The Environmental, Social, and Governance (ESG) investing industry has exploded over the last decade. The Forum for Sustainable and Responsible Investment reports that there are now over $17 trillion in U.S. assets managed via a strategy that incorporates some kind of ESG information. There is great appeal in the idea that ESG performance can be tracked for companies in a similar way to financial performance and used to make investment decisions. An accurate measure of how companies manage environmental and social opportunities and risks could inform investors all along the spectrum – from those whose main concern is financial impact, to those looking to maximize sustainability, and everybody in between.
But what is ESG performance exactly: who defines it, who measures it, and who says if it’s good or bad? ESG performance is generally rated through both quantitative measures (like those shown in the graphic from PricewaterhouseCoopers) and measures that are more subjective, such as evaluating the overall quality of a company’s risk planning. While there are a lot of examples of potential ESG metrics, there is a lack of consensus about which of these are meaningful to measure. According to the sustainability consulting firm ERM, there are more than 600 organizations (research firms, NGOs, investment companies, etc.) that each have their own framework or rating system for ESG performance. Surveying investment professionals, ERM found that the research vendors MSCI and Sustainalytics are among the most popular sources for ESG ratings. However, even these leading raters differ widely in their approaches to defining ESG, and the same company’s ESG performance can look great with one rater and terrible with another.
Variations in ESG performance tracking also effect the amount and types of information that public companies make available to investors. This is important because public information – from a company’s 10k, corporate social responsibility (CSR), or sustainability report – is still the main source of information for ESG raters. Relatively few ESG disclosures are required by the U.S. Securities and Exchange Commission (SEC) or by the regulators of individual industries, though many U.S. public companies voluntarily release additional ESG information. While 90% of the companies in the S&P 500 Index issued a sustainability report in 2019, research from the non-partisan U.S. Government Accountability Office indicated that investors found that disclosures lacked detail, consistency, and comparability.
Though ESG reporting quality still lags behind investor demand, there are a number of positive trends on the horizon. The desire to create universal ESG reporting standards is nothing new, but in the past this work has been attempted by different independent organizations simultaneously, resulting in multiple sets of standards. However, a constructive move forward was announced this past September. Five of the main standard setting bodies – the Global Reporting Initiative (GRI), the Climate Disclosure Standards Board (CDSB), the Sustainability Accounting Standards Board (SASB), the International Integrated Reporting Council (IIRC), and the Carbon Disclosure Project (CDP) – have all committed to work together on one comprehensive corporate reporting system. This could result in clearer guidance for companies to manage and report their ESG performance and provide more useful information to investors.
Finally, there has been increasing support inside the SEC for standardized ESG reporting. An ESG subcommittee was formed in early 2020, ostensibly to look into the ESG practices of investment products, and in late December issued the following recommendations for public company reporting: 1. The SEC should require the adoption of standards by which corporate issuers disclose material ESG risks. 2. The SEC should utilize standard setters’ frameworks to require disclosure of material ESG risks. 3. The SEC should require that material ESG risks be disclosed in a manner consistent with the presentation of other financial disclosures.
While there is still much work to be done to reach convergence of ESG standards, this is all very exciting news.
