Green Tape Environmental, Social and Governance FactorsApril 15, 2021
By John Carroll
Over the long-term, environmental, social and governance (ESG) issues–ranging from climate change to diversity to board effectiveness–have real and quantifiable financial impacts. noted BlackRock chief executive, Larry Fink, in the wake of the Paris Climate Agreement, following the UN (United Nations) adoption of the Sustainable Development Goals.
Since Fink’s 2016 annual letter, the desire to expand the concept of fiduciary duty to include Environmental, Social and Governance (ESG) concerns has intensified amongst investors and legislators alike.
In Europe, Christine Lagarde, the head of the European Central Bank and Mark Carney, former governor of the Bank of England, have both long advocated the adoption of monetary policy and banking supervision, supported by the adoption of improved corporate disclosures, to combat climate change. In Asia, the largest asset owners, including Japan’s Government Pension Investment Fund, are demanding investment managers better integrate the ESG criteria into their investment decision-making processes.
The body of evidence to support the growth in sustainability-focused investing is considerable and growing.
- Morningstar’s categorization of funds actively engaged in sustainable investing, boasts 204 members with $77bn in collective assets, with half of those funds launched in the last three years.
- In 2020 alone, close to 500 ESG funds were launched, with many investment managers announcing plans to force companies to cut their emissions and finance new projects.
Nor are investors and legislators alone in embracing a new model for corporate governance.
- Since 2018, the total number of firms that have committed to set emission goals in accordance with the Science-Based Targets Initiative (SBTI), a joint initiative intended to increase corporate ambition on climate action, has increased from 216 to over 1250.
- At the same time, organizations committed to disclosures framed by the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), an industry-led initiative created to develop a set of recommendations for voluntary climate-related financial disclosures, have grown from 580 to 1,884.
According to forecasting issued by Deutsche Bank, AUM accounting for ESG principles is expected to further pass the USD 100 trillion mark by 2028 (see below).
Consequently, the demand for more accurate and more consistent ESG data to support investors in the portfolio securities selection process has grown dramatically. That demand, in turn, has highlighted several significant complications.
Kingdom of loose ends
The first challenge is the absence of a global regulatory standard designed to evaluate outward impacts as part of the investment process.
- The Global Reporting Initiative (GRI), established in 1997, focuses on metrics that show the impact of firms on society and the planet. It has been embraced by close to 6,000 firms worldwide.
- By contrast, the Sustainability Accounting Standards Board (SASB), which is gaining significant ground in the United States) includes only ESG factors that have a significant effect on a firm’s financial performance.
- Different again are the Task Force on Climate-related Financial Disclosures (TCFD) and the Carbon Disclosure Project (CPD) both of which focus on climate change—primarily companies’ exposure to its physical effects and to potential regulations to reduce carbon emissions.
- The International Financial Reporting Standards Foundation (IFRS) will present a proposal to the United Nations in November of this year to establish a global sustainability standards board.
- Finally, the European Union plans to adopt standardized processes through its Non-Financial Reporting Directive (NFRD) and Sustainable Finance Disclosure Regulation (SFDR). Both measures will form part of a broader suite of ESG initiatives designed to direct funding to genuinely sustainable, rather than greenwashed investments, facilitating compliance with the Paris Agreement climate targets and the EU’s commitment to adopt the United Nations (UNs) 2030 Sustainable Development Goals.
What to measure, what to manage
While investors rightly lament that the diversity of standards thwarts comparability, the lack of comparability between standards is a consequence of a more fundamental complication. That is, the lack of regulatory consensus as to which ESG risk factors should be measured and how:
- Of the three categories represented by ESG, Environmental criteria is the most mature, with a focus on active disinvestment in companies that produce many externalities—costs not captured in the manufacturing process, like carbon or waste or other forms of pollution.
- Governance criteria, relating to how a company structures its board, disclosures, compensation, and so on.
- Whilst neither category is without difficulty, both pale in comparison to the difficulties posed by measuring Social criteria. This often involves labor rights, compensation, and fatalities, as well as the ability to pursue a grievance; and issues such as the categorization of employees by gender and ethnicity. A study by NYU’s Stern School (“Putting the ‘S’ in ESG”) examined 12 of the most popular approaches, extracting more than 1,700 different measures required to assess a firm’s commitment to social sustainability alone.
Agreeing to Disagree
Any future alignment of regulatory standards and agreed measures must be complemented by an improvement in the quality of available ESG data:
- Current ESG ratings are immature, with scores often poorly correlated with each other.
- Additionally, the current ratings focus on business models as opposed to the businesses themselves, thus diminishing the impact of what a firm sells, so long as it is manufactured and sold sustainably.
- The scoring systems often measure the wrong things and rely on incomplete, inaccurate figures. 
The proliferation of regulations has heightened the need to establish a common set of standards for ESG, equivalent to the Generally Accepted Accounting Principles used in financial reporting.
Here, it is essential that a dual mandate of Central Governments forcing firms to improve their disclosure commitments and asset managers moving towards coherent and measurable objectives is established.
In the pursuit of better standards, whilst political and regulatory roadblocks still stand in the way for US investors, the European Union has taken significant strides by issuing a suite of regulations, encompassing all asset managers, investment funds, and other categories of financial services firms.
The widespread availability of improved ESG data is essential in complementing traditional fundamental analysis. In this area, we are encouraged by the increased participation and investments made by larger data providers which, although still immature, should support those asset managers looking beyond the aggregated scores, with a view to creating their own ESG ratings.
Finally, we are encouraged by developments in the direction of alternative data analysis, especially in regards the decision making surrounding social criteria:
- Thinknum Alternative Data, a research firm, evaluates reviews of companies written by members of staff, which has proven to be highly effective in discovering examples of corporate malfeasance, omitted from traditional disclosures, or overlooked by audits.
- The data company, RepRisk, which analyses both articles and think-tank reports, whose 2017 risk ratings for Johnson & Johnson, Purdue Pharma, and Teva Pharmaceuticals presaged the impending opioid crisis long before its eventuation.
- The sentiment analysis of news and other media undertaken by Truvalue labs (now part of FactSet).
As our Capital Markets Consulting division continues to work closely with customers and partners in addressing the considerations, methodology, and adoption of ESG policies, the growing criticality of ESG data to the process cannot be overlooked. The improvements in standards, data contents, and types should be seen as essential components required to support investors in the pursuit of both more varied and nuanced ESG targets, as well as the accurate quantification of interrelationships between intangible, difficult-to-measure externalities. While ESG adoption certainly remains in its infancy, the green shoots of spring are appearing once again.
 According to Datamaran, 40% of S&P 500 companies cite GRI in their sustainability reports.
 25% of S&P 500 constituents refer to SASB in disclosures, up from 5% 20 years previously.
 The popularity of both SASB and TCFD has risen in large part due to support from asset managers, including BlackRock and State Street.
 Only 50% of companies within the MSCI world index choose to disclose carbon emissions.