ESG Investing

For True Impact, ESG Data Must Align

Environmental, social, and governance (ESG) analysis is the bedrock of sustainable, responsible, and impact investing. By providing insight beyond a company’s financial profile, ESG data and reporting offers investors a holistic perspective on the short- and long-term ripple effects of corporate actions.

The field is booming: the Forum for Sustainable and Responsible Investment’s latest biennial trend report found that $16.6 trillion worth of US-domiciled, professionally managed investments incorporated ESG criteria at the beginning of 2020—a 43% jump from 2018 levels. However, the wide variety of measures, descriptions, and disclosures employed by companies under the ESG umbrella leaves the door open for critics.

Consider the Department of Labor’s (DOL) 2020 challenge regarding ESG language in investments governed by the Employee Retirement Income Security Act of 1974, which sets the minimum standards and fiduciary responsibility rules for private sector employee benefit plans. Due in part to a lack of “consensus about what constitutes a genuine ESG investment, and ESG rating systems [that] are often vague and consistent,” the federal agency sought to minimize ESG’s role within the scope of fiduciary responsibility.

The language in the DOL’s final rule was softened after a wave of objections from the investment community. Still, the debate underscored the fact that without unanimity on ESG measurement and reporting, impact investing may face an uphill battle.

That said, there are signs that 2021 could mark a turning point in the discipline’s measurement framework.

The Landscape: Myriad Standard-Setters

Sustainability-minded investors have raised concerns about ESG data and reporting for years. In a 2013 EY study, 20% of institutional investors surveyed said that company-generated information was inconsistent, unavailable, or not verified. Four years later, that number had more than doubled to 42%. With no regulatory standards in place and a reliance on self-reporting, ESG data has long required an asterisk for many.

A number of “industry-wide” standards have been developed and promoted to fill the credibility void. Some emphasize environmental matters, such as the Task Force on Climate-related Financial Disclosures, the Carbon Disclosure Project, and the Climate Disclosure Standards Board (CDSB). Others cast a broader ESG net, such as the Global Reporting Initiative, the International Integrated Reporting Council (IIRC), the Sustainability Accounting Standards Board (SASB), and the International Organization of Securities Commissions.

The World Economic Forum also jumped into the fray with a set of universal ESG indicators in September 2020, one month after the Chartered Financial Analyst (CFA) Institute proposed its own ESG disclosure standards.

Meanwhile, ratings agencies such as MSCI, Sustainalytics, S&P Global, and Refinitiv have developed their own proprietary measures and assessments. The profit motive likely plays into varied efforts among data providers: consulting firm Opimas predicts the market for ESG data will eclipse $1 billion in 2021.

Though the permutations can be dizzying, the first step in what many see as a needed industry contraction has already arrived. IIRC and SASB announced a merger in November 2020 to create the Value Reporting Foundation. Immediately, the CDSB released a statement in which chair Richard Samans acknowledged a commitment to ensuring that corporations address climate risk in annual reporting. He said he was looking forward to “exploring a future where we can join forces with our partners under the auspices of a single organization with a common goal.”

Calls to unify the ESG front have been on the rise among critical stakeholders such as investors, analysts, and corporations.

The Stakes of ESG Measurement Convergence

Consolidation cannot come soon enough for some investors. Many consider the preponderance of measurements to both undermine comparability and heighten the risk of greenwashing.

In an open letter to World Economic Forum leaders in January 2020, World Business Council for Sustainable Development president and CEO Peter Bakker called for standardized ESG data disclosures. He wrote that otherwise, “the current fragmentation of KPIs, reporting frameworks, surveys, ratings and benchmarks, makes comparability of information impossible and thus ineffective.”

The Organisation for Economic Co-operation and Development assessed the situation even more bluntly in its September 2020 report, ESG Investing: Practices, Progress, and Challenges. The 37-member global organization warns that the multitudes of ESG data, measurements, and motives among those promoting ESG approaches “risk undermining ESG meaningfulness and integrity.”

As awareness of the potential perils of fragmentation grows, calls to unify the ESG front have also been on the rise among critical stakeholders such as investors, analysts, and corporations.

A 2020 paper from MIT Sloan School of Management and University of Zurich researchers highlights a key subgroup—the ESG ratings community. The paper describes how substantial divergence among leading agencies undermines the work in three ways:

  1. Inconsistencies reduce the likelihood of asset prices reflecting ESG performance.
  2. This disconnect can lead to fewer incentives for corporations to improve ESG performance.
  3. At the same time, ESG initiatives are not as definitive if one rating agency’s emphasis is discounted by another.

Ultimately, the paper concludes that investors, companies, and others will rely on greater transparency among the ESG ratings firms to get the insights needed to gauge the value of each assessment.

Rapid Growth in the International Disclosure Movement

Many see disclosure in the corporate realm as a regulatory matter. The DOL’s recent efforts have turned new attention to the Securities and Exchange Commission (SEC), where a Biden administration could foster advances in an agency that last addressed climate change disclosures in 2010.

Current SEC commissioner Allison Lee told a conference in late 2020 that markets “have passed something of a tipping point with respect to the efficacy of a voluntary [ESG disclosure] regime.” She added that standardized and reliable ESG data must allow for variations between sectors and industries, ultimately suggesting that international efforts could provide a measurement framework.

For example, the European Union is a consistent leader in ESG and sustainability. It operates under recently adopted EU Commission regulations on ESG disclosure and taxonomy, which seek to eliminate the fragmentation that follows when individual countries and market participants create their own sustainability standards.

Separately, one of the most influential nongovernmental financial entities in the world appears ready to assume an ESG data leadership role. The International Financial Reporting Standards oversees the International Accounting Standards Board, the keepers of the globally accepted accounting standards in more than 140 countries. In September 2020, it proposed creating a new Sustainability Standards Board.

The process is still in the early stages, having undergone a public comment period through December 2020. Still, the proposal emphasized the urgency of the matter, concluding that reporting standards “could play a vital role” in capital markets’ endorsement of a low-carbon economy.

Without a consistent measurement framework, ESG data remains susceptible to skepticism about companies’ and investors’ true impact on their broader goals and objectives. However, new momentum building for universal standards may allow financial markets to start coalescing and eventually move discussions past methods to focus on outcomes.

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