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min read

Underlining Problem of ESG

ESG has an underlying problem at the core.

Introduction

Elon Musk attacked ESG. He described it as an “outrageous scam.” ESG ratings, according to Musk, make no sense. There is some truth to his words, but rating agencies are not the only issue. Rating agencies are a symptom of a larger real problem. In this article, I will discuss three underlying issues:

  1. Investments Do Not Equate to Climate Transition
  2. Lack of impact evaluation
  3. Challenges of ESG Teams & Investment Management

Investments Do Not Equate to Climate Transition

Money must be spent in order to have a significant climate impact. Assets in ESG funds continue to grow significantly, with new products, new investments, and re-brandings of funds. In December 2021, global ESG fund assets reached $2.74 trillion, up from $1.65 trillion in 2020 and $1.28 trillion in 2019. One-third of AUM could be ESG assets by 2025, worth $53 trillion. However, capital and asset managers are currently paying for the problem because not every company in the world has an ESG policy in place. A study reported only 80% of North America has ESG policies, whereas Europe, Asia, Latin America, and Africa all have policies. Additionally, 85% of European managers include ESG metrics in corporate reporting, compared to 47% in North America and 43% in Asia. In 2022, more managers agreed to international ethical investment criteria in addition to:

  • 66% increase in commitment to the UNPRI up from 49% in 2021.
  • 12% increase in commitment to the Sustainability Accounting Standards Board (SASB) up from 7% in 2021.
  • 10% increase to the UN Global Compact up from 3% in 2021.
  • 36% stated they follow multiple international standards.

Companies have responded to the ESG shift report metrics, strategies, and ratings to meet stakeholder and regulatory expectations. Finance flows back into the pockets of corporations and shareholders, but there is a lack of corporate responsibility from pledges to impact. Companies need to provide a transparent transition plan.

Companies currently lack a transition plan, and no investor places their investment in a company's forward-looking statements. For example, a regional sales manager is in charge of managing profits and implementing the company’s ESG pledge. Management is thinking about how to make room for more environmentally friendly products. Many of these businesses do not have enough money for sales promotions, which are an important part of their annual sales targets. How should the target of sustainability and profit be balanced? Will compensation be adjusted to reflect new goals? Managers are eager to implement ESG pledges but are faced with additional uncertainty, resulting in inaction. Managers require more funding and transitional planning to make a positive impact.

ESG requires a transformation initiative. The United Kingdom’s government acknowledges this by assembling a task force to create a transition plan. The Transition Plan Taskforce (TPT) will identify best practices for firm-level transition plans and create templates with sector-specific and general disclosures and metrics. This effort should help execute the UK's Sustainability Disclosure Requirements (SDR) and impact global standards. UK’s SDR strategy is to "green the financial system" by making it simple for investors to assess their investments and how their companies impact the environment.

Companies must develop a transition plan, followed by funding. The real issue, however, is how businesses are putting plans in place to help prevent climate change. This is shown through geopolitical tensions with increasing news about climate change. Climate finance is increasing, but developed countries are $20.4 billion short of their goal of raising $100 billion per year to assist developing countries in going green. Underdeveloped countries lack funding but are the most vulnerable to climate disasters. Geopolitical risks between superpowers will rise as natural resources become scarcer. Among the issues are:

  • Food Security: Climate change will make it harder to grow food in many countries, while population increase and meat demand will strain agricultural land.
  • Migration: The widespread internal and external migration caused by climate change will worsen the conflict and social instability. Rising sea levels endanger lives by providing uninhabitable land. The World Bank predicts that by 2050, there will be at least 200 million refugees.

As previously stated, inaction results from a lack of transition planning and insufficient funding to carry out the plans. The reality may be that asset managers are poorly equipped and that a change of management practice is required to successfully implement a transition strategy. Will current strategies work in a society that is always changing with its current way of thinking?

Lack of Impact Evaluation

Asset managers are hesitant to invest in climate initiatives due to the uncertain financial instability and long-term risks that climate change can bring. Managers tackle risks, returns, and the volatility of the market. When it comes to investments, every scenario involving risk assessment has risk management tools. Leading to the second problem: their systems are not designed to measure impact.

A case study by Huntington Capital stated, “We recognize that fund managers are tasked with an incredible amount of work for small management fees. If we want to ask managers to innovate on impact, we need to put in time ourselves, or provide them with resources for either other aligned service providers or new in-house support.”

Due to potential climate risks, asset managers give asset owners’ concerns about the environment the least consideration. Yet, owners are aware of the uncertain financial instability that climate change can bring. For example, risks known 50 years ago and decisions made now can have an impact on your future. Asset owners are only beginning to influence asset managers. Yet, nearly 40% of asset owners claimed they lack knowledge of impact-focused asset managers. Owners mentioned this was a problem when increasing impact theme priorities.

Asset managers are under pressure to make an impact. Commitments must accompany organizational change that gives decision-makers more power and hold them accountable for commitments. In order to do that, companies must modify how decisions are made at all levels to have an impact. They must focus on outcomes rather than profits and risks. Managers are currently underutilizing the environmental and sustainable impact benefits of ESG. ESG integration is a unique alpha-adding element to fundamental analysis, helping recruit and maintain assets. Investors will understand how ESG variables can affect a company's and its stock's performance when corporate communication and openness improve. This improves alpha delivery and engagement.

Asset managers focus on risk management, their tools are designed to measure risks, and businesses must change their operations to account for impacts. ESG is made up of three distinct components: environmental, social, and governance, which makes impact assessment more complicated.

  • Environmental: Topics about nature. Examples: Deforestation, sustainability, carbon footprint.
  • Social: Aspects involving human rights. Examples: Community relations, privacy, resource management.
  • Governance: Governance encompasses both business operations and stakeholder interests. Examples: Board diversity, salary, bribery.

Investing becomes more difficult than traditional risks and returns when three separate factors are combined because no standard exists for measuring each factor separately.

Companies use various parameters and rating methods. A study published in 2014 compared several rating agencies. Sustainalytics, S&P Global, Moody's ESG, Refinitiv, KLD, and MSCI are shortened as SA, SP, MO, RE, KL, and MS, respectively. The report indicated the environmental category had the highest correlation with an average of 0.53, followed by social with an average of 0.42, and governance with an average of 0.30. Sustainalytics and Moody's ESG have the highest correlation of 0.71. For overall ESG rating and individual dimensions, KLD and MSCI have the lowest correlations with other raters.

The table above compares ESG ratings from 2014. In comparison to the ESG ratings listed below for 2017, the overall rating methodology has not changed over time. ESG requires more research. This makes it difficult for investors who want simple portfolios with a clear investment direction.

In et al. stated, “today’s ESG ratings are inconsistent and incomparable, as they are not relying on shared theoretical foundations, nor sharing the common reporting standards.”

Due to a lack of robust ESG data, impact and ESG were not brought together quickly enough. There are conversations and impressions of environmental awareness, and sustainability. There are talks of progress when in reality, how big is the impact? The United Nations Principles for Responsible Investment (UNPRI) launched an initiative advocating for ESG issues in investing. Investors such as Coca-Cola, Walmart, Comcast, and others with $100 trillion assets signed on. Yet, managers would rather not put their clients' investments at risk by speaking out against climate change, even if it means doing nothing. According to a study, the social and environmental performance of investors' investments did not increase. The study suggests, “We find that PRI signatories attract a large fund inflow but we do not observe improvements in fund-level ESG scores or fund returns. We note that PRI signatories are not superior performers in ESG issues prior to signing, relative to non-PRI funds, but PRI affiliation tends to be widely advertised on company websites, marketing materials, and fund documents. Overall, a reasonable reader may perceive our findings as consistent with PRI funds’ greenwashing.” Inadvertently, this creates a negative feedback loop. Businesses risk undermining the work of others when they make false or overly ambitious change promises.

A European study published in 2016 identified organizations that manage more than USD $20 trillion in ESG data as professionally managed assets. These data may contain useful information about factors that affect a company's financial ratios, but it may be difficult to analyze them. Challenges include accessibility, historical data is often provided instead of current, and the use of a qualitative method that makes data unapproachable with traditional analysis methodologies.

ESG data would be harmful to investors. ESG teams strive to be clear and understandable, but due to a lack of transparent ESG data, investors are unable to fully comprehend them. As a result, investors are discouraged from using the data to make investment decisions.

Rating agency employees we spoke with said that they do not understand the process by which ratings are given, nor how an individual can make them subjective. Rating agencies are not the whole problem, they are a symptom of a bigger problem.

Challenges of ESG Team and Investment Management

ESG teams have doubled from 2017 to 2020. As more companies start to think about sustainability in all areas, there are conflicting ideas between ESG teams and investors. This is the root of the problem - people who are not investors trying to influence the investment process while learning capital markets. There aren't enough people with experience or knowledge on both sides. 13% of the 3,700 top ESG professionals at the world's 100 largest banks and asset management firms have degrees in ESG, sustainability, stewardship, diversity, the environment, or climate change.

When 15Rock questioned investors about their frustrations with ESG teams, nearly 200 investors responded that their teams were unaware of the constraints of their funds. As previously stated, ESG teams try to give investors ESG data, but investors can't compare metrics.

Christopher J. Ailman, CalSTRS' chief investment officer and a speaker at the 62nd Annual Financial Analysts Seminar, expressed his irritation with ESG themes and integration, especially responsible investing. He discussed labels can differentiate ESG factors from standard investment decisions. Ailman said, “People won’t use the phrase ‘E, S, and G. But almost always I find I can label those things back into an environmental risk, a social risk, or a governance risk.”

ESG teams seek to add value and company reputation. They conduct research, read articles about the sector, and participate on social media platforms in order to provide thought leadership. If a rating agency offers to rate the entire portfolio, the ESG team sends it off to their acquainted provider. The ranking demonstrates the ESG team and corporate worth. This is a conflict of interest. Rating agencies and securities dealers may have different goals. Agencies are paid by people who sell securities, thus they may be reluctant to give low ratings. Credit rating companies have been criticized for assigning high credit ratings to debts that later proved to be high-risk ventures. This contributed to the 2008 global financial crisis. They failed to identify hazards that would have warned investors about the perils of investing in particular debts.

RepRisk's executive vice president of data science, Alexandra Mihailescu Cichon said, “Over the years, numerous rating agencies have created ESG ratings based on company self-disclosures, which can often result in potentially biased, incomplete, and unreliable findings. Self-reported data is opaquely one-dimensional and often does not account for ESG risks that have bottom-line compliance, financial, and reputational impacts for companies.”

An article written by Stanford Social Innovation Review (SSIR) said, “Contrary to what many investors think, most ratings don't have anything to do with actual corporate responsibility as it relates to ESG factors. Instead, what they measure is the degree to which a company’s economic value is at risk due to ESG factors.”

A company with high emissions could obtain a positive ESG score if the polluting behaviour is well managed or doesn't harm its financial worth. For example, MSCI gave Exxon Mobil Corporation an average score of "BBB" despite being an existential hazard to the planet.

Exxon is a major energy and chemical supplier that has been aware of climate change for decades. Then they became a leader in climate denial. Additionally, it explains why Phillip Morris, an international tobacco company is on the Dow Jones Sustainability Indices (DJSI). DJSI is a series of benchmarks for investors who recognize that sustainable company practices are vital for long-term shareholder value. They consider several problematic topics such as tobacco for their investors. Recently, Phillip Morris commitment to a "smoke-free" future may reduce regulatory risk, even though its next-generation products are still dangerous and addictive.

Conclusion

Consumers are noticing a lack of movement among asset owners, and asset managers are unsure how to incorporate ESG into their policies in light of the numerous tools and standards available. A rating agency could be a temporary fix as businesses figure out how to organize themselves and where they want to go. However, this is not a viable option.

The financial system is broken. It's nearly impossible to make informed decisions when trapped in an increasingly complex economic web, it's practically impossible to make informed decisions. The fact that asset owners have chosen powerlessness is beginning to show.

15Rock contains the largest corporate transition database. It includes detailed information about what companies are doing to reduce their impacts on the planet, as well as how they are performing against other major industries when it comes down purely performance-wise metrics such as net-zero? It is not possible.

People should be talking about solutions more than ever before, followed by actions. The ability to effect meaningful change is determined not only by what we do but also by how much effort we put into it.

Emma Chiu

Product Analyst

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