The USA Should Clarify the ‘E’ in ‘ESG’ and Use Carbon Standards to Our Advantage

Defining 'environmental' investing and imposing a carbon border adjustment mechanism will benefit the USA

(Deemerwha studio/Shutterstock)

Commentary

When I first heard the term “green bonds” several years ago, I tried to find a definition for the term, but could not. There were multiple examples of how “green bonds” could be used, for things like mass transit systems, wetlands preservation, etc. But there was no “standard” definition per se.

So what qualified as “green”? I understood the general nation that a green bond was environmentally friendly, but what exactly did that mean?

If a state built a bridge that cuts 40 miles off a daily commute each way, and thereby cuts gasoline usage for 100,000 commuters a day, is that a “green” project? What about a municipality cleaning up a landfill? What about financing a low-emissions film production studio as part of a state’s industrial policy?

Therein lies the problem with the market’s ESG—Environmental, Social, and Government investing—trend.

ESG “standards,” to the extent they exist at all, are nebulous, subjective, and indeterminate. Those standards that do exist are voluntary and largely discordant with one another.

Elon Musk’s recent dustup with the S&P 500 ESG Index makes the case. Tesla was dropped from the index for having its “ESG score” downgraded on allegations of racial discrimination at Tesla’s Fremont plant and some crashes of its autonomous vehicles. (Coincidentally, Tesla was dropped almost at the same time as Musk declared he was voting Republican.)

Although scientists say climate change may present a catastrophic—and perhaps even existential—threat, bond issuers are pitching investors, institutions, and pension funds the “environmental,” or “E,” element of ESG bonds the same way that “organic” was pitched to grocery shoppers back in the 1980s.

Back then, “organic” was whatever the seller said it was. It wasn’t until 1990, when the Organic Foods Production Act was passed, that consumers had their first objective, defined, measurable, empirical, standards for products that purported to be “organic.” Even after the legislation passed, it took until 2002 to take full effect, and has been amended since. Today, the USDA-Organic label comes with the government’s assurance, under penalty of law, that the product complies with federal standards.

Founder and CEO of Tesla Motors Elon Musk speaks during a media tour of the Tesla Gigafactory, which will produce batteries for the electric carmaker, in Sparks, Nev., on July 26, 2016. (James Glover II/Reuters)

We in the United States can take a lesson from what we did on organic products to create similar defined, measurable, empirical, and determinate standards for environmental investment to ensure the “E” segment of ESG means something.

The European Union is substantially well ahead of the United States in this regard, having built a rather detailed taxonomy, or classification, of the types of investments that will qualify as “environmental” bonds. Broadly speaking, the EU links its standards to the United Nations Framework Convention on Climate Change, commonly known as the “Paris Agreement.“

In 2018, the EU named a Technical Expertise Group (TEG) to develop a Green Bond Standard (GBS) as part of its “Action Plan on Financing Sustainable Growth.“ The group came back with recommendations that identified six categories of expenditures that could, with additional conditions,  qualify for labeling as meeting the ”European Green Bond Standard.” The expenditures were: climate change mitigation; climate change adaptation; sustainable use and protection of water and marine resources; transition to a circular economy; pollution prevention and control; and protection and restoration of biodiversity and ecosystems.

The EU proposal has a variety of checks, including independent verification, to ensure compliance with the GBS. But it is a voluntary standard, and it has not yet been formally adopted by the EU, so it lacks the force of law. At the same time, the International Capital Markets Association (ICMA) has similar but somewhat different guidelines.

Notably, neither the EU nor the ICMA standards conflate “E” investing with the “social” and “governance” standards, so environmental investing can be isolated from both those issues.

The United States has no formal “E” standards, despite some states, like New York, putting forth what its politicians describe as “Environmental Bond Issues“ on the ballot in November. (Few, if any, of the New York environmental projects would appear to qualify as ”environmental” under the standards of either the EU or the ICMA.)

Wind turbines are viewed at a wind farm in Colorado City, Texas, on Jan. 21, 2016. (Spencer Platt/Getty Images)

Another Path

It’s time for the United States, the EU, the UK, and our allies in Asia to harmonize and codify “E” standards that would be required, not voluntary, to issue bonds bearing that designation in U.S. and foreign securities markets. Investors who hold bonds from companies complying with the “E” standards should be incentivized to do so, perhaps by exempting some portion of the interest payments from federal income tax. For bonds issued by state and local governments, which can be federal tax exempt, E bonds might be structured so that interest payments generate a refundable tax credit to holders.

But the United States can and should go further to integrate sustainable finance into U.S. investment and trade policy, including an emphasis on the “global” aspect of what used to be called “global warming,” by imposing a uniform standard of climate-friendly manufacturing business practices on countries that currently abuse them.

The United States, as well as our two principal trading partners, Mexico and Canada, should scale up a Climate Border Adjustment Mechanism (CBAM), similar to the one currently being considered by the EU. Our State Department should encourage our allies to do the same.

The CBAM would impose tariffs on foreign goods imported from countries that are not manufactured, or services that are not performed, in a manner that is consistent with U.S. environmental standards. But unlike the EU CBAM, which imposes the tariff on the importer, the vision I hope to see realized by the USA and our trading partners imposes tariffs on the foreign exporter as a condition of importation into, or a grant of visas to perform services in, the USA. The burden for non-compliance should belong to the foreign producer, not the U.S. consumer.

President Joe Biden speaks in the Roosevelt Room of the White House in Washington on March 8, 2022. (Win McNamee/Getty Images)

Conclusion

As I’ve written previously, President Joe Biden and his fellow Democrats, who relentlessly posture as champions of  environmental policies, all seem to think “global warming” activities are limited to those that occur within U.S. airspace. Doing so has forced U.S. production overseas in a fashion that enables and enriches countries like China and Venezuela, who have geopolitical and economic interests hostile to our own.

The Biden administration, for example, has urged Venezuela, an ally of our mortal enemy Iran, to produce more oil to counter inflation in U.S. petrochemical markets. Most recently, the Biden administration has made clear its intention to drop the tariffs former President Donald Trump imposed on Chinese imports to reduce inflation.

Biden is set exactly on the wrong course.

Instead of following Biden’s policy the next Congress—likely to be Republican, if current polls are to be believed—should set clear deadlines to codify the “E” standard of ESG, including tax incentives, as set forth above and prohibit the sale of purported “E” bonds that do not meet that standard by the first day of 2024.

Then the next Congress should adopt a timetable for adopting a CBAM that applies U.S. environmental standards to goods and services exported to the United States. Indeed, a truly courageous Congress would impose similar tariffs on goods and services from foreign countries that do not meet International Labor Organization and U.S. Occupational Safety and Health Administration standards which are rarely observed by some of the countries exporting goods and services to the USA.

Both these steps would not only improve the environment, but encourage companies to re-shore production to the United States and North America or to countries that observe our standards of environmental protection.

It’s time for the USA to get serious about both environmental policy and the need to re-shore our manufacturing base. This will both create a more robust supply chain and “box out” those chronic environmental abusers, like China, who rely on their flagrant abuse of the environment as an element of “comparative advantage.“ Political posturing by politicians seeking short-term fixes to inflation, and well-intentioned investors having to rely on nebulous claims of ”environmental” bonds, do none of that.

We’re at a time when we can and should address both.

This is the first in an occasional series on ESG investing. Look for articles on social and governance investing in the future.