ESG: In Need of a Clean Up

The Economist magazine issued a special report on Environment, Society and Governance (ESG) in its 23 July 2022 edition. It describes ESG as having had a ‘negligible impact on carbon emissions’. Social issues, such as workplace diversity, are hard to measure and in terms of governance ‘the ESG industry does a lousy job of holding itself to account, let alone the companies it is supposed to be stewarding.’ 

The article, though, argues for reform, starting with the measurements used. Six ESG ratings agencies, for example, use 709 different metrics across 64 categories. Ten of those 64 appeared in every ratings agency categories. Green house gas (GHG) emissions weren’t in all of them.

ESG partly measures and discloses things that firms, and their customers, turn a blind eye to – their impact on the atmosphere, oceans, air, water and biodiversity. ESG is a way of assessing the regulatory or reputational risks that come from ‘negative externalities’. To be useful, the measurements need to be standardised and trustworthy. While measuring scope one (direct emissions of the organisation) and scope two (eg. bought in electricity) is relatively straightforward, an index provider, MSCI, is quoted as saying that less than 40% of almost 10,000 firms in its world index reported scope one and two emissions.

Scope three emissions, those of third-party suppliers, is complex and hard. Less than a quarter of organisations in MSCI’s index measure scope three emissions. The quality of what is reported is poor.

The rise of ESG

The Governance part of ESG started to take shape after 2002 when the Sarbanes- Oxley act was passed seeking to address the audit and financial reporting problems revealed in the Enron scandal.

The Economist claims inequalities revealed and exacerbated in the 2007-09 financial crisis gave a boost to ‘S’ and awareness of climate change has driven the ‘E’. There are now some 160 ratings companies worldwide. The ratings are meant to measure how exposed companies are to non-financial risk. Data that lacks reliability, comparability and transparency makes the ratings hard to use.

Rating shortcomings

The EU’s European Securities and Markets Authority is looking to regulate the rating agencies. An indication of the challenge is that while the credit-rating arms of Moody’s, S&P Global and others are close to being 99% correlated, ESG scores even from reputable firms barely reach 50% correlation. The OECD found that some rating agencies focused more on Society and Governance than the Environment.

Despite that, environmental scores are regarded by asset managers as more reliable than the Society scores.

New regulations

The European Union (EU) introduced a sustainable-finance disclosure regulation in 2021. This requires funds that claim to use ESG to categorise themselves based on their sustainability ambitions. The lowest level, article six, covers mainstream funds. The highest level, article nine, has ESG as its main objective. The evidence that high ESG scores are linked to higher investor returns is absent though.

The US Securities and Exchange Commission (SEC) is also looking at proposals to force companies to disclose climate related information. The International Sustainability Standards Board (ISSB), a new part of the International Financial Reporting Standards Foundation, wants to make non-financial disclosures as consistent as financial ones. The EU has its corporate-responsibility reporting directive due to become law by the end of 2022.

All this activity is because the current pricing of climate change risk is seen as too low. There is also a view that shareholders want more information.

The EU directive, unlike the SECs, goes beyond information useful to investors, aiming to measure a company’s impact on people and the environment directly. The cost, complexity and usefulness of all these efforts is fiercely debated. In terms of driving capital flows, it would help if anybody knew what effective climate solutions will emerge. The Wall Street Journal estimates the cost to business of complying with the rules will increase from $3.9 billion per year to $10.2 billion. It does not help that environment reporting is regarded by some as about a political agenda rather than managing financial risk. No doubt in the US all this will end up in court.

The importance of the ISSB, SEC and EU proposals is that they reduce the burden of reporting on companies, particularly those that have to operate globally, reducing the costs while allowing investors to make choices. Accounting firms are reported to be hiring sustainability experts and training existing staff to work on ESG-related issues. There is a school of thought that good ESG reporting could allow a ‘shadow price’ for carbon emissions and provide an excuse for governments not to charge for carbon emissions.

Unhappy status quo

At the moment, the article argues, ESG is neither a good measurement tool nor an effective risk management tool. The link between what companies actually do is not properly captured and the data isn’t reliable enough to be used as the basis for a future carbon tax. It also risks confusion because it makes unclear what a company is ‘for’.

In contrast, profit and loss accounting is crystal clear without moral judgement or political influence.

At the moment ESG is too broad. It is all things to all men and does none of them well. The Economist argues asset managers should have climate funds, social funds and governance funds. For products that put sustainability first, have ‘impact funds’ but don’t promise high returns.

ESG will be discussed as part of the Cash & Payments Sustainability Forum™ in Edinburgh in November 2022.