&sigma;(X)</td>
    <td>Standard deviation of the random variable X</td>
  </tr>
  <tr>
    <td>&Sigma;</td>
    <td>Covariance matrix</td>
  </tr>
  <tr>
    <td>&Sigma;&#x0303;</td>
    <td>Empirical covariance matrix</td>
  </tr>
</table>

<table>
  <tr>
    <td>t<sub>ν</sub></td>
    <td>Student's t distribution with ν degrees of freedom</td>
  </tr>
  <tr>
    <td>t<sub>n</sub> (Σ, ν)</td>
    <td>Multivariate t distribution with ν degrees of freedom and covariance matrix Σ</td>
  </tr>
  <tr>
    <td>trace (A)</td>
    <td>Trace of the matrix A</td>
  </tr>
  <tr>
    <td>T (x; ν)</td>
    <td>Cumulative density function of the Student's t distribution with ν degrees of freedom</td>
  </tr>
  <tr>
    <td>T<sup>-1</sup> (α; ν)</td>
    <td>Inverse of the cdf of the Student's t distribution with ν degrees of freedom</td>
  </tr>
  <tr>
    <td>T<sub>n</sub> (x; Σ, ν)</td>
    <td>Cumulative density function of the t distribution with parameters Σ and ν</td>
  </tr>
  <tr>
    <td>T<sub>2</sub> (x<sub>1</sub>, x<sub>2</sub>; ρ, ν)</td>
    <td>Cumulative density function of the bivariate t distribution with parameters ρ and ν</td>
  </tr>
  <tr>
    <td>T (u)</td>
    <td>Matrix T (u) = uu<sup>T</sup> of dimension n &times; n where a is a n &times; 1 vector</td>
  </tr>
  <tr>
    <td>T = (V, E)</td>
    <td>Tree with vertices V and edges E</td>
  </tr>
  <tr>
    <td>T</td>
    <td>Temperature</td>
  </tr>
  <tr>
    <td>T<sub>a</sub></td>
    <td>Air/atmospheric temperature</td>
  </tr>
  <tr>
    <td>T<sub>e</sub></td>
    <td>Effective temperature (default value = degK255.81 or -17.34°C)</td>
  </tr>
  <tr>
    <td>T<sub>s</sub></td>
    <td>Earth's surface temperature</td>
  </tr>
  <tr>
    <td>TS</td>
    <td>Temperature score</td>
  </tr>
  <tr>
    <td>τ</td>
    <td>Relaxation time (or half-life)</td>
  </tr>
  <tr>
    <td>τ</td>
    <td>Hitting time</td>
  </tr>
  <tr>
    <td>θ</td>
    <td>Vector of parameters</td>
  </tr>
  <tr>
    <td>θ&#x0303;</td>
    <td>Estimator of θ</td>
  </tr>
  <tr>
    <td>U<sub>[a,b]</sub></td>
    <td>Uniform distribution between a and b</td>
  </tr>
  <tr>
    <td>U (W)</td>
    <td>Utility function of the wealth W</td>
  </tr>
  <tr>
    <td>U (x<sub>1</sub>, x<sub>2</sub>)</td>
    <td>Cardinal utility function</td>
  </tr>
  <tr>
    <td>var (X)</td>
    <td>Variance of the random variable X</td>
  </tr>
  <tr>
    <td>V</td>
    <td>Set of vertices in a graph</td>
  </tr>
  <tr>
    <td>VSL (t)</td>
    <td>Value of a statistical life</td>
  </tr>
</table>
<table><tr><td>VSLY (t)</td><td>Value of per statistical life year</td></tr><tr><td>w</td><td>Vector of weights (w<sub>1</sub>,...,w<sub>n</sub>) for portfolio w</td></tr><tr><td>w*</td><td>Mean-variance optimized portfolio</td></tr><tr><td>w*</td><td>Tangency portfolio</td></tr><tr><td>w<sub>i</sub></td><td>Weight of asset i in portfolio w</td></tr><tr><td>w<sub>gmv</sub></td><td>Global minimum variance portfolio</td></tr><tr><td>w<sub>m</sub></td><td>Market portfolio</td></tr><tr><td>W</td><td>Wealth</td></tr><tr><td>W<sub>CS</sub></td><td>Consumer surplus</td></tr><tr><td>W<sub>PS</sub></td><td>Producer surplus</td></tr><tr><td>WTA</td><td>Willingness to accept</td></tr><tr><td>WTP</td><td>Willingness to pay</td></tr></table>

<table><tr><td>x<sup>+</sup></td><td>Maximum value between x and 0</td></tr><tr><td>X</td><td>Random variable</td></tr><tr><td>X<sub>i:n</sub></td><td>i<sup>th</sup> order statistic of a sample of size n</td></tr></table>

<table><tr><td>y</td><td>Yield to maturity</td></tr></table>

<table><tr><td>z</td><td>Altitude</td></tr><tr><td>z</td><td>Exponent of the species-area relationship S = cA<sup>z</sup></td></tr><tr><td>z</td><td>z-score (or Gaussian score)</td></tr></table>

## Other scientific conventions

YYYY-MM-DD We use the international standard date notation where YYYY is the year in the usual Gregorian calendar, MM is the month of the year between 01 (January) and 12 (December), and DD is the day of the month between 01 and 31.

AD Anno Domini
BP Before present (1950)
Kyr/kyr/ka 1 000 years
Myr/myr/Ma 1 000 000 years
Gyr/byr/Ga 1 000 000 000 years

USD (or $) US dollar
EUR (or €) Euro
KUSD One thousand dollars
$1 mn/bn/tn One million/billion/trillion dollars

% Percent or 0.01
%o Per mil or 0.1%
bp Basis point or 0.01%

E/MSY Number of extinctions per million species per year
Mbp Million base pairs
2n Diploid number of chromosomes
pg C-value of DNA (picogram)
ha Hectare (square with 100-meter sides = 10 000 m<sup>2</sup>)
Mha Million hectares
$/ha/yr Value of ecosystem services in international dollars per hectare per year (alternative notation: $ ha<sup>-1</sup> yr<sup>-1</sup>)
$bn/yr, $tn/yr Value of ecosystem services in billions/trillions of dollars per year
<table><tr><td>ppm</td><td>Part per million</td></tr><tr><td>ppmv</td><td>Part per million by volume</td></tr><tr><td>ppb</td><td>Part per billion</td></tr><tr><td>ppbv</td><td>Part per billion by volume</td></tr></table>

<table><tr><td>AS</td><td>Arsenic</td></tr><tr><td>B(a)P</td><td>Benzo[a]pyrene</td></tr><tr><td>Cd</td><td>Cadmium</td></tr><tr><td>CH<sub>4</sub></td><td>Methane</td></tr><tr><td>CO</td><td>Carbon monoxide</td></tr><tr><td>CO<sub>2</sub></td><td>Carbon dioxide</td></tr><tr><td>CO<sub>2</sub>e</td><td>Carbon dioxide equivalent</td></tr><tr><td>Cr</td><td>Chromium</td></tr><tr><td>H<sub>2</sub>O</td><td>Water vapor</td></tr><tr><td>Hg</td><td>Mercury</td></tr><tr><td>N<sub>2</sub>O</td><td>Nitrous oxide</td></tr><tr><td>NH<sub>3</sub></td><td>Ammonia</td></tr><tr><td>Ni</td><td>Nickel</td></tr><tr><td>NO<sub>2</sub></td><td>Nitrogen dioxide</td></tr><tr><td>NO<sub>x</sub></td><td>Nitrogen oxides</td></tr><tr><td>O<sub>3</sub></td><td>Ozone</td></tr><tr><td>Pb</td><td>Lead</td></tr><tr><td>PM<sub>2.5</sub></td><td>Particulate matter</td></tr><tr><td>PM<sub>10</sub></td><td>Particulate matter</td></tr><tr><td>SO<sub>2</sub></td><td>Sulfur dioxide</td></tr></table>

<table><tr><td>gCO<sub>2</sub>e</td><td>One gram of CO<sub>2</sub>e</td></tr><tr><td>kgCO<sub>2</sub>e</td><td>One kilogram of CO<sub>2</sub>e (= 1 000 gCO<sub>2</sub>e)</td></tr><tr><td>tCO<sub>2</sub>e</td><td>One tonne of CO<sub>2</sub>e (= 1 000 kgCO<sub>2</sub>e)</td></tr><tr><td>ktCO<sub>2</sub>e</td><td>One kilotonne of CO<sub>2</sub>e (= 1 000 tCO<sub>2</sub>e)</td></tr><tr><td>MtCO<sub>2</sub>e</td><td>One megatonne of CO<sub>2</sub>e (= 10<sup>6</sup> tCO<sub>2</sub>e)</td></tr><tr><td>GtCO<sub>2</sub>e</td><td>One gigatonne of CO<sub>2</sub>e (= 10<sup>9</sup> tCO<sub>2</sub>e)</td></tr><tr><td>gCO<sub>2</sub>e/$</td><td>One gram of CO<sub>2</sub>e per one dollar</td></tr><tr><td>tCO<sub>2</sub>e/$ mn</td><td>One tonne of CO<sub>2</sub>e per one million of dollar</td></tr></table>

<table><tr><td>Ton</td><td>Imperial unit of weight equivalent to 1 016.047 kilograms</td></tr><tr><td>Tonne</td><td>Metric unit of weight equivalent to 1 000 kilograms (also known as a metric ton)</td></tr></table>

<table><tr><td>Cal (or kcal)</td><td>Calorie, kilocalorie or 1 000 calories</td></tr><tr><td>Hz</td><td>Frequency (Hertz or s<sup>-1</sup>)</td></tr><tr><td>J</td><td>Energy (Joule or m<sup>2</sup> kg s<sup>-2</sup> or N m)</td></tr><tr><td>K</td><td>Temperature (Kelvin)</td></tr><tr><td>kg</td><td>Mass (kilogram)</td></tr><tr><td>m</td><td>Length (meter)</td></tr><tr><td>m<sup>2</sup></td><td>Area (square meter)</td></tr><tr><td>m s<sup>-2</sup></td><td>Acceleration (meter per square second)</td></tr><tr><td>N</td><td>Force (Newton or m kg s<sup>-2</sup>)</td></tr><tr><td>Pa</td><td>Pressure (Pascal or m<sup>-1</sup> kg s<sup>-2</sup> or N m<sup>-2</sup>)</td></tr><tr><td>s</td><td>Time (second)</td></tr><tr><td>W</td><td>Power (Watt or m<sup>2</sup> kg s<sup>-3</sup> or J s<sup>-1</sup>)</td></tr><tr><td>W m<sup>-2</sup></td><td>Irradiance (Watt per square meter or kg s<sup>-3</sup>)</td></tr></table>
<figure><img src="image_4.png" /></figure>
Abbreviations

**ACPR** Autorité de contrôle prudentiel et de ré-solution

**ADB** Asian development bank

**AGM** Annual general meeting

**AI** Artificial intelligence

**AIF** Alternative investment fund

**AMOC** Atlantic meridional overturning circulation

**APS** Announced pledges scenario

**AQI** Air quality index

**AUM** Assets under management

**B-Corp** Benefit corporation

**BAU** Business as usual

**BCBS** Basel committee on banking supervision

**BCR** Benefit-cost ratio

**BECCS** Bio-energy carbon capture and storage

**BII** Biodiversity intactness index

**BIS** Bank for international settlements

**BMI** Body mass index

**BMR** EU benchmark regulation

**BoE** Bank of England

**CAPM** Capital asset pricing model

**CAT** Cap-and-trade

**CBA** Cost-benefit analysis

**CBAM** Carbon border adjustment mechanism

**CBD** Convention on biological diversity

**CBI** Climate bonds initiative

**CBIRC** China banking and insurance regulatory commission

**CCF** Corporate carbon footprint

**CCUS** Carbon capture, use, and storage

**CDP** Carbon disclosure project

**CDR** Carbon dioxide removal

**CDSB** Climate disclosure standards board

**CE** Carbon emissions

**CEA** Cost-effectiveness analysis

**CEO** Chief executive officer

**Ceres** Coalition for environmentally responsible economies

**CFP** Corporate financial performance

**CI** Carbon intensity

**CICES** Common international classification of ecosystem services

**CITES** Convention on international trade in endangered species of wild fauna and flora

**CMA** Conference of the parties serving as the meeting of the parties to the Paris Agreement

**CMP** Conference of the parties serving as the meeting of the parties to the Kyoto Protocol

**COP** Conference of the parties

**CPI** Consumer price index

**CRA** Credit rating agency

**CRF** Concentration-response function

**CSDDD** Corporate sustainability due diligence directive

**CSP** Corporate social performance

**CSR** Corporate social responsibility

**CSRD** Corporate sustainability reporting directive

**CTB** Climate transition benchmark

**DAC** Direct air capture

**DACCS** Direct air carbon capture with carbon storage

**DALY** Disability-adjusted life years

**DDQ** Due diligence questionnaire

**DEC** Dietary energy consumption

**DFI** Development finance institution

**DIB** Development impact bond

**DICE** Dynamic integrated climate-economy model
DNSH Do no significant harm

DTS Duration-times-spread factor

EAR Endemics-area relationship

EBA European banking authority

EC European Commission

ECB European central bank

ECS Equilibrium climate sensitivity

EDCI ESG data convergence initiative

EDGAR Emission database for global atmospheric research

EEA European economic area

EEA European environment agency

EEIO Environmentally-extended input-output model

EET European ESG template

EFAMA European fund and asset management association

EFDB Emission factor database

EFRAG European financial reporting advisory group

EIB European investment bank

EIOPA European insurance and occupational pensions authority

ENCORE Exploring natural capital opportunities, risks and exposure

ENSO El Niño Southern Oscillation

EPA Environmental protection agency

EPICA European project for ice coring in Antarctica

ERA Extra-financial rating agency

ERF Effective radiative forcing

ESA European supervisory authority

ESFS European system of financial supervision

ESG Environmental, social and governance

ESM European stability mechanism

ESMA European securities and markets authority

ESRS European sustainability reporting standards

ETC Energy transitions commission

ETS Emissions trading scheme

EUGBR EU green bonds regulation

Eurosif European sustainable investment forum

EUTR European Union taxonomy regulation for sustainable activities

EV Electric vehicle

FA Financial advisor

FAO Food and agriculture organization

FCA Financial conduct authority

FDI Foreign direct investment

FDIC Federal deposit insurance corporation

FIO Federal insurance office

FMP Financial market participant

FRB Board of governors of the federal reserve system

FSB Financial stability board

FSOC Financial stability oversight council

FUND Climate framework for uncertainty, negotiation, and distribution

GB Green bond

GBF Kunming-Montreal global biodiversity framework

GBP Green bond principles

GC Global Compact

GCM General circulation model

GEVA Greenhouse gas emissions per unit of value added

GFANZ Glasgow financial alliance for net zero

GHG Greenhouse gas

GICS Global industry classification standard

GIIN Global impact investing network

GISP Greenland ice sheet project

GLP Green loans principles

GMO Genetically modified organism

GMV Global minimum variance portfolio

GQE Green quantitative easing

GRI Global reporting initiative

GRIP Greenland ice core project

GRS Green revenue share

GSAT Global mean surface air temperature

GSIA Global sustainable investment alliance

GSIR Global sustainable investment review

GSS Green, social and sustainability bonds

GTAP Global trade analysis project

GTB Green-to-brown ratio

GTP Global temperature potential

GTS Geologic time scale

GWP Global warming potential

HCIS High climate impact sector

HKMA Hong Kong monetary authority

HLEG High-level expert group on sustainable finance
IAIS International association of insurance supervisors

IAM Integrated assessment model

IAS Invasive alien species

IASB International accounting standards board

IBAT Integrated Biodiversity Assessment Tool

ICE Internal combustion engine

ICMA International capital market association

ICP Internal carbon pricing

IDD Insurance distribution directive

IEA International energy agency

IFC International finance corporation

IFRS International financial reporting standards

IIASA International institute for applied systems analysis

IIRC International integrated reporting council

ILO International labour organization

IMF International monetary fund

IOPS International organisation of pensions supervisors

IOSCO International organization of securities commissions

IOT Input-output table

IPBES Intergovernmental science-policy platform on biodiversity and ecosystem services

IPCC Intergovernmental panel on climate change

IPSL Institut Pierre-Simon Laplace

IRENA International Renewable Energy Agency

IRR Internal rate of return

ISSB International sustainability Aästandards board

ITR Implied temperature rating

IUCN International union for conservation of nature

JSIF Japan sustainable investment forum

KF Kalman filter

KPI Key performance indicator

LCA Life cycle assessment

LP Linear programming

LPI Living planet index

LSEG London stock exchange group

LULUCF Land use, land-use change, and forestry

MAC Marginal abatement cost

MACC Marginal abatement cost curve

MAS Monetary authority of Singapore

MD Modified duration

MDB Multilateral development bank

MDER Minimum dietary energy requirement

MEB Marginal excess burden

MFI Microfinance institution

MiFID Markets in financial instruments directive

MRIO Multi-regional input-output model

MSA Mean species abundance

MSY Maximum sustainable yield

MVO Mean-variance optimized portfolio

MVPF Marginal value of public funds

NACE Nomenclature statistique des activités économiques dans la Communauté Européenne

NCA National competent authority

NCAR National center for atmospheric research

NCAVES Natural capital accounting and valuation of ecosystem services

NDC Nationally determined contribution

NET Negative emissions technology

NFRD Non-financial reporting directive

NGFS Network of central banks and supervisors for greening the financial system

NGO Non-governmental organization

NGRIP North Greenland ice core project

NICE Nested inequalities climate-economy model

NIR National inventory report

NLP Natural language processing

NOAA National oceanic and atmospheric administration

NPV Net present value

NRSRO Nationally recognized statistical rating organization

NSB Net social benefit

NZAM Net zero asset managers initiative

NZAOA Net zero asset owner alliance

NZBA Net zero banking alliance

NZE Net zero emissions scenario

NZFSPA Net zero financial service providers alliance

NZIA Net zero insurance alliance
NZICI Net zero investment consultants initiative

OCC Office of the comptroller of the currency

OCIO Outsourced chief investment officer

OCR Office of credit ratings

OECD Organisation for economic cooperation and development

OLR Outgoing longwave radiation

OLS Ordinary least squares

OPS One planet summit

OPSWF One planet sovereign wealth fund

ORSE Observatoire de la responsabilité sociale des entreprises

PAB Paris aligned benchmark

PAGE Policy analysis of the greenhouse gas effect

PAI Principal adverse impact

PAII Paris aligned investment initiative

PBOC People's Bank of China

PBR Payment-by-results

PCAF Partnership for carbon accounting officials

PCF Product carbon footprint

PDB Pee Dee Belemnite

PDF Potentially disappeared fraction

PF Pension fund

PIK Potsdam institute for climate impact research

PM Particulate matter

POP Persistent organic pollutant

PPI Producer price index

PRI Principles for responsible investment

QALE Quality-adjusted life expectancy

QALY Quality-adjusted life year

QOV Quasi-option value

QP Quadratic programming

RCP Representative concentration pathway

RIAA Responsible investment association Australasia

RICE Regional integrated climate-economy model

RLI Red list index

RLS Recursive least squares

RTS Regulatory technical standard

SAC Species accumulation curve

SAD Species abundance distribution

SAR Species-area relationship

SASB Sustainability accounting standards board

SB Social bond

SBE Sustainable blue economy

SBP Social bond principles

SBTi Science-based targets initiative

SCC Social cost of carbon

SDA Sectoral decarbonisation approach

SDG Sustainable development goal

SDR Sustainability disclosure requirement

SDTF Sudan divestment task force

SEC Securities and exchange commission

SEEA System of environmental-economic accounting

SF Sustainable finance

SFDR Sustainable finance disclosure reporting

SIB Social impact bond

SIF Sustainable investment forum

SLB Sustainability-linked bond

SMOW Standard mean ocean water

SOC Social outcomes contract

SPO Second party opinion

SREP Supervisory review and evaluation process

SRI Socially responsible investing

SRP Supervisory review process

SSP Shared socioeconomic pathway

STAR Species Threat Abatement and Restoration metric

STEPS Stated policies scenario

SWF Social welfare function

SWF Sovereign wealth fund

TAB Taxonomy-aligning benchmark

TCFD Task force on climate-related financial disclosures

TEEB The economics of ecosystems and biodiversity

TEG Technical expert group on sustainable finance

TFP Total factor productivity

TIB Theory of island biogeography

TNFD Task force on nature-related financial disclosures

TSI Total solar irradiance
**UCITS** Undertakings for collective investment in transferable securities

**UK SIF** UK sustainable investment and finance association

**UN** United Nations

**UN PRI** UN principles for responsible investment

**UNDP** United Nations development programme

**UNECE** United Nations economic commission for Europe

**UNEP** United Nations environment programme

**UNEP FI** United Nations environment programme finance initiative

**UNFCCC** UN framework convention on climate change

**UNICEF** United Nations children's fund

**US SIF** Forum for sustainable & responsible investment

**VBDO** Vereniging van beleggers voor duurzame ontwikkeling

**VCM** Voluntary carbon market

**VOLY** Value of life year

**VSL** Value of a statistical life

**VSLY** Value per statistical life year

**WACC** Weighted average cost of capital

**WACI** Weighted average carbon intensity

**WAIS** West Antarctic ice sheet project

**WBCSD** World business council for sustainable development

**WCW** Who cares wins

**WDPA** World Database on Protected Areas

**WEF** World economic forum

**WEO** World energy outlook

**WHO** World health organization

**WIOD** World input-output database

**WMO** World meteorological organization

**WRI** World resources institute

**WTA** willingness to accept

**WTP** willingness to pay

**YLD** Years lived with disability

**YLL** Years of life lost
<figure><img src="image_5.png" /></figure>
# Chapter 1

# Introduction

In this chapter, we first define the concept of sustainable finance (SF) and discuss its historical origins, particularly the motivations of responsible investors. We also present the responsible investing ecosystem and the related regulatory framework. Finally, we provide some figures on the sustainable finance market.

## 1.1 Definition

The European Commission (EC) defines the concept of sustainable finance as follows<fnref n="1" />:

> "Sustainable finance refers to the process of taking **environmental, social and governance (ESG) considerations** into account when making investment decisions in the financial sector, leading to more long-term investments in sustainable economic activities and projects. **Environmental considerations** might include climate change mitigation and adaptation, as well as the environment more broadly, for instance the preservation of biodiversity, pollution prevention and the circular economy. **Social considerations** could refer to issues of inequality, inclusiveness, labour relations, investment in human capital and communities, as well as human rights issues. The **governance** of public and private institutions — including management structures, employee relations and executive remuneration — plays a fundamental role in ensuring the inclusion of social and environmental considerations in the decision-making process."

In this definition, the EC also introduces the concept of ESG (Environmental, Social and Governance), which is very popular among asset owners and managers. For example, unlike business-as-usual (BAU) or traditional investing, the goal of ESG investing is to incorporate extra-financial analysis into asset selection. Nevertheless, the boundary between SF and ESG is not very clear. This is also the case with other commonly used terms such as responsible investment (RI), sustainable investing (SI) and, socially responsible investing (SRI). Here are a few definitions we found in financial textbooks:

* **Responsible investment** is an approach to investing that explicitly recognizes the relevance to the investor of environmental, social and governance factors, as well as the long-term health of the market as a whole.

* **Sustainable investing** is an investment approach that considers environmental, social and governance factors in portfolio selection.

<footnote n="1">¹See the webpage https://finance.ec.europa.eu/sustainable-finance/overview-sustainable-finance_en.</footnote>
* **Socially responsible investing** is an investment strategy that is considered socially responsible, because it invests in companies that have ethical practices.

* **ESG** refers to the factors that measure the sustainability of an investment.

In fact, it is really difficult to make the difference between all these concepts, because they all encompass the same underlying idea. Therefore, we can consider them as the same topic (Figure 1.1). We can complete this list with other terms such as green finance, climate finance, blue finance, etc. In general, the term green finance is reserved for the environmental pillar, while blue finance is an emerging area of climate finance and concerns the ocean economy (IFC, 2022).

<figure><img src="image_6.png" /><figcaption>Figure 1.1: Many words, one concept</figcaption></figure>

## 1.2 Short history of responsible and ethical investing

From a historical point of view, we observe three phases. In the 1990s and 2000s, the word “sustainable finance” is not really used. The term “responsible investment” is preferred because of ethical considerations of some end investors and asset owners. In the 2010s, “ESG investing” takes the lead as it gains momentum in the asset management industry. In addition, ESG rating agencies have adopted the breakdown of extra-financial information into environmental, social and governance pillars. Finally, the concept of ESG is spreading to all financial actors and sectors (e.g., companies, banks, regulators, policy makers and central banks). In this context, it affects not only the investment side, but also regulation, society and public policy. Therefore, it is better to use the term “sustainable finance”, which is more generic than responsible or ESG investing.

The previous evolution (responsible investment → ESG → sustainable finance) can be explained by the history of ethical investing. Religious motivations explain the earliest examples of responsible (or faith-based) investing. In 1758, the Quaker Philadelphia yearly meeting prohibited its members from participating in the slave trade (buying or selling humans). They were followed by religious groups (e.g., Muslims, or Methodists), which urged people and members to avoid investing in companies related to weapons, tobacco, alcohol, or gambling. According to Beabout and Schmiesing (2003), the first SRI mutual fund (Pioneer Fund) was created in 1928 by Philip Carret for evangelical
Protestants. The years 1930–1960 saw the emergence of several investment doctrines. In particular, a series of corporate scandals led to an increased focus on governance issues. During the Vietnam War, shareholders organized resolutions against the production of napalm<fnref n="2" /> and Agent Orange³. So we see the development of engagement policies alongside exclusion policies. In 1971, two members of the United Methodist Church (Luther Tyson and Jack Corbett) and the portfolio manager Tony Brown launched the Pax World Fund, which can also claim to be the first sustainable mutual fund in the United States. In fact, the fund’s strategy mixed both financial and social criteria. This is a step forward because the fund considers selection screening, not just exclusion screening. Moskowitz (1972) published a first list of socially responsible stocks, including Chase Manhattan, Johnson Products, Levi Strauss, New York Times, Whirlpool and Xerox. These stocks are challenged by Vance (1975), who found that they largely underperformed the Dow Jones from 1972 to 1975. The concept of “sin stocks” was born, and the relationship between responsible investing and profitability led to many academic publications on these topics. This first period of sustainable finance can be summarized as follows:

> "Do no harm. That is the central concept of traditional faith-based investing and, to some degree, the central concept of socially responsible investing: Avoiding products or industries that conflict with a set of moral values." (Townsend, 2020, page 2).

The question of moral values is also the main factor explaining the development of corporate social responsibility (CSR). This theory begins with the publication of "Social Responsibilities of the Businessman" by Bowen (1953). In this book, the author analyzes the responsibilities that corporations have to society. Considered the "father of corporate social responsibility" (Carroll, 1999), Howard Bowen argued that "CSR can help business reach the goals of social justice and economic prosperity by creating welfare for a broad range of social groups, beyond the corporations and their shareholders." Viewed as an alternative to socialism and pure capitalism, CSR has been rejected by neoclassical economists. One of its most famous opponents is Milton Friedman:

> "There is one and only one social responsibility of business — to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." (Friedman, 1962).

In particular, his article published in the New York Times (Friedman, 1970) has had a major impact on the shareholder vs. stakeholder debate. Stakeholder theory suggests that the true success of a company lies in satisfying all of its stakeholders, not just shareholders (Freeman, 2004). The stakeholder ecosystem includes customers, suppliers, employees, local communities, government agencies, financiers, and others. In this theory, each business entity creates and sometimes destroys value for each stakeholder group. Again, much academic research has been published on this topic, particularly on how to define corporate social performance (CSP), and its relationship to corporate financial performance (CFP). However, even though the debate is still raging, stakeholder theory has profoundly changed the vision of business. Indeed, there's now a broad consensus that the purpose of business objective should be more than just profit maximization. One example is the Global Compact (GC) initiative launched by the UN Secretary-General Kofi Annan in July 2000. It is a voluntary initiative based on CEO commitments to implement a set of human rights, labor,

<footnote n="2">²In 1968, the Medical Committee for Human Rights bought shares in Dow Chemical to stop the sale of napalm.
³Agent Orange is a mixture of two herbicides. It was used by the US military to defoliate forests and terrorize the people of South Vietnam (Townsend, 2020, page 3).</footnote>
environmental, and anti-corruption principles<fnref n="4" />. The UN Global Compact is widely used by responsible investors to define lists of excluded issuers, to engage with companies, and to develop impact investing products. The 10 principles are:

* Human rights

1. Businesses should support and respect the protection of internationally proclaimed human rights;

2. Ensure that they are not complicit in human rights abuses;

* Labor

3. Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining;

4. The elimination of all forms of forced and compulsory labor;

5. The effective abolition of child labor;

6. The elimination of discrimination in respect of employment and occupation;

* Environment

7. Businesses should support a precautionary approach to environmental challenges;

8. Take initiatives to promote greater environmental responsibility;

9. Promote the development and diffusion of environmentally friendly technologies;

* Anti-corruption

10. Businesses should work against corruption in all its forms, including extortion and bribery.

From 2004 to 2008, the UN Global Compact, the International Finance Corporation (IFC) and the Swiss government sponsored a series of annual conferences for investment professionals, asset managers, and financial institutions to develop guidelines and recommendations on how to better integrate environmental, social and corporate governance issues. The term ESG was first coined in the 2004 conference report “Who Cares Wins — Connecting Financial Markets to a Changing World” (WCW, 2004) and popularized by the next four reports<fnref n="5" />.

Socially responsible investing applies not only to companies, but also to sovereigns and countries. For instance, in 1986, the US Congress passed the “Comprehensive Anti-Apartheid Act”, which banned new investments in South Africa. Similarly, the Sudan Divestment Task Force (SDTF) was formed in 2005 to coordinate and provide resources for the Sudan divestment campaign in response to the genocide occurring in the Darfur region. The US “Sudan Accountability and Divestment Act” came into force in December 2007. It authorizes a state or local government to divest assets in companies that engages in business operations in Sudan that include power production activities, mineral extraction activities, oil-related activities, or the production of military equipment.

<footnote n="4">⁴The Global Compact initiative has its roots in the code of conduct for companies developed in 1977 by Leon Sullivan, a clergyman and civil rights leader. The original Sullivan Principles consisted of seven requirements to be met by a company operating in South Africa. They were a response to apartheid and an alternative to total divestment, which was perceived as a costly strategy (Grossman and Sharpe, 1986; Rudd, 1979).</footnote>

<footnote n="5">⁵The titles of the four conference reports are “Investing for Long-Term Value — Integrating Environmental, Social and Governance Value Drivers in Asset Management and Financial Research” (2005), “Communicating ESG Value Drivers at the Company-Investor Interface” (2006), “New Frontiers in Emerging Markets Investment” (2007) and “Future Proof? Embedding Environmental, Social and Governance Issues in Investment Markets” (2008).</footnote>
According to Townsend (2020), the current concept of sustainable finance mixes “the traditional North American model for socially responsible investing, and ESG, which first took hold in Europe.” It is true that the Who Cares Wins (WCW) conferences have had a more European focus, with participants coming primarily from European asset owners and managers, especially the 2005 conference (WCW, 2005). While SRI is more an exclusion and qualitative process at its inception in North America, ESG is a best-in-class and quantitative process when implemented in the early 2000s. The growth of ESG data and ESG rating agencies<fnref n="6" /> largely explains this shift. One reason is “the strong intellectual and legal debate on the relationship between fiduciary duty and issues of sustainability” (Townsend, 2020, page 6). In 2005, UNEP invited the law firm Freshfields Bruckhaus Deringer to prepare a report on the legal use of ESG integration by pension funds (PFs), insurance companies and asset managers. The objective of the report was to answer the following question:

> "Is the integration of environmental, social and governance issues into investment policy (including asset allocation, portfolio construction and stock-picking or bond-picking) voluntarily permitted, legally required or hampered by law and regulation; primarily as regards public and private pension funds, secondarily as regards insurance company reserves and mutual funds?" (Freshfields Bruckhaus Deringer, 2005, page 6).

The 154-page report analyzed the legal frameworks for institutions in Australia, Canada, France, Germany, Italy, Japan, Spain, the United Kingdom and the United States. While the analysis is highly technical and results vary by jurisdiction, the report concludes that integrating ESG issues is consistent with fiduciary duty when ESG factors impact investment value and long-term risks. In this context, we are seeing a growing shift among European institutional investors who consider that their fiduciary duty requires them to integrate ESG into their investment analysis. As institutional investors are sophisticated investors and base their decisions on in-depth quantitative analysis, this has meant transforming the original qualitative approach based on discretionary exclusions to a more systematic model based on extra-financial quantitative data.

A second reason that explains the shift from a qualitative SRI to a quantitative ESG is the factor of climate change. In response to global warming, the Intergovernmental Panel on Climate Change (IPCC) was established in 1988 by the World Meteorological Organization (WMO) and the United Nations Environment Programme (UNEP). The IPCC produces periodic assessment reports on the state of knowledge about climate change. The first assessment report (AR1) was published in March 1990, while the synthesis of the latest assessment report (AR6) was completed in March 2023. These reports are used extensively at the United Nations conferences on climate change. In June 1992, the Earth Summit held in Rio de Janeiro produced two important legal agreements: the Convention on Biological Diversity (CBD) and the UN Framework Convention on Climate Change (UNFCCC). The objective of this international treaty is to reduce global environmental impacts. The implementation of the UNFCCC to combat global warming is an ongoing process. For instance, the Kyoto Protocol negotiated in 1997 and the Paris Agreement adopted in 2015 are certainly the two most famous international treaties on climate change. On the investor side, the Coalition for environmentally responsible economies (Ceres) was founded in 1989 with the goal of changing corporate environmental practices. In the wake of the Exxon Valdez oil spill, Ceres developed the Valdez Principles<fnref n="7" />. In 2000, it also launched the Global Reporting Initiative (GRI) to standardize corporate disclosure on ESG issues.

<footnote n="6">⁶This topic will be discussed in more detail in the next chapter.</footnote>

<footnote n="7">⁷The 10 principles are (1) protection of the biosphere, (2) sustainable use of natural resources, (3) reduction and disposal of wastes, (4) energy conservation, (5) risk reduction, (6) safe products and services, (7) environmental restoration, (8) informing the public, (9) management commitment, and (10) audits and reporting.</footnote>
The last twenty years have strengthened the place of ESG in finance, not only on the investment side, but also on the financing side<fnref n="8" />. Regulators are now involved, accounting standards have been developed, climate change is recognized as a key risk factor, controversies can damage a company’s reputation, social pressure affects corporate governance, and so on. In the next chapters, we will extensively document the evolution of sustainable finance over the last period. The motivations for implementing socially responsible investment are now many and varied. In Figure 1.2, we show some of them. They can be divided into two groups. The first (economic sustainability, moral values and social pressure) is related to the "do no harm principle", and can be applied to many situations or decisions. The second group, which includes financial performance, fiduciary duty, and risk management, is related to investment principles. The underlying idea is that ESG risks need to be managed and cannot be ignored in portfolio construction.

<figure><img src="image_7.png" /><figcaption>Figure 1.2: The raison d’être of sustainable finance</figcaption></figure>

## 1.3 The ESG ecosystem

As we have just seen, the ESG landscape involves many financial actors. First, investors are at the center of the ecosystem. We generally distinguish between asset owners and managers. Asset owners correspond to end investors and include pension funds (PFs), institutional investors, sovereign wealth funds (SWFs), insurance companies, endowments and foundations, family offices, retail investors, etc. The asset management industry, on the other hand, manages funds for end-investors. In this category we have mutual funds, hedge funds, private equity funds, infrastructure funds, third-party distributors, etc. We could also mention ESG index providers, as they are essential for passive management. Asset managers then act as financial intermediaries between the financial markets (e.g., equity and bond markets) and the savings of households, companies and organizations. While asset owners and managers form the investment side, banks and issuers form the financing side. Sustainable finance therefore also involves the issuance of debt and the structuring of ESG products such as green bonds.

<footnote n="8">⁸However, we observe an ESG backlash in the US starting in 2021, with high political polarization and a setback or slowdown in the momentum of ESG regulation in the United States.</footnote>
1.3.1 Sustainable investment forum

The sustainable investment forums (SIFs) are membership-based sustainable and responsible in-
vestment organizations. They work to promote the wider adoption of sustainable and responsible
investment practices and, more generally, the mainstreaming of sustainability issues into financial
markets and the investment chain. They are organized on a country or regional basis. For ex-
ample, the European Sustainable Investment Forum (Eurosif) was established in 2001 and brings
together Forum per la Finanza Sostenibile (Italy), Forum Nachhaltige Geldanlagen (Germany), Fo-
rum pour l'Investissement Responsable (France), Foro de Inversión Sostenible (Spain), Sustainable
Finance Ireland, Swiss Sustainable Finance (Switzerland) and UK Sustainable Investment and Fi-
nance Association. Other SIFs include the Responsible Investment Association Australasia<fnref n="9" /> (RIAA),
the Responsible Investment Association Canada (RIA Canada), The Forum for Sustainable & Re-
sponsible Investment (US SIF), the Dutch Association of Investors for Sustainable Development¹⁰
(VBDO) and the Japan Sustainable Investment Forum (JSIF). All of these organizations are
members of the Global Sustainable Investment Alliance (GSIA).

These forums were created at different times, reflecting the evolution of sustainable finance. US SIF was founded in 1984 and is the oldest SIF. It is followed by RIA Canada in 1990, UK SIF in 1991 and VBDO in 1995. Most of the European forums were established in 2001 (e.g., Germany, France, Italy). The main activities of these sustainable investment forums are public policy, education, training, research and promotion of sustainable investment best practices. Founded in 2010, the GSIA is charged with aggregating responsible investment market data from its members in order to analyze the global sustainable investment market and the evolution of ESG trends. In particular, it publishes a Global Sustainable Investment Review or GSIR every two years (GSIA, 2013, 2015, 2017, 2019, 2021, 2023). We will make extensive use of these reports in Section 1.5 on page 42 when we analyze the market for ESG investing.

<figure><img src="image_8.png" /><figcaption>Figure 1.3: 2018, 2020 & 2022 GSIA reports</figcaption></figure>

1.3.2 Initiatives

In this section, we highlight the most relevant initiatives (PRI, Climate action 100+, and net-zero alliances). We also list other initiatives that are part of the ESG ecosystem. Some of these are discussed in more detail in the following chapters.

<footnote n="9">⁹It covers both Australia and New Zealand.
¹⁰The Dutch name is Vereniging van Beleggers voor Duurzame Ontwikkeling.</footnote>
Principles for responsible investment

In early 2005, UN Secretary-General Kofi Annan invited a group of the world's largest institutional investors to participate in a process to develop the Principles for Responsible Investment<fnref n="11" /> (PRI). A group of 20 investors from institutions in 12 countries was supported by a group of 70 experts from the investment industry, intergovernmental organizations and civil society. The PRI were launched at the New York Stock Exchange in April 2006.

Box 1.1: PRI signatories’ commitment

"As institutional investors, we have a duty to act in the best long-term interests of our beneficiaries. In this fiduciary role, we believe that environmental, social, and corporate governance (ESG) issues can affect the performance of investment portfolios (to varying degrees across companies, sectors, regions, asset classes and through time).

We also recognise that applying these Principles may better align investors with broader objectives of society. Therefore, where consistent with our fiduciary responsibilities, we commit to the following:

* Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.

* Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.

* Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.

* Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.

* Principle 5: We will work together to enhance our effectiveness in implementing the Principles.

* Principle 6: We will each report on our activities and progress towards implementing the Principles.

The Principles for Responsible Investment were developed by an international group of institutional investors reflecting the increasing relevance of environmental, social and corporate governance issues to investment practices. The process was convened by the United Nations Secretary-General.

In signing the Principles, we as investors publicly commit to adopt and implement them, where consistent with our fiduciary responsibilities. We also commit to evaluate the effectiveness and improve the content of the Principles over time. We believe this will improve our ability to meet commitments to beneficiaries as well as better align our investment activities with the broader interests of society.

We encourage other investors to adopt the Principles.”

Source: https://www.unpri.org.

<footnote n="11">¹¹UN PRI and PRI are two interchangeable terms. For example, the website URL is https://www.unpri.org. However, PRI is the official term.</footnote>
Signatories' commitment is reported in Box 1.1. The principles are voluntary and aspirational, and offer a range of possible actions to integrate ESG issues into investment practice. For example, here are some possible actions for Principle 1:

* Address ESG issues in investment policy statements;

* Support the development of ESG-related tools, metrics, and analysis;

* Promote ESG training for investment professionals;

Becoming a signatory requires the payment of an annual fee<fnref n="12" />, but there are no other formal requirements for signing the membership agreement. However, signatories are required to report annually on their responsible investment activities. Members' responses, which make up the transparency report, are public and available to anyone<fnref n="13" />. Starting in 2019, members will also be required to complete a climate transparency report, which includes specific indicators on the management of risks and opportunities related to climate change. These indicators are modeled on the disclosure framework of the Task Force on Climate-related Disclosures (TCFD). Based on the transparency report, PRI produces an assessment report for each member, which consists of a series of scores on several dimensions (from 0 to 100) and a rating system (from one to five stars). The assessment report is confidential, unless the member chooses to make it public. It is also used by PRI to verify that signatories meet minimum requirements. If not, PRI engages with the member (one-on-one meetings, action plans, etc.). Delisting is a last resort if a signatory has not met the requirements after the two-year period. From 2018 to 2020, 165 signatories were identified as not meeting the minimum requirements. PRI has delisted 5 signatories, and 23 other members of the 165 identified have voluntarily delisted.

<table><caption>Table 1.1: Number of PRI signatories by region and year</caption><thead><tr><th>Region</th><th>2015</th><th>2016</th><th>2017</th><th>2018</th><th>2019</th><th>2020</th><th>2021</th><th>2022</th><th>2023</th></tr></thead><tbody><tr><td>Africa</td><td>2</td><td>3</td><td>6</td><td>3</td><td>11</td><td>11</td><td>23</td><td>19</td><td>12</td></tr><tr><td>Asia</td><td>9</td><td>21</td><td>25</td><td>31</td><td>49</td><td>57</td><td>122</td><td>107</td><td>79</td></tr><tr><td>Australasia</td><td>6</td><td>8</td><td>18</td><td>11</td><td>21</td><td>23</td><td>45</td><td>28</td><td>19</td></tr><tr><td>Europe</td><td>67</td><td>94</td><td>129</td><td>188</td><td>293</td><td>433</td><td>532</td><td>374</td><td>221</td></tr><tr><td>Latin America</td><td>1</td><td>1</td><td>8</td><td>12</td><td>26</td><td>59</td><td>66</td><td>49</td><td>20</td></tr><tr><td>Middle East</td><td>2</td><td>0</td><td>1</td><td>1</td><td>2</td><td>8</td><td>10</td><td>8</td><td>9</td></tr><tr><td>North America</td><td>38</td><td>41</td><td>66</td><td>85</td><td>137</td><td>187</td><td>260</td><td>191</td><td>105</td></tr><tr><td>Total</td><td>125</td><td>168</td><td>253</td><td>331</td><td>539</td><td>778</td><td>1 058</td><td>776</td><td>465</td></tr></tbody></table>

Source: PRI (2024), https://www.unpri.org/signatories/signatory-resources/signatory-directory & Author's calculations.

Figure 1.4 shows the growth of the PRI. At inception, most of the 63 founding signatories were asset owners<fnref n="14" /> with a few asset managers<fnref n="15" /> and data providers<fnref n="16" />. They were mainly located in

<footnote n="12">¹²The fee for 2022/23 ranges from £478 to £14222 depending on the size and category (asset owner, investment manager and service provider) of the signatory.</footnote>

<footnote n="13">¹³Reports from 2014 to 2020 are available on the website https://www.unpri.org/signatories/reporting-and-assessment/public-signatory-reports, while more recent reports can be downloaded from the data portal (or PRI's central depository for signatories' reporting data): https://ctp.unpri.org/dataportalv2.</footnote>

<footnote n="14">¹⁴The most important were AP2, BT Pension Scheme, CDC, CDPQ, CalPERS, CPPIB, ERAFP, FRR, NYCERS, NZSF, NGPF, PGGM, TIAA-CREF, UNJSPF and USS.</footnote>

<footnote n="15">¹⁵The best known asset managers were ABN AMRO Asset Management, Aviva Investors, BNP PAM, Candriam, CAAM (now Amundi), Daiwa AM, Henderson Global Investors and Threadneedle AM.</footnote>

<footnote n="16">¹⁶e.g., Ethix, Trucost and Vigeo.</footnote>
<figure><img src="image_9.png" /><figcaption>Figure 1.4: PRI signatory growth 2006–2021</figcaption></figure>

Source: https://www.unpri.org.

the US, Canada, UK, France<fnref n="17" />, the Netherlands and the Nordics. As of September 2022, the PRI has 5 020 signatories representing approximately $121 trillion in assets under management (AUM). Investment managers are the most represented category (76%) followed by asset owners (14%) and service providers (10%). We observe a rapid evolution since 2015 and even an acceleration in 2020 and 2021, followed by a slowdown in 2022 and 2023, as the number of potential candidates remains limited. In total, the PRI has 5 372 of signatories on 31 December 2023, of which 740 are asset owners. Table 1.1 shows the current picture of where the signatories are located. More than half of them are located in Europe, with North America (Canada and the United States) being the second largest region. In terms of signatories by country, the United States is the largest, followed by the United Kingdom and France.

Climate action 100+

Climate Action 100+ is a collaborative investor initiative to ensure that the world's largest corporate greenhouse gas emitters take necessary action on climate change. It was formed in the wake of the 2015 Paris Agreement, and is launched in December 2017. It is supported by 700 investors, responsible for over $68 trillion in assets under management. Climate Action 100+ focuses on engagement and coordinates the efforts of investor signatories. In a nutshell, engagement corresponds to the active dialogue between the investor and the company by discussing sustainability risks and communicating the investor's expectations for corporate behavior. The main objectives are to improve the climate performance of the company, reduce GHG emissions across the value chain and

<footnote n="17">¹⁷There are 8 founding signatories: BNP PAM, CDC, CAAM (now Amundi), ERAFP, FRR, Groupama AM, Macif Gestion and Vigeo.</footnote>
ensure transparent disclosure. The engagement process can be described as follows:

* Engagement with focus company executives and board members is led by one or more Lead Investors, working with a number of Collaborating Investors and supported by technical experts.

* When signing up for the initiative, investors are asked to nominate which focus companies they would like to work with and whether they would like to be a lead or co-investor.

* Engagement takes a variety of forms, including meeting with companies, making a statement at a company AGM, supporting shareholder resolutions on climate change, and voting to remove directors who fail to address climate change risks.

As of 1 January 2024, Climate Action 100+ engagement focuses on 168 companies that account for up to 80% of global corporate industrial greenhouse gas emissions. The geographic breakdown is as follows: 1.8% in Africa, 20.4% in Asia, 9.0% in Australasia, 33.5% in Europe, 32.3% in North America, and 3.0% in South America. The sector distribution is shown in Table 1.2, where we indicate the number of companies and the market capitalization<fnref n="18" />. For example, the 5 focus companies for the airlines sector are Air France, American Airlines, Delta Air Lines, Qantas Airways, United Airlines, the 12 focus companies for the automobile sector are BMW, Ford, General Motors, Honda, Mercedez-Benz, Nissan, Renault, SAIC, Stellantis, Suzuki, Toyota, Volkswagen, etc.

<table><caption>Table 1.2: Sector breakdown of Climate Action 100+ engagement</caption><thead><tr><th rowspan="2">Sector</th><th colspan="2">Frequency</th><th colspan="2">Market capitalisation</th></tr><tr><th>Number</th><th>in %</th><th>in $ bn</th><th>in %</th></tr></thead><tbody><tr><td>Airlines</td><td>5</td><td>3.0%</td><td>57.7</td><td>0.6%</td></tr><tr><td>Automobiles</td><td>12</td><td>7.1%</td><td>737</td><td>7.1%</td></tr><tr><td>Cement</td><td>11</td><td>6.5%</td><td>181</td><td>1.8%</td></tr><tr><td>Chemicals</td><td>8</td><td>4.8%</td><td>287</td><td>2.8%</td></tr><tr><td>Coal mining</td><td>3</td><td>1.8%</td><td>68.5</td><td>0.7%</td></tr><tr><td>Consumer goods & services</td><td>12</td><td>7.1%</td><td>1 900</td><td>18.4%</td></tr><tr><td>Diversified mining</td><td>11</td><td>6.5%</td><td>484</td><td>4.7%</td></tr><tr><td>Electric utilities</td><td>31</td><td>18.5%</td><td>1 000</td><td>9.7%</td></tr><tr><td>Oil & gas</td><td>40</td><td>23.8%</td><td>3 700</td><td>35.8%</td></tr><tr><td>Oil & gas distribution</td><td>2</td><td>1.2%</td><td>160</td><td>1.5%</td></tr><tr><td>Other industrials</td><td>15</td><td>8.9%</td><td>1 100</td><td>10.6%</td></tr><tr><td>Other transportation</td><td>7</td><td>4.2%</td><td>501</td><td>4.8%</td></tr><tr><td>Paper</td><td>2</td><td>1.2%</td><td>33.6</td><td>0.3%</td></tr><tr><td>Shipping</td><td>1</td><td>0.6%</td><td>39</td><td>0.4%</td></tr><tr><td>Steel</td><td>8</td><td>4.8%</td><td>85</td><td>0.8%</td></tr></tbody><tfoot><tr><td>Total</td><td>168</td><td>100.0%</td><td>10 334</td><td>100.0%</td></tr></tfoot></table>

Source: https://www.climateaction100.org/whos-involved/companies.

With the advent of the net-zero emissions goal, most of the actions coordinated by Climate Action 100+ focus on net-zero corporate policies. According to the 2023 Progress Update report, this year's engagement wins include National Grid, Volkswagen, Engie, CEZ, AES, Petroleo Brasil S.A., American Electric, Incitec Pivot and Toray Industries.

<footnote n="18">¹⁸Market capitalization is computed as of 15 December 2020.</footnote>
Net-zero alliances

Net-zero emissions refers to a state in which greenhouse gas emissions to the atmosphere are balanced by removals from the land and ocean (carbon sink). This is a condition for stopping global warming. According to IPCC (2018), the global temperature increase must be limited to 1.5°C above pre-industrial levels to mitigate the worst impacts of climate change and preserve a livable planet. In general, we assume that net zero emissions must be achieved by 2050 (IEA, 2021), otherwise several tipping points with irreversible consequences could be triggered.

The concept of “Net-Zero Alliance” starts with the launch of the Net Zero Asset Owner Alliance (NZAOA) in September 2019 under the umbrella of UNEP FI. As of January 2024, the Alliance counts 88 members representing $9.5 tn in AUM (UNEP, 2022). These members must adhere to a common protocol for target setting and reporting based on four components:

1. Engagement targets

* Engage with 20 companies, focusing on those with the highest owned emissions or those responsible for a combined 65% of owned emissions in the portfolio;

2. Sub-portfolio emission targets

* 22 to 32% CO₂e reduction by 2025 (per IPCC 1.5°C SR scenarios);

* 40 to 60% CO₂e reduction by 2030 (per IPCC 1.5°C SR scenarios);

* Cover portfolio Scope 1 + 2 emissions, track Scope 3 emissions, and use absolute or intensity-based reduction KPIs;

3. Sector targets

* Use absolute or intensity-based reductions on all material sectors;

* Scope 3 to be included wherever possible;

* Sector specific intensity KPIs recommended;

4. Financing transition targets

* Reporting progress on a climate-positive trend for all Alliance members internally to the Alliance;

* Build solutions or enhance climate solution reporting.

For example, the targets<fnref n="19" /> defined by Munich Re are the following: (1) concentrate on and engage with large contributors of financed emissions within the listed equity and corporate bond portfolios; (2) reduce absolute emissions from the listed equity, corporate bond and real estate portfolios by 25-29% (Scope 1+2 emissions of investee companies) by 2025; (3) reduce emissions from listed equities and corporate bonds for thermal coal (−35%) and oil & gas (−25%); (4) double the renewable portfolio (equity and debt) from €1.6 bn to €3 bn.

In June 2020, the UNFCCC launches the “Race to Zero” campaign, which has significantly accelerated net-zero commitments. For example, the Glasgow Financial Alliance for Net Zero (GFANZ)

<footnote n="19">¹⁹The reader can consult the web page https://www.unepfi.org/net-zero-alliance/resources/member-targets to retrieve the 2025 member targets.</footnote>
is created in April 2021 by Mark Carney<fnref n="20" /> and the COP26 presidency to coordinate efforts across all sectors of the financial system to accelerate the transition to a net-zero global economy<fnref n="21" />. GFANZ is an umbrella organisation covering seven net-zero initiatives: NZAOA, the Net Zero Asset Managers initiative (NZAM), the Paris Aligned Investment Initiative (PAII), the Net Zero Banking Alliance (NZBA), the Net Zero Insurance Alliance (NZIA), Net Zero Financial Service Providers Alliance (NZFSPA) and the Net Zero Investment Consultants Initiative (NZICI).

## Other initiatives

There is a growing list of initiatives related to ESG issues. Here are some examples related to the three pillars:

* **Environmental**
  Asia Investor Group On Climate Change (AIGCC), Finance for Biodiversity Pledge, Finance for Tomorrow, Institutional Investors Group on Climate Change (IIGCC), Montreal Carbon Pledge, One Planet Sovereign Wealth Fund (OPSWF), Portfolio Decarbonization Coalition, etc.

* **Social**
  Platform Living Wage Financials (PLWF), PRI Human Rights Engagement, Tobacco-Free Finance Pledge, Workforce Disclosure Initiative (WDI), etc.

* **Governance**
  Australian Shareholders' Association (ASA), European Corporate Governance Institute (ECGI), International Corporate Governance Network (ICGN), Say on Climate, etc.

### 1.3.3 Regulators

While regulators and supervisors have long been absent from the ESG ecosystem, they are now at the forefront of the ESG debate. This is largely due to the phenomenal growth of ESG and climate investing, as well as changing motivations. When responsible investing was driven by moral values, ESG investing affected a small market of investors. Today, ESG has become a marketing argument and the risk of ESG-washing and greenwashing has become very high. We need to differentiate between two types of risk: (1) explicit & deliberate greenwashing; (2) unintentional greenwashing. Deliberate greenwashing is a mis-selling risk that is closely scrutinized by regulators. One example is the DWS scandal<fnref n="22" />. Unintentional greenwashing is a risk of misinterpretation that needs to be addressed by regulators<fnref n="23" />. One example is the definition of a net-zero investment policy. In this context, clients need to be protected from both types of greenwashing risk. Another reason for

<footnote n="20">²⁰Mark Carney was the governor of the Bank of Canada from 2008 to 2013, the governor of the Bank of England from 2013 to 2020 and the chairman of the Financial Stability Board (FSB) from 2011 to 2018. Since 2020, he has been a United Nations special envoy for climate action and finance.</footnote>

<footnote n="21">²¹We report here the press release of November 3, 2021 during the COP 26 summit: "Today, through the Glasgow Financial Alliance for Net Zero (GFANZ), over $130 trillion of private capital is committed to transforming the economy for net zero. These commitments, from over 450 firms across 45 countries, can deliver the estimated $100 trillion of finance needed for net zero over the next three decades."</footnote>

<footnote n="22">²²Read about litigation issues in ESG investing in the Financial Times: https://www.ft.com/content/1094d5da-70bf-40b5-98f4-725d50620a5a.</footnote>

<footnote n="23">²³Here we make the difference between regulation and supervision from a risk management point of view (Roncalli, 2020a, page 12). The regulator is responsible for setting rules and policy guidelines. The supervisor assesses the safety and soundness of financial institutions and verifies that regulatory rules are being applied. For example, in Europe, the regulator of the banking sector is EBA while the supervisor is ECB.</footnote>
the recent interest of regulators is the political will to mitigate global warming. Indeed, financial regulation is undoubtedly one of the most important instruments for achieving this goal. It is therefore no coincidence that the financial sector is expected to play a key role in the decarbonization of the corporate sector.

<table><caption>Table 1.3: The supervision institutions in finance</caption><thead><tr><th></th><th>Banks</th><th>Insurers</th><th>Markets</th><th>All sectors</th></tr></thead><tbody><tr><td>Global</td><td>BCBS</td><td>IAIS</td><td>IOSCO</td><td>FSB</td></tr><tr><td>EU</td><td>EBA/ECB</td><td>EIOPA</td><td>ESMA</td><td>ESFS</td></tr><tr><td>US</td><td>FDIC/FRB</td><td>FIO</td><td>SEC</td><td>FSOC</td></tr></tbody></table>

The regulators responsible for sustainable risk are the same as those responsible for traditional risk (e.g., market risk, credit risk, or liquidity risk). In Table 1.3 we have provided a list of financial regulators. At the global level, four international authorities have primary responsibility for financial regulation: the Basel Committee on Banking Supervision (BCBS), the International Association of Insurance Supervisors (IAIS), the International Organization of Securities Commissions (IOSCO), and the Financial Stability Board (FSB). The FSB, which is responsible for regulating systemic risk, identified climate risk at a very early stage. The speech “Breaking the tragedy of the horizon” by Mark Carney, Chairman of the FSB, in London on September 29, 2015, marked a turning point in the recognition of climate change as a major risk to financial stability (Carney, 2015). According to Mark Carney, financial stability can be affected through three channels: physical risk (the impact of extreme climatic events occurring today on insurance liabilities and financial assets), liability risk (the impact that could occur tomorrow as parties harmed by climate change seek compensation from those they hold responsible) and transition risk (the financial risk that could result from the process of adapting to a lower-carbon economy). Following the G20 Antalya Summit, the FSB proposed then to “establish an industry-led disclosure task force, to design and deliver voluntary standards for effective disclosures that meet the needs of investors and creditors” (FSB, 2015). The Task Force on Climate-related Financial Disclosures (TCFD) was established in December 2015 under the chairmanship of Michael Bloomberg. In June 2017, the TCFD released its final recommendations for climate-related financial disclosures. The first status report on disclosure practices was published in September 2018. Disclosure is the first pillar of the FSB roadmap, which covers three other areas: (1) data, (2) vulnerability analysis, and (3) regulatory and supervisory practices and tools (Figure 1.5).

The disclosure recommendations for climate-related reporting have been widely adopted, notably through the ISSB's sustainability disclosure standards. The FSB supports these standards to achieve global consistency in reporting. In addition, the FSB has asked the ISSB to take over the monitoring of corporate climate-related disclosures from the TCFD starting in 2024, as outlined in the TCFD's 2023 annual status report. On the data pillar, the FSB has tasked the Network for Greening the Financial System (NGFS) to work on this issue, and the NGFS published its final report on identifying and filling data gaps in July 2022. To develop vulnerability analysis, the FSB is promoting the adoption of scenario analysis based on the climate scenarios provided by the NGFS. Finally, under the regulatory and supervisory pillar, the FSB continues to work with the BCBS, IAIS and IOSCO to strengthen the regulation of climate risks for banks, insurance companies and asset managers, with a particular focus on the integrity of capital markets and the mitigation of greenwashing. In 2023, the FSB updated its roadmap to encompass risks related to nature or biodiversity, while various international organizations such as NGFS, OECD, and the World Bank are actively engaged in crafting analyses and policy frameworks concerning these environmental risks.
<figure><img src="image_10.png" /><figcaption>Figure 1.5: Stylised overview of the FSB roadmap for addressing climate-related financial risks (July 2021)</figcaption></figure>

Source: Financial Stability Board (2021),
www.fsb.org/work-of-the-fsb/financial-innovation-and-structural-change/climate-related-risks.

The Basel Committee on Banking Supervision (BCBS) provides a forum for regular cooperation on banking supervisory matters. Its main objective is to improve the quality of banking supervision worldwide. Its first publication on climate-related financial risks dates back to April 2020. In June 2022, the BCBS released its first guidelines on this topic (BCBS, 2022). These guidelines include 12 principles for effective risk management of climate risks and 6 principles for the supervisory review process (SRP). We report here on the first principle, which states that climate risk must be managed like financial risks (e.g., market risk or credit risk):

> "Banks should develop and implement a sound process for understanding and assessing the potential impacts of climate-related risk drivers on their businesses and on the environments in which they operate. Banks should consider material climate-related financial risks that could materialise over various time horizons and incorporate these risks into their overall business strategies and risk management frameworks." (BCBS, 2022).

Knowing that the BCBS is capable of developing new regulatory frameworks quickly, we can expect the publication of new standards including climate risk in the coming years. For example, the Basel Committee issued a public consultation paper on a Pillar 3 disclosure framework for climate-related financial risks in November 2023 (BCBS, 2023). This consultation is aligned with the TCFD, and the proposed Pillar 3 regime includes disclosure of qualitative information (governance, strategy, risk management, transition risk, physical risk, and concentration risk) and quantitative information (exposures and financed emissions by sector, exposures subject to physical risks, real estate exposures in the mortgage portfolio by energy efficiency level, emission intensity per physical output and by sector, facilitated emissions related to capital markets and financial advisory activities by sector). As for the other two global supervision institutions, IOSCO has produced a report on ESG rating agencies and data providers (IOSCO, 2021) and analyzed the supervisory practices to address
greenwashing (IOSCO, 2023), while the IAIS focuses more on climate risk and its supervision in the insurance sector (IAIS, 2021). In March 2023, the IAIS launched its first consultation to propose changes to the Insurance Core Principles (ICPs) on governance, risk management and internal controls. In November 2023, the IAIS published two draft application papers on climate risk in the insurance sector, one on market conduct in relation to greenwashing and natural catastrophes, and another on scenario analysis for assessing insurance risks. It is interesting to note that asset management supervisors are more focused on ESG data and greenwashing, while insurance supervisors are more concerned with physical risk.

We are also seeing rapid changes in the regulatory framework at the regional or national level. For example, a new SEC rule requiring all registrants to disclose information on climate risks was proposed in March 2022, but the SEC has since delayed releasing a final version<fnref n="24" />. The reason for this is mainly political, due to the anti-ESG movement we are seeing in a number of US states. At the same time, however, California Governor Gavin Newsom signed a climate disclosure bill in October 2023 that will require private and public companies doing business in California to disclose their Scope 1, 2 and 3 emissions from 2026. In Europe, the sustainable finance roadmap 2022-2024 identifies three priorities for ESMA<fnref n="25" />: (1) tackling greenwashing and promoting transparency, (2) building NCAs' and ESMA's capacities and, (3) monitoring, assessing and analysing ESG markets and risks. Banking supervisors have already conducted several climate stress tests (ACPR, 2021; Bank of England, 2022; ECB, 2022). Central banks have also been very active. Thus, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) was launched at the Paris One Planet Summit (OPS) in December 2017. Its 8 founding members are Banco de Mexico, Bank of England (BoE), Banque de France, Dutch Central Bank, Deutsche Bundesbank, Swedish FSA, Hong Kong Monetary Authority (HKMA), Monetary Authority of Singapore (MAS) and The People's Bank of China (PBOC). As of 27 December 2023, the NGFS consists of 134 members and 21 observers<fnref n="26" />. In addition to its methodological publications, the NGFS is known for its database of climate scenarios<fnref n="27" />.

Sustainable finance is not only regulated by financial regulators. Figures 1.6 and 1.7 shows charts from the MSCI website, listing ESG regulations by type of regulator or by type of regulated party. We find that the number of regulations is greater for issuers than for investors. In addition, bodies other than financial regulators are involved in the ESG regulatory landscape, notably governments. For instance, the French law “Climat et Résilience” (Climate and Resilience) of 22 August 2021 implements part of the 146 proposals of the Citizen’s Climate Convention adopted by the French government to reduce greenhouse gas emissions by 40% by 2030 in a spirit of social justice. In Europe, most ESG regulations are defined by the European Commission (EC) and the European Parliament. This is for example the case of the EU Non-Financial Reporting Directive (NFRD, 2014), the EU Taxonomy Regulation for sustainable activities (EUTR, 2020) and the EU Sustainable Finance Disclosure Regulation (SFDR, 2021). All of these policy initiatives are part of the “European Green Deal”, whose aim is making the European Union climate neutral by 2050. New legislations on the circular economy, building renovation, biodiversity, agriculture and innovation are underway. In order to define these guidelines, the EC is supported by technical working groups such as the High-Level Expert Group on sustainable finance (HLEG) or the Technical Expert Group on sustainable finance (TEG). For example, the EC has mandated the European Financial Reporting Advisory Group (EFRAG) to carry out work for the development of the new EU Corporate Sustainability Reporting Directive (CSRD) in 2020, which will amend the current NFRD.

<footnote n="24">²⁴Visit https://www.sec.gov/news/press-release/2022-46.</footnote>

<footnote n="25">²⁵Visit https://www.esma.europa.eu/policy-activities/sustainable-finance.</footnote>

<footnote n="26">²⁶Including BIS, BCBS, ESM, FSB, IAIS, IMF, IOPS, IOSCO and OECD.</footnote>

<footnote n="27">²⁷They can be found at https://www.ngfs.net/ngfs-scenarios-portal.</footnote>
<figure><img src="image_11.png" /><figcaption>Figure 1.6: Who will regulate ESG? — The regulators viewpoint (MSCI, 2022)</figcaption></figure>

Source: https://www.msci.com/who-will-regulate-esg.

<figure><img src="image_12.png" /><figcaption>Figure 1.7: Who will regulate ESG? — The regulated viewpoint (MSCI, 2022)</figcaption></figure>

Source: https://www.msci.com/who-will-regulate-esg.
### 1.3.4 Reporting frameworks

As we have seen, reporting is a key element in understanding the ESG and climate policies of issuers and investors. Over the past 20 years, we have seen a proliferation of new reporting frameworks. Table 1.4 lists the most prominent. For each report, we indicate the date the initiative was created and the date the standards were implemented. The first two reporting frameworks were the Global Reporting Initiative (GRI) and the GHG Protocol. The most recent is the International Sustainability Standards Board (ISSB). In the following, we distinguish between sustainability reporting and climate-specific reporting.

<table><caption>Table 1.4: List of the main reporting frameworks</caption><thead><tr><th>Perimeter</th><th>Acronym</th><th>Name</th><th>Dates</th></tr></thead><tbody><tr><td rowspan="6">General</td><td>GC</td><td>UN Global Compact Initiative</td><td>2000/2000</td></tr><tr><td>GRI</td><td>Global Reporting Initiative</td><td>1997/2000</td></tr><tr><td>IIRC</td><td>International Integrated Reporting Council</td><td>2010/2013</td></tr><tr><td>ISSB</td><td>International SustainabilityÂåStandards Board</td><td>2021/2024</td></tr><tr><td>SASB</td><td>Sustainability Accounting Standards Board</td><td>2011/2016</td></tr><tr><td>SDGs</td><td>UN Sustainable Development Goals</td><td>2015/2016</td></tr><tr><td rowspan="7">Climate</td><td>CDP</td><td>Carbon Disclosure Project</td><td>2000/2000</td></tr><tr><td>CDSB</td><td>Climate Disclosure Standards Board</td><td>2007/2015</td></tr><tr><td>GHG Protocol</td><td>Greenhouse Gas Protocol</td><td>1998/2001</td></tr><tr><td>PCAF</td><td>Partnership for Carbon Accounting Financials</td><td>2019/2020</td></tr><tr><td>SBTi</td><td>Science Based Targets initiative</td><td>2015/2015</td></tr><tr><td>TCFD</td><td>Task Force on Climate-Related Financial Disclosures</td><td>2015/2017</td></tr></tbody></table>

#### Sustainability reporting

**International Sustainability Standards Board** After a decade of framework proliferation, the sustainability reporting landscape has changed significantly in the past three years. In June 2021, SASB and IIRC permanently merged into one organization to form the Value Reporting Foundation (VRF). On 3 November 2021, the IFRS Foundation Trustees announced the creation of the International Sustainability Standards Board (ISSB), chaired by Emmanuel Faber<fnref n="28" />, with the goal of providing a comprehensive global baseline of sustainability disclosure standards. On 31 January 2022, the Climate Disclosure Standards Board (CDSB) was consolidated into the IFRS Foundation to support the work of ISSB. On 1 August 2022, the IFRS Foundation completes a new consolidation with VRF. On 10 July 2023, a new stage in the convergence of sustainability reporting has been reached with the Financial Stability Board's announcement that it will transfer the responsibility for monitoring progress on firms' disclosures from the TCFD to the ISSB in 2024. Although the previous frameworks will continue to exist and be used by companies, it is clear that the ISSB reporting framework is now the benchmark for sustainability reporting standards and will be used more and more in the future.

The ISSB standards are part of the larger body of IFRS standards and are referred to as IFRS-S (S for sustainability) to distinguish them from the accounting standards issued by the International Accounting Standards Board (IASB). In March 2022, ISSB published the drafts of its first proposed standards, which are definitively adopted in June 2023 with implementation in 2024:

<footnote n="28">²⁸Emmanuel Faber was CEO and Chair of the Board at multi-national food products company Danone.</footnote>
* IFRS S1 general requirements for disclosure of sustainability-related financial information (ISSB, 2022a);

* IFRS S2 climate-related disclosures (ISSB, 2022b).

IFRS S1 requires companies to identify sustainability-related risks and opportunities until the SASB standards are replaced by the IFRS Sustainability Disclosure Standards. IFRS S2 builds on the TCFD recommendations and can be seen as a new version of the TCFD reporting. On October 2022, the ISSB decided to include Scope 3 GHG emissions in the climate reporting according to the fifteen Scope 3 categories described in the GHG Protocol. Although the ISSB standards have definitely taken the lead in sustainability reporting, one of the biggest concerns is the adoption of the single materiality approach rather than the double materiality approach<fnref n="29" />, which is at odds with European standards such as the CSRD.

<figure><img src="image_13.png" /><figcaption>Figure 1.8: The SDGs icons</figcaption></figure>

Source: https://sdgs.un.org/goals#icons.

**Sustainable Development Goals** The SDGs are a set of 17 interrelated global goals that serve as a “blueprint to achieve a better and more sustainable future for all.” They were adopted by the United Nations in 2015 and are to be achieved by 2030. The 17 SDGs are listed in Table 1.5. Each goal is defined by specific targets, and the progress toward each target is measured by indicators. In total, there are 69 goals and 231 unique indicators. The Goal Target Indicator numbering system is used to structure the SDGs tree map. For instance, the first target of the first goal is: 1.1 — By 2030,

<footnote n="29">²⁹Single materiality refers to how climate and other ESG risks and opportunities affect a company's financial performance and position. In contrast, double materiality considers how the company also impacts the climate and the environment.</footnote>
<table><caption>Table 1.5: The 17 SDGs</caption><thead><tr><th>#</th><th>Name</th><th>Description</th><th>E</th><th>S</th><th>G</th></tr></thead><tbody><tr><td>1</td><td>No poverty</td><td>End poverty in all its forms everywhere</td><td>✓</td><td></td><td></td></tr><tr><td>2</td><td>Zero hunger</td><td>End hunger, achieve food security and improved nutrition and promote sustainable agriculture</td><td></td><td>✓</td><td></td></tr><tr><td>3</td><td>Good health and well-being</td><td>Ensure healthy lives and promote well-being for all at all ages</td><td></td><td>✓</td><td></td></tr><tr><td>4</td><td>Quality education</td><td>Ensure inclusive and equitable quality education and promote lifelong learning opportunities for all</td><td></td><td>✓</td><td></td></tr><tr><td>5</td><td>Gender equality</td><td>Achieve gender equality and empower all women and girls</td><td>✓</td><td>✓</td><td></td></tr><tr><td>6</td><td>Clean water and sanitation</td><td>Ensure availability and sustainable management of water and sanitation for all</td><td>✓</td><td>✓</td><td></td></tr><tr><td>7</td><td>Affordable and clean energy</td><td>Ensure access to affordable, reliable, sustainable and modern energy for all</td><td>✓</td><td></td><td></td></tr><tr><td>8</td><td>Decent work and economic growth</td><td>Promote sustained, inclusive and sustainable economic growth, full and productive employment and decent work for all</td><td></td><td>✓</td><td>✓</td></tr><tr><td>9</td><td>Industry, innovation and infrastructure</td><td>Build resilient infrastructure, promote inclusive and sustainable industrialization and foster innovation</td><td>✓</td><td>✓</td><td>✓</td></tr><tr><td>10</td><td>Reduced inequality</td><td>Reduce inequality within and among countries</td><td></td><td>✓</td><td></td></tr><tr><td>11</td><td>Sustainable cities and communities</td><td>Make cities and human settlements inclusive, safe, resilient and sustainable</td><td></td><td>✓</td><td>✓</td></tr><tr><td>12</td><td>Responsible consumption and production</td><td>Ensure sustainable consumption and production patterns</td><td>✓</td><td>✓</td><td>✓</td></tr><tr><td>13</td><td>Climate action</td><td>Take urgent action to combat climate change and its impacts</td><td>✓</td><td></td><td>✓</td></tr><tr><td>14</td><td>Life below water</td><td>Conserve and sustainably use the oceans, seas and marine resources for sustainable development</td><td>✓</td><td></td><td></td></tr><tr><td>15</td><td>Life on land</td><td>Protect, restore and promote sustainable use of terrestrial ecosystems, sustainably manage forests, combat desertification, and halt and reverse land degradation and halt biodiversity loss</td><td>✓</td><td></td><td></td></tr><tr><td>16</td><td>Peace, justice, and strong institutions</td><td>Promote peaceful and inclusive societies for sustainable development, provide access to justice for all and build effective, accountable and inclusive institutions at all levels</td><td></td><td>✓</td><td>✓</td></tr><tr><td>17</td><td>Partnerships for the goals</td><td>Strengthen the means of implementation and revitalize the Global Partnership for Sustainable Development</td><td></td><td></td><td>✓</td></tr></tbody></table>

Source: https://sdgs.un.org/goals.
eradicate extreme poverty for all people everywhere, currently measured as people living on less than $1.25 a day. This target is measured by only one indicator: 1.1.1 — Proportion of the population living below the international poverty line by sex, age, employment status and geographic location. The fifth target of the first goal is: 1.5 — By 2030, build the resilience of the poor and those in vulnerable situations and reduce their exposure and vulnerability to climate-related extreme events and other economic, social and environmental shocks and disasters. This target is measured by three indicators: 1.5.1 — Number of deaths, missing persons and directly affected persons attributed to disasters per 100 000 population, 1.5.2 — Direct economic loss attributed to disasters in relation to global gross domestic product and 1.5.3 — Number of countries that adopt and implement national disaster risk reduction strategies in line with the Sendai Framework for Disaster Risk Reduction 2015–2030. Initially, the SDGs are built to assess the progress of each country on the different pillars. We can then analyze the evolution of each indicator per country and per year. Synthetic scores are also available at the country or goal level. A compilation of these scores<fnref n="30" /> can be found in Sachs et al. (2024).

The SDGs have been quickly adopted by financial institutions as a framework for impact investing. In Table 1.5, we map the 17 SDGs and the 3 ESG pillars. Therefore, we can assign the SDGs targets to each ESG dimension. An example applied to artificial intelligence companies is provided by Sætra (2022). The SDGs have also been used to assess the ESG objectives of sustainable financial products. For example, ICMA has published a mapping<fnref n="31" /> to the SDGs for green and social bonds (ICMA, 2022), where the targets are linked to GBP and SBP categories.

## Climate reporting

**GHG Protocol** The GHG Protocol was created in 1998 by WRI and WBCSD with the goal of “establishing comprehensive global standardized frameworks to measure and manage greenhouse gas emissions from private and public sector operations, value chains and mitigation actions.” First published in 2001, the standard defines the accounting and reporting of six greenhouse gases covered by the Kyoto Protocol, including carbon dioxide (CO2) and methane (CH4).

The GHG Protocol corporate standard classifies a company's greenhouse gas emissions into three scopes (GHG Protocol, 2004):

* Scope 1 refers to direct GHG emissions from sources owned and controlled by the issuer.

* Scope 2 represents the indirect GHG emissions from the consumption of purchased electricity, heat, or steam.

* Scope 3 are other indirect emissions (not included in Scope 2) from the entire value chain.

Scope 2 emissions can be computed using two methods<fnref n="32" /> (GHG Protocol, 2015):

1. the energy mix of the countries (location-based);

2. the energy mix of the utilities supplying the electricity (market-based).

<footnote n="30">³⁰They are also available at the web page https://dashboards.sdgindex.org.</footnote>

<footnote n="31">³¹The link to the Excel mapping file is https://www.icmagroup.org/assets/documents/Sustainable-finance/2022-updates/Mapping-to-SDGs_June-2022-280622.xlsx.</footnote>

<footnote n="32">³²The exact definitions are the following: “a location-based method reflects the average emissions intensity of grids on which energy consumption occurs (using mostly grid-average emission factor data)”, while “a market-based method reflects emissions from electricity that companies have purposefully chosen (or their lack of choice).”</footnote>
Scope 3 is based on 15 sub-categories (GHG Protocol, 2011, 2013), which are divided into two main categories<fnref n="33" />:

* Upstream Scope 3 emissions are defined as indirect carbon emissions related to the upstream value chain. More specifically, Upstream Scope 3 is based on 8 sub-categories: (1) purchased goods and services, (2) capital goods, (3) fuel and energy related activities, (4) upstream transportation and distribution, (5) waste generated in operations, (6) business travel, (7) employee commuting and (8) upstream leased assets.

* Downstream Scope 3 emissions are defined as indirect carbon emissions associated with the downstream value chain. They correspond to these 7 sub-categories: (9) downstream transportation and distribution, (10) processing of sold products, (11) use of sold products, (12) end-of-life treatment of sold products, (13) downstream leased assets, (14) franchises and (15) investments.

Scope 1 emissions are also called direct emissions, while indirect emissions include both Scope 2 and 3 GHG emissions. Unlike Scope 1 and 2, Scope 3 is an optional reporting category.

**Carbon Disclosure Project** The CDP (formerly the Carbon Disclosure Project) is a UK-based not-for-profit charity<fnref n="34" /> co-founded by Paul Dickinson and Tessa Tennant in 2000. CDP manages a global disclosure system for investors, companies, cities, states and regions to manage their environmental impacts. Each year, CDP sends a questionnaire to organizations and collects information on three environmental dimensions:

1. Climate change (based on the GHG Protocol<fnref n="35" />).

2. Forest management;

3. Water security.

In addition, CDP introduces a pilot questionnaire for biodiversity in 2022 and plastics in 2023. The CDP database<fnref n="36" /> is extensively used to measure the carbon footprint of companies, cities and governments. In 2022, more than 18 700 companies and 1 100 cities, states and regions have completed the questionnaire. This represents half of the global market capitalization. In 2023, the number of disclosures increases by 24% and there are now more than 18 700 companies disclosing through CDP. There is also strong demand for biodiversity reporting, with 2 800 companies disclosing on all biodiversity issues in 2022.

**Remark 1** *Because CDP is the most comprehensive reporting database for carbon emissions<fnref n="37" />, CDP data is used extensively by commercial data providers (e.g., Trucost and MSCI) to provide carbon footprint estimates.*

<footnote n="33">³³The upstream value chain includes all activities related to the suppliers whereas the downstream value chain refers to post-manufacturing activities.</footnote>

<footnote n="34">³⁴The global budget of CDP is approximately $30 mn. CDP's funding comes primarily from philanthropic grants (32%), service-based memberships (30%), and government grants (12%).</footnote>

<footnote n="35">³⁵The differences between the GHG Protocol and CDP reporting templates are as follows The GHG Protocol reporting is more focused on numbers, while the CDP reporting includes more open-ended questions and comments. In addition, the CDP report is slightly more comprehensive as it also covers forest management and water security.</footnote>

<footnote n="36">³⁶It is available at https://www.cdp.net/en/data.</footnote>

<footnote n="37">³⁷The fact that the CDP report is an Excel file may explain why it has been more successful than the GHG Protocol report, which is a Word file. However, they are very similar in terms of carbon disclosure.</footnote>
**TCFD** The Task Force on Climate Related Financial Disclosures (TCFD) was established by the FSB in 2015 to develop a set of voluntary and consistent disclosure recommendations that companies can used to inform investors, lenders and insurance underwriters about their climate-related financial risks. The TCFD consists of 31 members from the G20, representing both preparers and users of financial disclosures and is chaired by Michael Bloomberg. The TCFD framework is published in June 2017 and the 11 recommendations are organized around 4 core elements: (1) governance, (2) strategy, (3) risk management, and (4) metrics and targets (Table 1.6). The first core element describes the organization's governance of climate-related risks and opportunities, while the second core element lists the actual and potential impacts of climate-related risks and opportunities on the organization's business, strategy, and financial planning. The processes used by the organization to identify, assess, and manage climate-related risks are specified in the risk management tag. Finally, the last core element defines the metrics and targets used to measure and manage relevant climate-related risks and opportunities. The implementation of the reporting framework is extensively described in TCFD (2021a,b), and many examples can be found in CDSB (2021c) and TCFD (2022).

<table><caption>Table 1.6: The 11 recommended disclosures (TCFD, 2017)</caption><thead><tr><th>Recommendation</th><th>#</th><th>Recommended Disclosure</th></tr></thead><tbody><tr><td rowspan="2">Governance</td><td>1</td><td>Board oversight</td></tr><tr><td>2</td><td>Management's role</td></tr><tr><td rowspan="3">Strategy</td><td>3</td><td>Risks and opportunities</td></tr><tr><td>4</td><td>Impact on organization</td></tr><tr><td>5</td><td>Resilience of strategy</td></tr><tr><td rowspan="3">Risk management</td><td>6</td><td>Risk ID and assessment processes</td></tr><tr><td>7</td><td>Risk management processes</td></tr><tr><td>8</td><td>Integration into overall risk management</td></tr><tr><td rowspan="3">Metrics and targets</td><td>9</td><td>Climate-related metrics</td></tr><tr><td>10</td><td>Scope 1, 2, 3 GHG emissions</td></tr><tr><td>11</td><td>Climate-related targets</td></tr></tbody></table>

Source: https://www.fsb-tcfd.org.

Unlike other climate frameworks (e.g., GHG Protocol and CDP), the TCFD framework is a risk reporting, and not just a carbon emission reporting. For instance, below are some examples of recommended metrics (TCFD, 2022, pages 16-17):

* GHG emissions (absolute scope 1, scope 2, and scope 3 GHG emissions; financed emissions by asset class; weighted average carbon intensity);

* Transition risks (volume of real estate collaterals highly exposed to transition risk; concentration of credit exposure to carbon-related assets; percent of revenue from coal mining);

* Physical risks (number and value of mortgage loans in 100-year flood zones; revenue associated with water withdrawn and consumed in regions of high or extremely high baseline water stress; proportion of property, infrastructure, or other alternative asset portfolios in an area subject to flooding, heat stress, or water stress; proportion of real assets exposed to 1:100 or 1:200 climate-related hazards);

* Climate-related opportunities (net premiums written related to energy efficiency and low-
carbon technology; revenues from products or services that support the transition to a low-carbon economy; proportion of green buildings);

* Capital deployment (percentage of annual revenue invested in R&D of low-carbon products/services; investment in climate adaptation measures);

* Internal carbon prices (internal carbon price, shadow carbon price);

* Remuneration (portion of employee's annual discretionary bonus linked to investments in climate-related products; weighting of climate goals on long-term incentive; scorecards for executive directors).

Similarly, targets are more general and not limited to reducing carbon emissions. For example, they may relate to the amount of executive compensation influenced by climate considerations by 2025, the internal price of carbon by 2030, the amount invested in green buildings by 2035, and so on.

<table><caption>Figure 1.9: Examples of TCFD reports</caption><tr><td>Amundi (2022)</td><td>BlackRock (2021)</td><td>Sanofi (2021)</td></tr><tr><td>NFC (2023)</td><td>Engie (2022)</td><td>SG (2021)</td></tr><tr><td>Eiffage (2022)</td><td>BP (2022)</td><td>Vodafone (2023)</td></tr></table>

Source: Corporate websites.
**Remark 2** Examples of TCFD reporting are given in Figure 1.9. We can generally find TCFD and climate reports by using the Google search bar with the keywords year + “TCFD report” + corporate name or year + “climate report” + corporate name. As we can see, the formats of TCFD reports are diverse. They can correspond to a PowerPoint file or a written document, the number of pages ranges from 3 to 100, etc.

The TCFD framework is endorsed by many international bodies and regulators: European Commission, IFRS, IOSCO, Singapore Exchange Regulation, Central Bank of Brazil, Australian Prudential Regulatory Authority, Canadian Securities Administrators, etc. In this context, it has become the most popular reporting framework from a regulatory perspective. However, much progress remains to be made as this reporting is voluntary and not mandatory. For fiscal year 2021 reporting, “80% of companies disclosed in line with at least one of the 11 recommended disclosures; however, only 4% disclosed in line with all 11 recommended disclosures and only around 40% disclosed in line with at least five” (TCFD, 2022, page 5). The average level of disclosure is 60% for European companies, 36% for Asia Pacific companies and 29% for North American companies. Nearly 50% of asset managers and 75% of asset owners reported information consistent with at least five of the 11 recommended disclosures. The most popular recommended disclosures were (#3) risks and opportunities (61%), (#4) impact on organization (47%), and (#9) climate-related metrics (47%), while the less popular items were (#5) resilience of strategy (16%), (#2) management’s role (22%) and (#1) board oversight (29%). On average, we see an increase of 20% between fiscal years for companies that report on climate risks. For example, for fiscal year 2022 reporting, 58% of companies disclosed in line with at least five of the eleven recommended disclosures (TCFD, 2023). However, the number of companies disclosing in line with all eleven recommendations remains at 4%. With the transfer of responsibility for monitoring progress from the TCFD to the ISSB, we can expect this situation to evolve rapidly.

### 1.3.5 Rating agencies and data providers

To implement ESG strategies, we need extra-financial data. In the 1980s and 1990s, several research firms were established to provide research on responsible investing. These small firms tend to specialize in a particular dimension and region. Some focus on the environmental pillar, but most specialize in the social pillar. In addition to research and advisory activities, they begin to collect a lot of extra-financial data and build sustainability scores. After an initial period of expansion and innovation, they structure themselves as global rating agencies following the model of credit rating agencies (CRA). We then observe a concentration of the industry and a period of consolidation in the 2010s.

#### The early stage of extra-financial rating agencies

In 2001, the French observatory centre for the corporate social responsibility<fnref n="38" /> ORSE published a guide of companies specialized in ESG analysis (ORSE, 2001). This guide has been updated several times until 2012. For instance, in the 2005 edition, ORSE listed 34 sustainability research organizations of which 25 are located in Europe, 5 in North America and 4 in the rest of the world (Australia, Japon, South Korea). This number did not change much during the 2000s. In fact, most of the extra-financial rating agencies were created in the 1990s. Here is a list<fnref n="39" /> of some well-known

<footnote n="38">³⁸The French name is Observatoire de la Responsabilité Sociétale des Entreprises.</footnote>

<footnote n="39">³⁹This list is based on the works of Eccles and Stroehle (2018) and the company profiles provided by ORSE (2007).</footnote>
entities<sup>40</sup>: Ethical Investment Research Services Ltd. (Eiris<sup>41</sup>, 1983, UK), Institutional Shareholder Services (ISS<sup>42</sup>, 1985, UK), Kinder, Lydenberg, Domini & Co. (KLD<sup>43</sup>, 1988, US), Jantzi Research (Jantzi Research<sup>44</sup>, 1992, Canada), Global Engagement Services (GES<sup>45</sup>, 1992, Sweden), Innovest Strategic Value Advisors (Innovest<sup>46</sup>, 1995, US), Sustainable Asset Management Ltd. (SAM<sup>47</sup>, 1995, Switzerland), RepRisk (RepRisk<sup>48</sup>, 1998, Switzerland), Oekom Research AG (Oekom<sup>49</sup>, 1999, Germany), Ethix SRI Advisors (Ethix<sup>50</sup>, 1999, Sweden), Trucost Plc (Trucost<sup>51</sup>, 2000, UK), Inrate (Inrate<sup>52</sup>, 2001, Switzerland), Vigeo (Vigeo<sup>53</sup>, 2002, France), Dutch Sustainability Research (DSR<sup>54</sup>, 2002, Netherlands), EthiFinance (EthiFinance<sup>55</sup>, 2004, France).

## The consolidation of the industry

As shown by Eccles and Stroehle (2018) and Demartini (2020), we are seeing a period of consolidation in the 2010s. Here are some examples:

* Vigeo and Eiris merged in October 2015 to form Vigeo-Eiris (V.E), which will be acquired by Moody's in April 2019.

* In September 2015 and March 2018, ISS acquired Ethix SRI Advisors and Oekom to form ISS ESG solutions (ISS-ethix, ISS-climate and ISS-oekom). In November 2020, ISS is majority owned by Deutsche Börse Group.

* In February and November 2009, RiskMetrics acquired Innovest and KLD. RiskMetrics is bought by MSCI in 2010, froming MSCI ESG Research LLC.

* In September 2009, DSR and Jantzi Research merged to form Sustainalytics. In the 2010s, Sustainalytics acquired Responsible Research (Singapore), ESG Analytics (Switzerland), Solaron

<footnote n="40"><sup>40</sup>The date of creation and the country are shown in the parentheses.</footnote>

<footnote n="41"><sup>41</sup>EIRIS was founded in 1983 by charities and churches as the UK's first independent research service for ethical investors.</footnote>

<footnote n="42"><sup>42</sup>Institutional Shareholder Services was originally founded in 1985 by Robert Monks, an ESG advocate. It began offering proxy voting services in 1992.</footnote>

<footnote n="43"><sup>43</sup>KLD was founded in 1989 by Amy Domini, Peter Kinder and Steve Lydenberg to provide institutional investors with social research on US companies. In May 1990, the firm launched the Domini 400 Social Index (DSI).</footnote>

<footnote n="44"><sup>44</sup>Founded in 1992 by Michael Jantzi, Jantzi Research became a pioneer in the field of ESG research in Canada. In January 2000, it launched the Jantzi Social Index (JSI) consisting of 50 Canadian stocks.</footnote>

<footnote n="45"><sup>45</sup>Caring Capitalism was founded in 1992 and renamed Global Engagement Services in 2003.</footnote>

<footnote n="46"><sup>46</sup>Innovest was founded by Matthew Kierman and Hewson Batlzell as "a green analogy to Moody's" (Eccles et al., 2020). In its early years, it focused on environmental screening. Later, it created the IVA ratings using the credit-like rating scale (AAA, AA, A, BBB, BB, B, and CCC).</footnote>

<footnote n="47"><sup>47</sup>SAM was founded in 1995. In 1999, SAM and Dow Jones launched the Dow Jones Sustainability Indexes. In 2001, SAM launched the first global sustainable water fund (SAM Sustainable Water Fund). In 2006, SAM was acquired by Robeco and renamed RobecoSAM in 2013.</footnote>

<footnote n="48"><sup>48</sup>RepRisk was established in 1998. The RepRisk database was launched later, starting in January 2007.</footnote>

<footnote n="49"><sup>49</sup>The environmental publishing house ökom was founded in 1989. In 1993, ökom GmbH was created to provide environmental research. Oekom research AG became independent in 1999, focusing on corporate responsibility ratings.</footnote>

<footnote n="50"><sup>50</sup>Established in 1999, Ethix developed norm-based screening in 2000 and expanded to emerging markets in 2005.</footnote>

<footnote n="51"><sup>51</sup>Trucost was established in 2000 to help organizations, investors and governments understand and quantify the environmental impacts of business activities. Trucost's database was launched later, starting with the 2005 fiscal year.</footnote>

<footnote n="52"><sup>52</sup>Inrate was officially created in 2001, but its roots go back to 1990 with the creation of Centre Info.</footnote>

<footnote n="53"><sup>53</sup>Founded in 1997, Arese was the first SRI rating agency in France. In June 2002, it became Vigeo under the leadership of Nicole Notat, former General Secretary of the labor union CFDT. In June 2005, Vigeo merged with the Belgian agency Ethibel.</footnote>

<footnote n="54"><sup>54</sup>DSR was the research team of Triodos Bank, a Dutch niche player in sustainable finance founded in 1980. In 2008 it changed its name to Sustainalytics.</footnote>

<footnote n="55"><sup>55</sup>EthiFinance was founded in 2004. It merged with Spread Research in 2017.</footnote>
(India) and GES (Sweden). In April 2020, Sustainalytics becomes a wholly owned subsidiary of Morningstar.

* S&P Global acquired Trucost in October 2016 and the ESG ratings business of RobecoSAM in November 2019.

Today, the industry of extra-financial analysis and ESG ratings is dominated by ISS-Oekom, MSCI, Refinitiv<fnref n="56" />, Reprisk, S&P Global, Sustainalytics and Moody's.

**Remark 3** In Chapter 2 we will see that these ESG rating agencies are specialized and do not offer the same solutions. For instance, on controversy risk, the main players are MSCI, Reprisk and Sustainalytics. For climate risk, CDP, MSCI and Trucost are the leading agencies, while Verisk Maplecroft is the specialized agency for sovereign ESG risk.

**Remark 4** Even if we observe a consolidation, this does not mean that we observe a convergence of ESG methodologies (Chatterji et al., 2016; Berg et al., 2022). This point will be discussed in the next chapter.

## The current business of extra-financial data

As noted by Demartini (2020), the industry consists mainly of large Anglo-Saxon companies (US and UK) and small European start-ups. More precisely, it can be divided into three main categories:

1. **Market data providers**
This category includes financial information providers (Bloomberg, Morningstar), index sponsors (Bloomberg, FTSE Russell, MSCI, Solactive) and stock exchanges (LSEG, Deutsche Börse Group).

2. **Financial rating agencies**
Moody's, S&P Global and Fitch are now involved in the ESG landscape.

3. **Specialized ESG firms**
In this category, we generally find a few pioneering companies such as Inrate, ISS ESG, RepRisk and Sustainalytics.

4. **Technology start-ups**
Most of the new entrants use artificial intelligence (AI), big data, natural language processing (NLP), sentiment analysis and quantitative approaches. Some examples include Arabesque, Covalence, OWL ESG, and Truvalue Labs.

This explains the discrepancy in the number of ESG analysts between the companies. About 20% of extra-financial rating agencies have more than 200 ESG analysts<fnref n="57" />, while 30% have less than 20 analysts (Demartini, 2020, page 11). Another difference is the wide range of activities: provision of raw data, provision of processed data (indicators, scores and ratings), ESG index creation, ESG screening, portfolio analysis, normative analysis, ESG controversy tracking, engagement monitoring, proxy advisory services, consulting, etc. (Demartini, 2020). These activities explain that the business model of extra-financial rating is based on the investor-pays principle, in contrast to credit rating

<footnote n="56">⁵⁶Refinitiv is the former financial and risk unit of Thomson Reuters (including Eikon and Datastream). It is now part of the London Stock Exchange Group (LSEG), which has also acquired FTSE Russell (and Beyond Ratings).</footnote>

<footnote n="57">⁵⁷For instance, Sustainalytics has more than 800 ESG analysts (source: https://www.sustainalytics.com/about-us).</footnote>
agencies, whose historical model was mainly driven by the issuer-pays principle. This means that investors pay a fee to access data, but issuers don't pay to be rated.

The issue of certification and supervision is on everyone's lips. For instance, credit rating agencies registered in the EU are supervised by ESMA<sup>58</sup> (Regulation 462/2013/EU and Directive 2013/14/EU). In the US, the Office of Credit Ratings (OCR) assists the Security and Exchange Commission (SEC) in overseeing those registered as nationally recognized statistical rating organizations<sup>59</sup> (NRSRO). As the market for ESG ratings is expected to grow, the supervision of this industry and the protection of investors are becoming an unavoidable topic. For instance, on April 2022, the EC launched a targeted consultation on the functioning of the ESG rating market in the European Union and on the consideration of ESG factors in credit ratings (EC, 2022a). The summary report, based on 204 responses<sup>60</sup> is published in August 2022. Its main conclusions are:

> "The large majority of respondents (over 84%) consider that the market is not functioning well today. On the quality of ESG ratings, two thirds of respondents consider the quality to be fine to very good, with about one third considering it poor. A large majority of respondents (83%) consider that the lack of transparency on the methodologies used by the providers is a problem in the ESG ratings market. The vast majority of respondents (91%) also consider that there are significant biases with the methodology used by providers [...] Almost all respondents (94%) consider that intervention is necessary, of which the large majority (80%+) support a legislative intervention with the remainder supporting the development of non-regulatory intervention in the form of guidelines, code of conduct. Respondents largely indicated (90%+) that the main element to be addressed by the intervention should be improving transparency on the methodology used by ESG rating provider [...] The vast majority of respondents (82%) consider that ESG rating providers should be subject to some form of authorisation/registration regime in order to offer their services in the EU." (EC, 2022b, pages 3-4).

These results confirm previous analyses that found that the most common shortcomings are: (1) a lack of coverage, (2) data quality and, (3) a lack of transparency around the methodologies used by ESG rating providers (Boffo and Patalano, 2020). We can then expect that regulators will certainly provide regulatory safeguards for the use of ESG ratings in the near future.

## 1.4 Regulatory framework

The number of ESG regulations has increased dramatically in recent years. In Figure 1.10, we report on the global evolution and the breakdown by region. According to PRI (2022b), there are 868 policies and guidelines worldwide that encourage or require investors to consider ESG factors. Most have been developed since 2000, and we are seeing an acceleration that coincides with the Paris Agreement for climate change. The breakdown by region is shown in Figure 1.11. We observe that ESG regulations have gained the most momentum in Europe, but they are increasing in the other regions as well. By analyzing the PRI's regulation database, we obtain the following results<sup>61</sup>:

<footnote n="58"><sup>58</sup>The list of certified credit rating agencies is available at https://www.esma.europa.eu/supervision/credit-rating-agencies/risk.</footnote>

<footnote n="59"><sup>59</sup>The list of certified NRSROs is available at https://www.sec.gov/ocr/ocr-current-nrsros.html.</footnote>

<footnote n="60"><sup>60</sup>Including 21 ESG rating providers, 48 rating users (investors), 49 rated companies and 18 rating users (company).</footnote>

<footnote n="61"><sup>61</sup>For each item, we indicate the frequency in %. Because each policy can apply to multiple items, the frequencies may not add up to 100%. For example, a policy may apply to both asset owners, issuers and asset managers.</footnote>
<figure><img src="image_14.png" /><figcaption>Figure 1.10: Total number of ESG regulations</figcaption></figure>

Source: PRI (2022b), https://www.unpri.org/policy/regulation-database.

<figure><img src="image_15.png" /><figcaption>Figure 1.11: Number of ESG regulations per region</figcaption></figure>

Source: PRI (2022b), https://www.unpri.org/policy/regulation-database.
* Policies are primarily issued by governments and regulators (78.8%). 19% are issued by industry associations, including stock exchanges. Finally, less than 3% are issued by international organizations (OECD, UN, ILO, etc.).

* Most of these policies are mandatory. Nevertheless, the number of voluntary-based approaches is significant<fnref n="62" />, as they represent 33.2% of the sample.

* Four types of policy dominate: corporate ESG disclosure (61.5%), investor ESG disclosure (24.2%), investor ESG integration (20.3%) and national sustainable finance strategy (10.8%). The other types are sector-specific policies (5.6%), financial products<fnref n="63" /> (4.5%), stewardship codes (2.6%) and taxonomy (1.6%).

* The application of these policies mainly concerns corporations (72.4%), asset owners (60.9%), investment managers (40%) and insurance companies (28.2%). The other categories are financial services providers (16.2%) and credit rating agencies (6.5%).

* If we focus on countries, we get the following ranking: China (49 policies), Germany (31), European Union (29), Italy (28), Spain (26), France (24), USA (23), Netherlands (22), Japan (22) and UK (20).

Most of policies are national. They may also be specific-sector. For instance, if we focus on regulations aiming to promote the improvement of the energy performance of buildings, and their reduction of GHG emissions and energy consumption, we find many legislative policies, such as the energy performance of buildings directive (EPBD) in Europe, the French high environmental quality (HQE) certification, the German building energy act (Gebäudeenergiegesetz or GEG), the German sustainable building certification (Deutsche Gesellschaft für Nachhaltiges Bauen or DGNB), the Italian energy-efficient construction and renovation certification (CasaClima), the Spanish climate change and energy transition law, etc. In this context, it is not realistic to have an overview of the regulations in the world<fnref n="64" />. This is why we will focus on the European Union<fnref n="65" />.

The European regulatory framework is articulated around a series of policy initiatives by the European Commission:

* The action plan on sustainable finance (May 2018);

* The European Green Deal (December 2019);

* The Fit for 55 package (July 2021);

* The REPowerEU plan or energy security package (May 2022).

In December 2016, the EC established a high-level expert group on sustainable finance (HLEG), composed of 20 senior experts. HLEG (2018) published its final report on 31 January 2018 with

<footnote n="62">⁶²Especially when they are issued by industry bodies.</footnote>

<footnote n="63">⁶³This category includes green bonds, social bonds, green labels, etc.</footnote>

<footnote n="64">⁶⁴Section 8.2.3 on page 739 provides a more comprehensive overview of climate-related regulations in the European Union and the rest of the world.</footnote>

<footnote n="65">⁶⁵We will not talk about the situation in the US, because it is not stable, especially with the recent emergence of the anti-ESG movement. The issue seems to be highly controversial. On May 25, 2022, the US Securities and Exchange Commission (SEC) proposed new rules and reporting forms to improve the regulatory framework for disclosure of funds' and advisers' consideration of ESG factors. However, these rules are still under discussion. At the same time, we are seeing political moves in the US against ESG investing (e.g., Texas, Florida). Therefore, these backslashes place the US in an uncertain ESG environment.</footnote>
several recommendations and proposals: (1) a classification system (or taxonomy) to provide market clarity on what is sustainable, (2) clarification of investors' obligations to achieve a more sustainable financial system, (3) improved disclosure by financial institutions and companies on how sustainability is taken into account in their decision-making, (4) an EU-wide label for green investment funds, (5) inclusion of sustainability in the mandates of European Supervisory Authorities (ESAs), and (6) a European standard for green bonds. All of these recommendations have been endorsed by the EC and form the basis of the action plan on sustainable finance adopted by the EC in March 2018 and by the European Parliament in May 2018. In July 2018, a technical expert group on sustainable finance (TEG) was established to assist the EC in developing an EU green taxonomy (1), guidelines to improve corporate disclosure of climate-related information (3), an EU green bond standard (6) and methodologies for EU climate benchmarks. In December 2019, the EC proposed a set of climate change policies including biodiversity, circular economy, construction, energy, food, forests and transport. The overall goal of this European Green Deal is for the European Union to become the world's first climate neutral continent by 2050. To finance this climate change strategy, the EC adopted in July 2021 the Renewed Sustainable Finance Strategy, a package of measures to help improve the flow of money to finance the transition to a sustainable economy. The goal is to mobilize at least €1 tn of financing over the decade. At the same time, a new cycle of legislative packages are proposed under the European Green Deal framework. In particular, the EC adopted the Fit for 55 package, a set of policies to achieve the target of reducing GHG emissions by 55% by 2030 compared to 1990 levels<fnref n="66" />. The plan is based on four pillars:

1. A more pronounced industrial transformation, with a wider application of the EU Emissions Trading System<fnref n="67" /> (ETS) to new sectors, along with a tightening of the ETS itself;

2. A faster transition to clean mobility and aviation;

3. A significant growth in renewable energy<fnref n="68" /> and energy efficiency;

4. The restoration of natural ecosystems and forestry to absorb carbon from natural sinks.

On 18 May 2022, the EC published the REPowerEU plan, which includes a series of measures to phase out Russian fossil fuels by 2027 and boost EU renewable energy production and energy efficiency measures. The REPowerEU plan is presented as “*the response of the EC to the hardships and global energy market disruption caused by Russia’s invasion of Ukraine.*” The goal is clearly to reduce the gas dependence of the European Union. It is also an extension of the Fit for 55 package with four objectives: saving energy, diversifying supplies, accelerating the deployment of renewable energy, and reducing fossil fuel consumption in industry and transport.

**Remark 5** *The European Green Deal, the Fit for 55 package and the REPowerEU plan form the global climate strategy of the European Union. At first glance, one might think that they are almost exclusively about climate investing and not about ESG investing. Nevertheless, the EU climate strategy supports a just transition mechanism. According to ILO, “a just transition means greening the economy in a way that is as fair and inclusive as possible to everyone concerned, creating decent work opportunities and leaving no one behind.” This means that the S and G pillars of ESG factors cannot be ignored. For instance, to ensure a socially fair transition, the EC proposed the creation of a social climate fund of €86 bn. The aim of this fund is to protect the poorest citizens who are most affected by energy and mobility costs.*

<footnote n="66">⁶⁶With existing measures, EU carbon emissions are expected to fall only 36% below 1990 levels.</footnote>

<footnote n="67">⁶⁷Emissions trading systems are presented in Chapter 10 on page 988.</footnote>

<footnote n="68">⁶⁸The target for the share of renewable energy is set at 42.5% in 2030.</footnote>
<figure><img src="image_16.png" /><figcaption>Figure 1.12: Sustainable finance action plan timeline</figcaption></figure>

Source: Amundi Asset Management & Jaulin et al. (2022, page 10).
The implementation timeline shown in Figure 1.12 illustrates that the European ESG regulation is a continuous work in progress, which means that most of the frameworks discussed below are not yet finalized or may change.

1.4.1 EU taxonomy regulation

The purpose of a green financial taxonomy is to define what is green, and its objective is to inform
investors about the greenness of their investments. This allows them to evaluate whether or not
the green intensity of their portfolios meets their expectations. According to the European Com-
mission<sup>69</sup>, the EU taxonomy for sustainable activities is “*a classification system, establishing a list of environmentally sustainable economic activities.* [...] The EU taxonomy would provide companies, investors and policymakers with appropriate definitions for which economic activities can be considered environmentally sustainable. In this way, it should create security for investors, protect private investors from greenwashing, help companies to become more climate-friendly, mitigate market fragmentation and help shift investments where they are most needed.” In this context, the
EU taxonomy is a common basis for other ESG regulations (BMR, SFDR, MiFID II, IDD, CSRD),
acting as a “*common language*” around sustainable economic activities.

Developed by the Technical Expert Group on sustainable finance (TEG, 2020), the EU green
taxonomy defines economic activities that make a significant contribution to at least one of the
following six environmental objectives:

1. Climate change mitigation

2. Climate change adaptation

3. Sustainable use and protection of water and marine resources

4. Transition to a circular economy

5. Pollution prevention and control

6. Protection and restoration of biodiversity and ecosystem

To be considered sustainable, a business activity must also meet two other criteria. Namely, the activity must not cause significant harm to other environmental objectives (DNSH constraint) and it must comply with minimum social safeguards<sup>70</sup> (MS constraint). Figure 1.13 summarizes the different steps. However, according to the European Commission, the EU taxonomy is not a mandatory list for investors to invest in, and investors are free to choose what to invest in, but it is expected that over time the taxonomy will encourage a transition towards sustainability in order to meet the EU's climate and environmental goals.

In Table 1.7, we have listed the activities that are eligible for six environmental objectives. For example, the activity “*Human health and social work activities*” is eligible for the adaptation objective, but not for the five other objectives. For each activity, we have also indicated the number of sub-activities concerned. For instance, the activity “*Financial and insurance activities*” has only two eligible sub-activities: #10.1 Non-life insurance: underwriting of climate-related perils and #10.2 Reinsurance. For each sub-activity, the taxonomy also indicates the corresponding NACE

<footnote n="69"><sup>69</sup>See the EU website: https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance_en.</footnote>

<footnote n="70">⁷⁰For example, the UN guiding principles on business and human rights.</footnote>
<figure><img src="image_17.png" /><figcaption>Table 1.7: Activities eligible for the six environmental objectives</figcaption></figure>

<table><thead><tr><th rowspan="2">Activity name</th><th colspan="6"># of activity numbers</th></tr><tr><th>(1)</th><th>(2)</th><th>(3)</th><th>(4)</th><th>(5)</th><th>(6)</th></tr></thead><tbody><tr><td>Accommodation activities</td><td></td><td></td><td></td><td></td><td></td><td>1</td></tr><tr><td>Arts, entertainment and recreation</td><td></td><td>3</td><td></td><td></td><td></td><td></td></tr><tr><td>Construction and real estate</td><td>7</td><td>7</td><td></td><td>5</td><td></td><td></td></tr><tr><td>Disaster risk management</td><td></td><td>2</td><td>1</td><td></td><td></td><td></td></tr><tr><td>Education</td><td></td><td>1</td><td></td><td></td><td></td><td></td></tr><tr><td>Energy</td><td>31</td><td>31</td><td></td><td></td><td></td><td></td></tr><tr><td>Environmental protection and restoration activities</td><td>1</td><td>1</td><td></td><td></td><td></td><td>1</td></tr><tr><td>Financial and insurance activities</td><td></td><td>2</td><td></td><td></td><td></td><td></td></tr><tr><td>Forestry</td><td>4</td><td>4</td><td></td><td></td><td></td><td></td></tr><tr><td>Human health and social work activities</td><td></td><td>1</td><td></td><td></td><td></td><td></td></tr><tr><td>Information and communication</td><td>2</td><td>4</td><td>1</td><td>1</td><td></td><td></td></tr><tr><td>Manufacturing</td><td>21</td><td>17</td><td>1</td><td>2</td><td>2</td><td></td></tr><tr><td>Professional, scientific and technical activities</td><td>3</td><td>3</td><td></td><td></td><td></td><td></td></tr><tr><td>Services</td><td></td><td></td><td></td><td>6</td><td></td><td></td></tr><tr><td>Transport</td><td>20</td><td>20</td><td></td><td></td><td></td><td></td></tr><tr><td>Water supply, sewerage, waste management and remediation</td><td>12</td><td>13</td><td>3</td><td>7</td><td>4</td><td></td></tr><tr><td>Total</td><td>101</td><td>106</td><td>6</td><td>21</td><td>6</td><td>2</td></tr></tbody></table>

Source: EU Taxonomy Compass, https://ec.europa.eu/sustainable-finance-taxonomy.
sectors<sup>71</sup>, and the different criteria (technical screening and DNSH) for eligibility certification<sup>72</sup>. Looking at Table 1.7, there is an asymmetry between the first two objectives and the last four objectives. In fact, climate change mitigation and adaptation concerns more than 100 sub-activities, while there are only 2 sub-activities for the biodiversity objective, 6 for water management and pollution prevention, and 21 for the circular economy. The calculation of green intensities using the EU taxonomy is then biased towards climate change activities.

The EU's green taxonomy is of interest to a wide range of stakeholders because it defines the activities that need to be developed to achieve a low-carbon economy by 2050, with the goal of being net zero:

* All companies covered by NFRD and CSRD fall within the scope of the taxonomy. In fact, the green measurement tools and sustainability criteria developed for these two directives are aligned with the EU green taxonomy. These alignment indicators can then be found in companies' extra-financial reports.

* All financial products covered by SFDR must use the EU taxonomy to calculate the green metrics, some of the principal adverse impacts and the percentage of alignment with the European taxonomy. This information must be included in the prospectus and periodic reports of the funds and financial products.

* More generally, the EU taxonomy is widely used to define sustainable financial products. For example, the European green bond standard relies on the detailed criteria of the EU taxonomy to define green economic activities. While the EU climate-related benchmarks (CTB and PAB) do not specifically mention the taxonomy, most asset managers add green criteria that are aligned with the EU taxonomy. This is also the case for net-zero investment portfolios.

* For 2024, we expect the creation of two taxonomy-related benchmarks. On 13 December 2023, the EU Platform on Sustainable Finance published for consultation a draft report including proposals for EU taxonomy-aligning benchmarks (TAB). The two types proposed are a taxonomy-aligned benchmark (TAB) and a taxonomy-aligned benchmark excluding specific fossil fuel-related activities (TABex). The minimum standards for both TAB and TABex include at least a 7% average annual reduction in CO₂e intensity by 2050 and at least a 5% annual increase in taxonomy-aligned CapEx, with a minimum exposure to CapEx securities at least equal to the equity market benchmark exposure, and an additional minimum set of exclusions for TABex related to coal, oil and gas activities. The consultation is open until 13 March 2024.

**Remark 6** The EU Taxonomy Regulation cannot be reduced to a green taxonomy. Indeed, the environmental taxonomy is the most advanced area, but the objective is to cover other topics. In February 2022, the EU Platform on Sustainable Finance published a final report on social taxonomy, but there is no sign of progress on the creation of a social taxonomy since the publication of this report. Similarly, there has been discussion of an expanded taxonomy in March 2022 to introduce additional levels of performance, in particular amber for intermediate performance and red for significantly harmful (SH) performance. This could form the basis of a future brown taxonomy.

<footnote n="71"><sup>71</sup>NACE is the industry standard classification system used in the European Union. It is the abbreviation of the French term "Nomenclature statistique des Activités économiques dans la Communauté Européenne" (in English, statistical classification of economic activities in the European Community).</footnote>

<footnote n="72"><sup>72</sup>All this information can be found in the EU Taxonomy Compass Excel file, which corresponds to Annex 1 and Annex 2 of the Delegated Act on the climate objectives (Delegated Regulation 2021/2139 of 4 June 2021) and the Complementary Climate Delegated Act (Delegated Regulation 2022/1214 of 9 March 2022).</footnote>
1.4.2 Climate benchmarks

In September 2019, the EU Technical Expert Group on sustainable finance (TEG) proposed the
creation of two climate benchmark labels<sup>73</sup>: climate transition benchmark (CTB) and Paris aligned
benchmark (PAB). These labels are structured according to the following common principles:

1. A year-on-year self-decarbonization of 7% on average per year, based on Scope 1, 2 and 3 emissions;

2. A minimum reduction $\mathcal{R}^{-}$ in carbon intensity compared to the investable universe;

3. A minimum exposure to sectors highly exposed to climate change.

For the CTB label, the minimum reduction $\mathcal{R}^{-}$ is set at 30%, while for the PAB label it is set at 50%. Other restrictions are also imposed such as issuer exclusions (controversial weapons and violators of societal norms), a minimum green revenue share ratio (or green-to-brown ratio<sup>74</sup>), or some activity exclusions. These climate labels are now part of the EU Benchmarks Regulation (BMR), which also specifies ESG disclosure requirements for all benchmarks<sup>75</sup>. In particular, an index sponsor must disclose whether its benchmarks pursue ESG objectives and provide an explanation of the methodology used by those benchmarks to incorporate ESG factors. As mentioned above, we expect the creation of taxonomy-aligned benchmarks in 2024 to complete the European Union's climate change benchmarking framework. These various benchmarks are used in both passive and active management. In passive management, index sponsors create investable indexes that are replicated by asset managers. In active management, these climate indexes serve as benchmarks to measure the performance of climate-related and net-zero investment portfolios and to help identify responsible investment products.

1.4.3 Sustainable finance disclosure regulation

The SFDR is a European disclosure regulation<sup>76</sup> that applies at the entity level and product level. The aim is to encourage capital flows towards more sustainable investments and to prevent green-washing. The SFDR covers websites of financial market participants (Article 4), remuneration policies in relation to the integration of sustainability risks (Article 5), the disclosure of principal adverse impacts (Article 7), the promotion of ESG on websites (Article 10), and periodic and annual reports (Article 11). The level of disclosure depends on the ESG degree of the product and the following product/fund classification:

• Article 6 (or non-ESG products)

It covers standard financial products that cannot be Article 8 or Article 9.

- Article 8 (or ESG products)

It corresponds to financial products which “promote, among other characteristics, environmental or social characteristics, or a combination of those characteristics, provided that the companies in which the investments are made follow good governance practices.”

<footnote n="73"><sup>73</sup>According to the TEG (2019a), “a climate benchmark is defined as an investment benchmark that incorporates — next to financial investment objectives — specific objectives related to greenhouse gas (GHG) emission reductions and the transition to a low-carbon economy through the selection and weighting of underlying benchmark constituents.”</footnote>

<footnote n="74">⁷⁴The implementation of GRS or GTB ratios is delayed, because it requires a comprehensive definition of green/brown taxonomies.</footnote>

<footnote n="75">⁷⁵With the exception of interest rate and currency benchmarks.</footnote>

<footnote n="76">⁷⁶Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability-related disclosures in the financial services sector.</footnote>
* Article 9 (or sustainable products)

In addition to the points covered by Article 8, these financial products have a sustainable investment objective.

For Article 8 and Article 9 products, the SFDR implies disclosure of qualitative and quantitative ESG information (ex-ante requirements for KIID, prospectus and websites, and ex-post requirements for annual reports and MiFID client reports). In particular, pre-contractual documents must indicate ex-ante minimum and planned percentage of sustainable investment (SI) according to following breakdown:

* SI with environmental objective

- in economic activities that are taxonomy-aligned;

- in economic activities that are not taxonomy-aligned.

* SI with social objective

They must also indicate how the portfolio manager considers principal adverse impacts (PAI). Among the 64 PAI indicators, some are mandatory and others are voluntary. Table 1.8 shows the 18 mandatory PAI indicators, which depend on the type of investment (exposure on corporations, investment in sovereign and supranational securities, real estate assets). In addition to these mandatory indicators, the SFDR RTS<sup>77</sup> also defines 22 and 24 optional PAI indicators for the (E) and (S) pillars<sup>78</sup>, respectively.

The first level (SFDR Level I) came into force on 10 March 2021. It requires financial market participants (FMPs) to disclose general SFDR information at the entity level and SFDR classification at the product level. As SFDR Level I does not directly address all technical details, it was complemented<sup>80</sup> by SFDR Level II or SFDR Regulatory Technical Standards (RTS) and further amendments<sup>81</sup> on 20 February 2023. On 1st January 2023, SFDR Level 2 came into effect, requiring the publication of PAI indicators for Article 8 and Article 9 products. PAI reporting at the entity level for the fiscal years 2022 and 2023 must be published before June 2023 and June 2024, respectively.

Since August 2022, financial advisors (FAs) have to assess the sustainability preferences of their clients (MiFID II & IDD). For this purpose, FinDatEx has developed the European ESG Template (EET) to facilitate the exchange of ESG-related data between market participants. The EET is an Excel file containing qualitative information (e.g., fund's name, isin, currency, SFDR classification) and quantitative data, in particular PAI indicators and taxonomy figures. The EET can be used as an SFDR/taxonomy template. The latest version is available at https://findatex.eu.

<footnote n="77"><sup>77</sup>In European Union, a Regulatory Technical Standard RTS is a delegated act, technical, prepared by a European Supervisory Authority (ESA). It should further develop, specify and determine the conditions for consistent harmonisation of the rules included in the basic legislative act. For instance, the SFDR RTS has been developed by ESMA, EBA, EIOPA and the ESAs' Joint Committee.</footnote>

<footnote n="78"><sup>78</sup>The comprehensive list of PAI indicators and their associated metrics is given in Chapter 4 on page 233.</footnote>

<footnote n="79"><sup>79</sup>Final Report on draft Regulatory Technical Standards with regard to the content, methodologies and presentation of disclosures pursuant to Article 2a(3), Article 4(6) and (7), Article 8(3), Article 9(5), Article 10(2) and Article 11(4) of Regulation (EU) 2019/2088</footnote>

<footnote n="80"><sup>80</sup>Corrigendum to Commission Delegated Regulation (EU) 2022/1288 of 6 April 2022 supplementing Regulation (EU) 2019/2088 of the European Parliament and of the Council with regard to regulatory technical standards.</footnote>

<footnote n="81"><sup>81</sup>Commission Delegated Regulation (EU) 2023/363 of 31 October 2022 amending and correcting the regulatory technical standards laid down in Delegated Regulation (EU) 2022/1288.</footnote>
<table><caption>Table 1.8: The 18 mandatory PAI indicators</caption><tbody><tr><td colspan="2">Corporates</td></tr><tr><td colspan="2">Climate and other environment-related indicators</td></tr><tr><td>1</td><td>GHG emissions</td></tr><tr><td>2</td><td>Carbon footprint</td></tr><tr><td>3</td><td>GHG intensity of investee companies</td></tr><tr><td>4</td><td>Exposure to companies active in the fossil fuel sector</td></tr><tr><td>5</td><td>Share of non renewable energy consumption and production</td></tr><tr><td>6</td><td>Energy consumption intensity per high impact climate sector</td></tr><tr><td>7</td><td>Activities negatively affecting biodiversity sensitive areas</td></tr><tr><td>8</td><td>Emissions to water</td></tr><tr><td>9</td><td>Hazardous waste ratio</td></tr><tr><td colspan="2">Social and employee, respect for human rights, anti-corruption and anti-bribery matters</td></tr><tr><td>10</td><td>Violations of UN Global Compact principles and OECD Guidelines for Multi-national Enterprises</td></tr><tr><td>11</td><td>Lack of processes and compliance mechanisms to monitor compliance with UN Global Compact principles and OECD Guidelines for MNEs</td></tr><tr><td>12</td><td>Unadjusted gender pay gap</td></tr><tr><td>13</td><td>Board gender diversity</td></tr><tr><td>14</td><td>Exposure to controversial weapons (anti personnel mines, cluster munitions, chemical weapons and biological weapons)</td></tr><tr><td colspan="2">Sovereigns and supranationals</td></tr><tr><td colspan="2">Climate and other environment-related indicators</td></tr><tr><td>15</td><td>GHG intensity</td></tr><tr><td colspan="2">Social and employee, respect for human rights, anti-corruption and anti-bribery matters</td></tr><tr><td>16</td><td>Investee countries subject to social violations</td></tr><tr><td colspan="2">Real estate assets</td></tr><tr><td colspan="2">Climate and other environment-related indicators</td></tr><tr><td>17</td><td>Exposure to fossil fuels through real estate assets</td></tr><tr><td>18</td><td>Exposure to energy-inefficient real estate assets</td></tr></tbody></table>

Source: SFDR RTS⁷⁹ (2 February 2021).

### 1.4.4 MiFID II and sustainable preferences

MiFID is the Markets in Financial Instruments Directive (2004/39/EC). It has applied to investment advice and portfolio management throughout the European Union since November 2007. Its aim is to standardize practices across the EU for investment services and activities and to ensure a high degree of harmonised protection for investors in financial instruments. MiFID II is a revised version of the original MiFID and came into force in 2018. It covers organizational requirements for investment firms, regulatory reporting to prevent market abuse, over-the-counter trading, cost transparency, etc.

In terms of investor protection, financial advisors must make a suitability and appropriateness assessment when providing individual portfolio management or advice on financial instruments. This means that FAs must obtain information from the client before providing investment advice or individual portfolio management. The MiFID II Suitability Test includes questions about the investor's knowledge and experience, financial situation, and investment objectives. In September
2022, ESMA has published its guidelines on the integration of ESG risks and factors into MiFID II (ESMA, 2022). There are two main implications:

1. Integration of sustainability preferences to define the suitable product;

2. Integration of ESG criteria in the product governance.

The first point ensures that the product is in line with investors' values when providing financial advice and portfolio management services. This requires a new version of the suitability and appropriateness assessment (profiling questionnaire, suitability test, adequacy report). The second point concerns the product offering of FMPs. Indeed, manufacturers and distributors must specify their target markets and the sustainability goals with which the product is compatible.

"Sustainability preferences" is the key concept when selling an ESG product<sup>82</sup>. If the client has sustainability preferences (yes/no), they must select one or a combination of the following criteria:

1. Minimum percentage in environmentally sustainable investments aligned to the EU taxonomy;

2. Minimum percentage invested in sustainable investments as defined in the SFDR (Articles 8 and 9);

3. Quantitative/qualitative elements of principal adverse impacts defined by the client.

Once the selection has been made, the financial advisor can sell a product to the client after ensuring that the product meets the client's sustainability preferences.

**Remark 7** *The integration of sustainability preferences is not limited to financial investment products and MiFID II. It also applies to insurance-based investment products and the Insurance Distribution Directive (IDD).*

### 1.4.5 Corporate sustainability reporting directive

The Corporate Sustainability Reporting Directive (CSRD) requires companies to disclose sustainability information in their financial reports. It has replaced the NFRD on 5 January 2023. The CSRD applies to all listed companies in the EU and all large European companies that meet at least two of the following criteria: (1) 250 employees, (2) €50 mn turnover and, (3) €25 mn total assets. This represents approximately 50 000 companies and 75% of the total turnover of companies in the EU, while the NFRD covered about 11 700 large companies. According to EFRAG (2022), the sustainable reporting standards shall address the following topics:

*   **E**nvironmental factors: (1) climate change mitigation; (2) climate change adaptation; (3) water and marine resources; (4) resource use and circular economy; (5) pollution; (6) biodiversity and ecosystems.

*   **S**ocial factors: (1) equal treatment and opportunities for all; (2) working conditions; (3) respect for the human rights, fundamental freedoms and democratic principles.

*   **G**overnance factors: (1) role and composition of administrative, management and supervisory bodies; (2) features of the undertaking's internal control and risk management systems, in relation to the sustainability reporting; (3) business ethics and corporate culture, including anti-corruption and anti-bribery; (4) political engagements of the undertaking, including its lobbying activities; (5) management and quality of relationships with business partners.

<footnote n="82"><sup>82</sup>Client's sustainability preferences are required since August 2022.</footnote>
For the environmental factors, we recognize the 6 goals of the green taxonomy. It is no coincidence that the **CSRD** must be consistent with the **SFDR** and the European taxonomy. In fact, it must help financial institutions calculate **ESG** and climate metrics in a more robust and effective way. In addition to current **KPIs**, the **CSRD** also requires the company measure and assess its targets. This type of forward-looking information is helpful to investors, for example, in defining their net-zero investment policies. However, the **CSRD** has another ambition by considering double materiality. It is a first step in the development of a comprehensive extra-financial/climate accounting statement<sup>83</sup>. Materiality is an accounting principle that states that information about an entity is material if it is reasonably likely to influence an investor's decision. Therefore, it must be recorded or reported in the financial statements. It is now widely accepted that climate-related impacts on a company can be material and therefore require disclosure. This approach is known as financial or single materiality. The concept of double materiality is an extension of single materiality by considering the company's negative externalities. In this case, we need to consider two materiality perspectives:

* How do sustainability factors affect the financial value of the company?

* How does the company impact the environment, society, and people?

The first corresponds to financial (or outside-in) materiality, while the second defines impact (or inside-out) materiality. For example, the **SASB** framework is based on the financial materiality. In contrast, the **GRI** framework has adopted an inside-out materiality by reporting on the impact of companies on people and the planet. In the case of the **CSRD**, **EFRAG** has chosen to consider the double materiality assessment.

On 31 July 2023, the European Commission published a first set of 12 European Sustainability Reporting Standards (ESRS) developed by **EFRAG** (2022) (Figure 1.14). The two cross-cutting standards are **ESRS 1**, which covers general requirements, and **ESRS 2** which addresses general disclosures:

* **ESRS 1** describes the architecture of ESRS standards, explains drafting conventions and fundamental concepts, and sets out general requirements for the preparation and presentation of sustainability-related information: qualitative characteristics of information, double materiality, due diligence, value chain, etc.

* **ESRS 2** sets out disclosure requirements for the information that the company should provide at a general level on all material sustainability issues in the reporting areas of governance, strategy, impact, risk and opportunity management, and metrics and targets.

In addition to the two cross-cutting standards, there are 10 topical ESRS that cover a sustainability topic and are organized into topics and sub-topics:

* **ESRS E1** climate change: climate change adaptation, climate change mitigation, energy.

* **ESRS E2** pollution: pollution of air, pollution of water, pollution of soil, pollution of living organisms and food resources, substances of concern, substances of very high concern, microplastics.

* **ESRS E3** water and marine resources: water (water consumption, water withdrawals, water discharges), marine resources (water discharges in the oceans, extraction and use of marine resources).

<footnote n="83"><sup>83</sup>The **CSRD** standards are defined by **EFRAG** (European Financial Reporting Advisory Group), which represents the European accounting profession and the European voice in financial reporting. In particular, it participates in the standard setting process of the **IASB** and develops European views on international accounting standards (**IFRS**).</footnote>
<figure><img src="image_18.png" /><figcaption>Figure 1.14: ESRS standards</figcaption></figure>

Source: https://denkstatt.eu/esrs-standards-explained.

* ESRS E4 biodiversity and ecosystems: direct impact drivers of biodiversity loss (land-use change, fresh water-use change and sea-use change, direct exploitation, invasive alien species), impacts on the state of species, impacts on the extent and condition of ecosystems, impacts and dependencies on ecosystem services.

* ESRS E5 circular economy: resources inflows, including resource use, resource outflows related to products and services, waste.

* ESRS S1 own workforce: working conditions (secure employment, working time, adequate wages, social dialogue, freedom of association, collective bargaining, work-life balance, health and safety), equal treatment and opportunities for all (gender equality and equal pay for work of equal value, training and skills development, employment and inclusion of persons with disabilities, measures against violence and harassment in the workplace, diversity), other work-related rights (child labour, forced labour, adequate housing, privacy).

* ESRS S2 workers in the value chain: working conditions, equal treatment and opportunities for all, other work-related rights.

* ESRS S3 affected communities: communities' economic, social and cultural rights (adequate housing, adequate food, water and sanitation, land-related impacts, security-related impacts), communities' civil and political rights (freedom of expression, freedom of assembly, impacts on human rights defenders), rights of indigenous peoples (free, prior and informed consent, self-determination, cultural rights).
* ESRS S4 consumers and end-users: information-related impacts for consumers and/or end-users (privacy, freedom of expression, access to quality information), personal safety of consumers and/or end-users (health and safety, security of a person, protection of children), social inclusion of consumers and/or end-users (non-discrimination, access to products and services, responsible marketing practices).

* ESRS G1 business conduct: corporate culture, protection of whistle-blowers, animal welfare, political engagement and lobbying activities, management of relationships with suppliers including payment practices, corruption and bribery (prevention and detection including training, incidents).

These first 12 ESRS cover all companies subject to the CSRD. Sector-specific and SME-specific ESRS are expected to follow. Obviously, reporting on all of these dimensions requires the calculation of hundreds of metrics and data points, is time-consuming, and can be relatively costly. For this reason, the European Commission has introduced a phased approach to reporting requirements. The ESRS will apply first to companies that were previously subject to the NFRD. They will publish the first CSRD report in 2025 for data collected in the 2024 financial year. Other large companies that were not subject to the NFRD will publish in 2026 for data collected in the 2025 financial year. Finally, listed SMEs will publish in 2027.

According to the European Commission<fnref n="84" />, they have worked to “ensure a very high level of alignment between ESRS and the standards of the International Sustainability Standards Board (ISSB) and the Global Reporting Initiative (GRI). From the beginning of the development of draft ESRS by EFRAG, the GRI served as an important reference point, and many of the reporting requirements in ESRS were inspired by the GRI standards. The ESRS and the first two standards of the ISSB (IFRS S1 and S2) have been developed in parallel. Intensive and constructive discussions between the Commission, EFRAG and the ISSB have ensured a very high degree of alignment where the two sets of standards overlap.” However, we remind that there is a big difference between the ESRS and ISSB standards since the former is based on double materiality while the latter has adopted single materiality.

## 1.5 The market of ESG investing

In this section, we provide a global overview of the ESG market from an investment perspective. First, we define the various ESG strategies and provide some examples. We then discuss some figures on the ESG market and its growth.

### 1.5.1 ESG strategies

In Figure 1.15 we define the different types of ESG strategies. This list is based on several reports (Eurosif, 2018; GSIA, 2021; PRI, 2020). Depending on the region and the organization, these categories may have different names. For example, in the case of the seventh category, the term “community investing” is widely used in North America (RIA Canada, US SIF), while we prefer the term “microfinance” in Europe.

Most of these categories are based on the concept of screening, which refers to investment filters. Negative screening is an approach that excludes certain investments or groups of assets from the investable universe, such as companies, sectors or countries that do not meet specific ESG criteria. When applied to companies, it is also referred to as a worst-in-class exclusion strategy. In this

<footnote n="84">⁸⁴See the website https://ec.europa.eu/commission/presscorner/detail/en/qanda_23_4043.</footnote>
<table><caption>Figure 1.15: The 7 categories of ESG strategies</caption><tr><td>1.</td><td>Exclusion</td><td>Exclusion policy &amp; negative (or worst-in-class) screening</td></tr><tr><td>2.</td><td>Values</td><td>Norms-based screening</td></tr><tr><td>3.</td><td>Selection</td><td>Positive (or best-in-class) screening</td></tr><tr><td>4.</td><td>Thematic</td><td>Sustainability themed investing (e.g., green bonds)</td></tr><tr><td>5.</td><td>Integration</td><td>ESG scoring is fully integrated in portfolio management</td></tr><tr><td>6.</td><td>Engagement</td><td>Voting policy &amp; shareholder activism</td></tr><tr><td>7.</td><td>Impact</td><td>Impact investing</td></tr></table>

Source: Eurosif (2021), https://www.eurosif.org/responsible-investment-strategies.

<table><caption>Table 1.9: Comparison of Eurosif, GSIA and PRI classifications</caption><thead><tr><th>#</th><th>Eurosif</th><th>GSIA</th><th>PRI</th></tr></thead><tbody><tr><td>1</td><td>Exclusions</td><td>Negative/exclusionary screening</td><td>Negative screening</td></tr><tr><td>2</td><td>Norms-based screening</td><td>Norms-based screening</td><td>Norms-based screening</td></tr><tr><td>3</td><td>Best-in-class</td><td>Best-in-class/positive screening</td><td>Positive screening</td></tr><tr><td>4</td><td>Sustainability themed</td><td>Sustainability themed/thematic investing</td><td>Thematic</td></tr><tr><td>5</td><td>ESG integration</td><td>ESG integration</td><td>Integration of ESG issues</td></tr><tr><td>6</td><td>Engagement &amp; voting</td><td>Corporate engagement &amp; shareholder action</td><td>Engagement/proxy voting</td></tr><tr><td>7</td><td>Impact investing</td><td>Impact/community investing</td><td>Sustainability impact</td></tr></tbody></table>
case, the investor can systematically exclude issuers with the worst rating (e.g., companies rated CCC). This category also covers sector or sub-industry exclusions (e.g., coal & consumable fuels, fossil fuel production, conventional weapons, civilian firearms). This approach may also include certain activities, because they are inconsistent with the investor's values (e.g., pornography, tobacco, alcohol, gambling, genetically modified organisms). In most cases, the investor defines an exclusion list of individual issuers.

Norm-based screening consists of excluding companies that have been called into question for violating international standards and norms on social or environmental issues, such as those issued by the OECD, ILO, UN Global Compact and UNICEF. The first category is closed to this second category, but the latter is based on international values, while the former is based on individual values. For example, a company that meets all the minimum standards of business practice based on international norms may be excluded in the negative screening approach because it has a very poor ESG rating or belongs to a sector that the investor does not want to finance. Considering the first two categories, the top exclusion criteria in Europe are (1) controversial weapons (Ottawa and Oslo treaties), (2), tobacco, (3) all weapons, (4) gambling, (5) pornography, (6) nuclear energy, (7) alcohol, (8) genetically modified organisms and (9) animal testing (Eurosif, 2018).

The third category invests in issuers, sectors or projects selected for positive ESG performance relative to industry peers. For this reason, the selection category is also referred to as positive screening. For example, the best-in-class ESG strategy selects issuers with the best ESG ratings (e.g., AAA, AA and A), while the ESG momentum strategy selects issuers that have improved their ESG rating.

The goal of sustainability thematic investing is to invest in companies whose activities are related to sustainability, such as clean energy, green technology, sustainable agriculture, sustainable infrastructure, natural resources, biodiversity. ESG thematic investing considers all ESG issues, not just the environmental pillar. For example, it involves investing in social issues (e.g., health, food security, diversity) and governance issues (e.g., gender equality, inclusive boards). Generally, these thematic investments are implemented through mutual funds.

ESG integration is the systematic and explicit incorporation of ESG factors by investment managers into financial analysis and asset allocation. This strategy can be seen as an extension of exclusion and best-in-class strategies. For example, the stock or bond picking score may be a mix of the fundamental score and the ESG score. Some asset managers also require funds to have an ESG score greater than the ESG score of their benchmarks.

The sixth category uses shareholder power and active ownership to influence corporate behavior, including through direct corporate engagement, (i.e., communication with company management and/or boards of directors), filing or co-filing shareholder proposals, and proxy voting that is guided by ESG guidelines. Examples of engagement activities include voting policy, public divestment, engagement with target companies on a specific subject (e.g., pay ratio, living wage), proposing shareholder resolutions, public litigation, etc.

Impact investing is the term used to describe investments made with the intention of generating a positive, measurable social and environmental impact in addition to a financial return. Unlike thematic investing, which focuses on corporate stocks and bonds, impact investing considers assets and securities that finance specific projects. For example, impact investing includes microfinance, community investing, social entrepreneurship funds, funds with a social impact objective, and green and social bonds. Since the goal is to achieve positive social and environmental impacts, it is necessary to measure and report on these extra-financial impacts. Extra-financial reporting is then the key element of impact investing, as it must clearly define and measure the ESG objectives. (e.g., GHG emissions avoided per €1 mn invested per year, percentage of water consumption savings).