In the aftermath of last fall’s COP26 climate summit the environmental, social and governance (ESG) movement appeared to have many reasons to be optimistic, with some observers declaring that businesses are now inseparable from ESG. Money held in sustainable mutual funds and ESG-focused exchange-traded funds rose globally by 53 percent from 2020 to 2021 to $2.7 trillion, with a net $596 billion flowing into the strategy, according to Morningstar.
While that sounds like sugar there is some salt in the mixture, according to a recent report from the global professional services firm EY.
The report acknowledges the optimism about ESG in the run-up to last year’s COP26 climate summit. “Recognizing public concerns over climate change, numerous companies and governments committed to ambitious net-zero pledges,” the report’s authors say. “In tandem, investors identified the huge potential associated with funding the transition to a low-carbon economy.”
However, EY asserts that changing perceptions have left the movement facing some “existential questions” about what ESG really means and whether ESG-focused investors are being effectively served by the sustainability information ecosystem.
EY is hardly alone in expressing these concerns. The Economist argues that ESG has three “fundamental problems,” including a “dizzying array of objectives” lacking any coherent guide for investors and firms to make the “trade-offs that are inevitable in any society,” a lack of clarity about incentives, and a measurement problem because the various scoring systems have “gaping inconsistencies” that can be gamed easily.
Since last fall, the ESG movement has also had to contend the evolving priorities of policymakers and investors in a global economic and geopolitical climate roiled by inflation, Russia’s invasion of Ukraine, and growing tensions between the U.S. and China. There also are growing allegations of greenwashing, such as when a business improves their ESG score by selling assets to a different owner who keeps running them just as before.
The EY report acknowledges these complexities but nevertheless characterizes the maturation of the sustainability information ecosystem as “nothing short of extraordinary,” and that the challenges facing the ESG investing movement “are a product of its infancy.”
The availability and quality of “asset-specific climate data” has improved considerably in recent years,” according to Trevor Houser, a partner with the Rhodium Group. Improvement in the resolution of global climate models, combined with “rapid growth in climate-focused econometric research,” is increasing the understanding of how changes in the climate impact company revenue and operations, real estate investment performance, municipal and sovereign bond risk, etc. In addition, as Houser said within EY's report, more companies are also measuring and disclosing greenhouse gas (GHG) emissions data.
While ESG scores measure a company’s performance on a wide range of environmental, social and governance issues, such as labor relations, waste management, or business activities in countries with authoritarian governments, Houser said they provide “relatively little useful information about company-specific climate risk.”
Climate change-related considerations are usually less than 15 percent of an overall ESG score, said Houser, and other sources of data, including individual assessments of various ESG topics such as climate, are more likely to provide “more meaningful insight.”
Houser said most ratings agencies focus on climate risk management, but many investors are mostly interested in impact, such as how a company’s operations are affecting the climate.
“While these two objectives — risk and impact — are related, they are not the same,” said Houser. “Data providers [and] rating agencies need to be transparent about assumptions and methods and develop products to meet both risk and impact use cases.”
EY offers five recommendations the sustainability information ecosystem should act upon, starting with increasing the transparency of composite indicators like ESG ratings, “which do not serve investors interested in social impact as they are weighted on financial materiality.”
Next, the report calls for increasing understanding of the variety of ways sustainability information is used. The two primary uses of sustainability information are to assess financial risk and social impact, which “are not mutually exclusive but are easily confused.”
The third recommendation is to put in place the conditions to enable the rise of independent assurance — coupled with enhanced standards and increased automation and reporting rigor — to help “further build trust in sustainability information and among ecosystem actors.”
Fourth, the report calls for the development of “comparable and interoperable sustainable finance taxonomies,” systems designed for determining which economic activities should be considered sustainable. Taxonomies founded “on complementary principles” would help to increase comparability and transparency across markets while recognizing that “markets have different philosophies, legal architectures and economic structures.”
Lastly, the report asserts that it is crucial to lower barriers for market participants in emerging economies to put them in a better position to benefit from private capital seeking sustainable investments.
Meanwhile, the broader sustainability information ecosystem will continue to debate the roles played by the respective actors within the ecosystem, says EY.
“The recommendations in this report are not a panacea for addressing the difficult questions facing the ecosystem,” the report concludes, “but they are important areas of focus in the move toward information that is decision-useful and trusted.”
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