Shedding Some Light On The Murky World Of ESG Metrics
A new study illustrates how a lack of universal standards and transparency across industries means ratings don’t really amount to much. Shedding Some Light On The Murky World Of ESG Metrics
Two years ago, researchers at the University of Chicago Booth School of Business started collecting data to determine the real social and environmental credentials of companies in the S&P 500.
And to make matters worse, the lack of full transparency across industries makes it difficult to see any company’s ESG ranking in context.
For example, some ESG disclosures by utilities were robust. The industry provided statements on company websites listing the most metrics on workforce diversity compared with other sectors. The problem was that the industry performed poorly. A closer look showed utilities ranked second to last in the percentage of female workers employed, according to the study, which was based on an analysis of 2017 corporate social responsibility (CSR) reports.
As for within industries, the lack of universal, comparable disclosure makes internal rankings less than reliable.
“While the number of CSR reports has been increasing, there still isn’t mandatory disclosures, which makes comparing companies’ performance difficult,” said Shirley Lu, who has a doctorate in accounting from Booth and was part of the three-person team that compiled the study.
Lu and her colleagues focused their research on CSR reports published by S&P 500 companies to pinpoint the most commonly disclosed metrics and then used those details to compare relative performance by various industries. The report was compiled in conjunction with Jingwei Maggie Li and Salma Nassar of the business school’s Rustandy Center for Social Sector Innovation.
In the end, the team gathered 69 metrics to assess companies’ social and environmental records. The social bracket included four subcategories: diversity, safety, community engagement and suppliers. The environmental data was narrowed to five items: greenhouse gases, energy, waste, water, and accidents and fines. The exercise was somewhat constrained because only 65% of the companies in the S&P 500 issued a CSR report for 2017.
Among Their Other Notable Findings Were:
* The insurance industry provided the fewest details about greenhouse gas emissions, as well as energy, water and waste consumption.
* The computer industry was one of the biggest consumers of energy—just after petroleum, natural gas and chemical companies.
* Food producers were some of the largest consumers of water.
* The business supplies industry, which includes companies like International Paper and 3M, placed among the top emitters of Scope 1 greenhouse gases (direct emissions from the company’s facilities).
On the social side of the ledger, the retail industry reported having the largest percentage of female employees and apparel companies had the highest percentage of minority employees. As for community engagement, the pharmaceutical industry reported making big donations, led by Merck & Co. and Johnson & Johnson.
But having researchers dig around CSR reports for nuggets of actionable insight is far from a successful strategy for universal ESG rankings.
“The metrics aren’t an end point—they should be a starting point,” Lu said. “They should be used by investors to ask questions about what’s behind the numbers.”
Top ESG Fund With 131% Gain Buys More Asia Renewable Stocks
A top-performing environmental fund is buying more Asian stocks as governments in the region become more climate conscious and embrace renewable energy.
The BNP Paribas Energy Transition fund’s Asia allocation has increased to 18% from 11% in September, co-manager Ulrik Fugmann said in an interview. The fund, which has climbed 131% this year to beat most peers in the environmental, social and governance category, is exploring investments in China, Hong Kong, India and South Korea.
The region has seen growing awareness of climate change with China, Japan and South Korea earlier this year committing to achieving net-zero emissions in the coming decades. Regional companies have also pulled ahead of North American counterparts in climate-risk reporting as Asia’s sustainable funds gather record inflows.
The green ambitions provide a “unique opportunity to both deliver economic growth and turbo-charge progress on meeting our climate goals, and this could potentially translate into significant earnings growth for Asia’s energy transition companies,” Fugmann said.
The fund is underweight U.S. shares as Asia is likely to have better profit and economic growth in 2021. Expectations of a weaker dollar also help, he added.
The $1.8 billion environmental solutions-focused fund is adding positions in Chinese companies linked to wind power generation, and has investments in solar companies and battery makers. Shares of Korean electric-vehicle battery producer LG Chem Ltd. and Hong Kong-listed wind turbine producer Xinjiang Goldwind Science & Technology Co. — part of its top holdings as of October — are up 163% and 34%, respectively, this year.
China’s net-zero plan by 2060 is “incredibly appealing” and will benefit hydrogen fuel cell suppliers that have sizable operations and presence in Asia, Fugmann said.
He and co-manager Edward Lees are also evaluating Indian firms that “could be the main beneficiaries in the decarbonization of the power generation system” including solar power generators, equipment manufacturers and those involved in smart grid technologies. India expects 40% of its power-generation capacity to come from non-fossil sources by 2030.
Still, the U.S. continues to be the fund’s biggest country exposure with more than 40% of the portfolio allocated to companies listed there. Solar panel installer Sunnova Energy International Inc. and Ballard Power Systems Inc., a hydrogen fuel cell developer, were its top two holdings in October. Their shares are up 254% and 194%, respectively, in 2020.
How To Separate Real ESG Funds From The Not-So-Real
This is now a question for the U.S. Securities and Exchange Commission, as the regulatory watchdog wanders into a thicket of inconsistent standards.
Worldwide, there are more than 600 exchange-traded funds that claim to follow the principles of environmental, social and governance investing—in one way or another. But how many of them really do?
This is now a question for the U.S. Securities and Exchange Commission, as the formidable securities watchdog wanders into a thicket of inconsistent standards and yardsticks. In a recent examination, the regulator found both gaps in compliance and a lack of policies among such ETFs to ensure the funds actually match their publicized strategy.
And while the SEC didn’t single out any specific firms or funds for shellacking, that day is on the way. The agency warned in April of possible regulatory penalties for greenwashers.
Since then, analysts at research groups including Bloomberg Intelligence have been developing tools to help investors avoid ETFs that are inflating their ESG bona fides. “It’s a really big challenge due to the varying definitions of ESG and drastically different strategies,” said BI analyst Shaheen Contractor.
The best way to uncover questionable funds, given such an uneven landscape, is to examine their holdings and management fees, Contractor said. In general, actively managed ESG-focused ETFs are “far more opaque” and exposed to “greenwashing risks” than passively managed funds that simply track established ESG indexes, she said.
The world’s largest ESG-labeled ETF, for example, is only in the middle of the pack in BI’s ETF Exposure Scorecard.
The $17.5 billion iShares ESG Aware MSCI USA (ESGU), managed by BlackRock Inc., is an expensive fund based on its ESG characteristics, Contractor said. iShares charges a fee of 15 basis points ($1.50 for every $1,000 invested), which is high for a fund that so closely resembles its non-ESG benchmark, the MSCI USA Index.
Moreover, like many competing ESG offerings, ESGU is loaded with tech stocks, which doesn’t help differentiate it from rivals. The ETF’s largest holdings are Apple, Microsoft, Amazon, Facebook and Alphabet, which together account for almost 20% of the fund’s investments.
Three of these companies are among the biggest companies fighting the SEC over its adoption of—wait for it—new ESG-related disclosures.
Last week, Amazon, Facebook and Alphabet pushed back against SEC calls for more stringent ESG reporting in regulatory documents, such as 10-Ks, saying they’re concerned any missteps could spark shareholder litigation.
“Given that climate disclosures rely on estimates and assumptions that involve inherent uncertainty, it’s important not to subject companies to undue liability,” the tech companies wrote in a joint letter to the SEC.
For an ESG-focused ETF to be heavily invested in the very companies seeking to limit ESG transparency might send the wrong signal in a market where investors smell greenwashing on every corner of Wall Street.
But some funds are measuring up. Another iShares fund (SUSL) and one from Xtrackers (USSG), both versions of the ESG MSCI USA Leaders ETF, are top-ranked U.S.-based funds on the exposure scorecard. These funds have above-average ESG characteristics, meaning the companies they invest in have higher ESG scores from both a performance and disclosure standpoint, Contractor said.
In Europe, the iShares MSCI Europe SRI UCITS ETF (IUSK), overseen by BlackRock, is a market leader for the same reasons as USSG and SUSL, she said.
“With so many ETFs battling for investor dollars, the funds that are going to survive are those with unique strategies and relatively low costs,” Contractor said.
The New Math of Socially Responsible Investing
Investors are putting a lot more money into ESG funds, but they also expect a lot more in return.
ESG investing has come a long way in the past few years.
Once a niche investment sector, strategies that screen companies and other assets based on environmental, social and governance (ESG) criteria are attracting more money than ever.
There are various definitions of—and approaches to—so-called sustainable investing. Some strategies seek to avoid investments in industries deemed harmful to society such as tobacco, while others aim to further environmental or social causes like climate change or workplace diversity. Regardless of the approach, interest in the category as a whole is growing dramatically.
At the end of 2019, about $17.1 trillion—roughly one-third of all assets under professional management in the U.S.—was being managed using some type of sustainable-investment strategy or by institutions that filed shareholder resolutions on ESG issues, according to the most recent data from the US SIF Foundation, a sustainable-investing trade group. That was a 42% increase from two years earlier, the group said.
In the first quarter of this year, meanwhile, a net $21.5 billion flowed into mutual funds and exchange-traded funds that use ESG screens or some other type of sustainable-investing approach, a record amount and almost double the net inflows in the year-earlier quarter, according to a report from Morningstar Inc.
“Individual investors are connecting with the idea that they can address some of the challenges they are concerned about,” says Michael Jantzi, chief executive officer of Sustainalytics, a Morningstar company that focuses on ESG and corporate-governance research.
As more people dip their toes into ESG waters, however, expectations are changing: In addition to feeling good about where they are putting their money, these investors also crave good returns.
And while there are more ways to measure how seriously companies and asset managers take sustainability issues such as workplace diversity and carbon emissions, there still is a lack of clarity when it comes to ESG disclosures, an area where regulators have started weighing in.
Here Is A Closer Look At Those And Other Shifts Taking Place In ESG Investing In 2021:
For years, there has been a subset of investors focused on ESG, and companies that have quietly made such issues a priority, says John Streur, president and CEO of Calvert Research and Management, an investment-management firm that specializes in responsible and sustainable investing across global capital markets.
Now, more investors and companies are getting on board, he says, as a growing body of research suggests that focusing on material ESG issues can drive better financial performance. Outside factors also have been at play, including a political focus on climate change and racial and social unrest following the May 2020 killing of George Floyd and a global pandemic that showed how quickly a multitude of lives can be upended.
“Five years ago, people could still say this is some far-off problem and it could impact my great-great-grandchildren, and I’m not going to worry about it in my investments today,” Mr. Streur says. “That has been debunked and it’s right here, right now.”
The socially conscious investors of yesterday tended to be more focused on causes than performance—that is, they were willing to give up returns to do good things with their money. These days, a lot more people are in it not just to advance causes they believe in, but in the hopes of achieving returns that are equal to or greater than those of traditional investments.
“The whole movement has shifted,” says Craig Jonas, co-founder and CEO of CoPeace, an impact-investing holding company in Denver. “Investors like the idea of having measurable impact plus strong returns,” he says.
A notable 47% of respondents in the Schroders 2020 Global Investor Study say they are attracted to sustainable investments because of their environmental impact, while another 42% base their attraction to sustainable funds on the likelihood they will provide higher returns.
Whether values-based investing actually pays off, however, is a matter of debate. Last year, U.S. sustainable equity funds outperformed their traditional peer funds by a median total return of 4.3 percentage points, while U.S. sustainable bond funds outperformed their traditional peer funds by a median total return of 0.9 percentage point, according to a report from the Morgan Stanley Institute for Sustainable Investing.
But that isn’t the whole story. Meir Statman, professor of finance at Santa Clara University in California, says socially responsible funds tend to have higher annual fees, so their returns are likely to lag behind over time.
“Short-run realized returns are noisy because of luck or other circumstances, sometimes favoring ESG investors and sometimes favoring non-ESG ones,” Dr. Statman says. “Each tends to crow when returns favor them.
The logic of fees, however, suggests that, in the long run, ESG investors are likely to earn lower after-fee returns than non-ESG investors,” he says.
Dr. Statman advises ESG investors to see how their particular ESG fund stacks up over time against a low-cost index fund of the same category. He offers the example of the Vanguard FTSE Social Index Fund, categorized by Vanguard as a large growth fund.
It had an annualized return between May 31, 2000, and June 17, 2021, of 6.73%, compared with 7.67% for the Vanguard Growth Index Fund, also a large growth fund, over the same period.
A look at costs shows that the average annual expense ratio of sustainable ETFs that invest in U.S. stocks is 0.33% versus 0.09% for U.S. equity ETFs in the cheapest quintile by fee, according to Morningstar Direct, an investment-research platform.
A few years ago, it was hard to build a well-rounded portfolio solely from ESG investments, says Heidi Vanni, chief client officer and managing director at Boston Trust Walden Co., a Massachusetts chartered bank and trust company. That is no longer the case, she says.
“Today, in both the public and private markets, there’s no shortage of products—ESG opportunities abound,” says Ms. Vanni, meaning investors can stick to their values-based investing ideals and still be properly allocated across asset classes.
Just how fast have ESG investments grown? The number of U.S. open-ended funds and ETFs with defined sustainability objectives at the end of 2020 grew around 30% from the year before, according to Morningstar.
That’s a nearly fourfold increase over the past decade, with significant growth beginning in 2015. As of the end of the first quarter of 2021, there were 409 of these funds, according to Morningstar.
One thing that makes some investors wary of ESG is the lack of transparency around what ESG really means and how to measure it. Part of the problem is that there is no one global standard for ESG reporting.
In the U.S., the Securities and Exchange Commission generally requires public companies to disclose ESG information if they deem it “material” to their financial condition, operating performance or to risks investors may face. That leaves a lot of wiggle room.
Without a common standard for accountability, companies can cherry pick which metrics to make public in their annual sustainability reports and which to keep close to the vest. Some companies have even been accused of green-washing—that is, conveying a false impression or providing misleading information about their products being environmentally friendly.
Fund managers, too, can have different definitions of what constitutes an ESG investment, which makes comparing products complicated.
In a 2020 BlackRock investing survey, 53% of global respondents cited the “poor quality or availability of ESG data and analytics” as their biggest barrier to adopting sustainable investing, higher than any other barrier that was tested.
Efforts to improve transparency are under way. The European Union in March introduced rules requiring asset managers to start disclosing information on their funds’ environmental and social claims and prepare to back up their claims with more detailed disclosures in January 2022.
The EU also has proposed that starting in 2024, nearly 50,000 publicly traded and large private companies will have to report standardized data on various ESG metrics.
In the U.S., the SEC in March announced an enforcement task force to focus on areas that include climate and ESG-disclosure at public companies. In April, regulators published examples of what they believe fund managers and investment advisers are doing wrong with respect to ESG disclosures and related areas.
And in mid-June, the SEC announced its annual regulatory agenda, which includes disclosures related to climate change and corporate board diversity, among other things.
There also are legislature efforts afoot to hold public companies accountable for ESG-related and other disclosures. The U.S. House just passed a package of bills aimed at strengthening investor protections and requiring companies to provide certain disclosures about their ESG policies and climate risk, among other information.
Data providers, meanwhile, are developing more tools to help investors evaluate how companies stack up. Global index provider MSCI MSCI -0.25% just launched the MSCI Target Scorecard, which allows institutional investors to make direct comparisons between companies’ climate commitments and assess which companies have realistic decarbonization targets.
Under The Microscope
Investors also are watching closely to make sure executives live up to their ESG promises. This proxy season, in particular, institutional investors ratcheted up the pressure on company executives to take action in areas such as climate change, diversity, equity and inclusion and racial justice.
In particular, shareholders at American Express, Berkshire Hathaway, International Business Machines and Union Pacific showed strong support for resolutions requiring the companies to provide data to support their claims of diversity and inclusion, according to As You Sow, a nonprofit that promotes environmental and social corporate responsibility.
“Companies currently tell us stories about their commitments to diverse employees,” says Meredith Benton, workplace-equity program manager at As You Sow. “We’re asking companies to show investors if they can, or cannot, provide data that substantiates what they tell us.”
With the Biden administration pledging to substantially slash U.S. emissions of greenhouse gases by 2030, U.S. companies in all industries are likely to be under scrutiny when it comes to their climate policies. It’s an issue that investors and executives at every company will have to address in some way—big or small, given the underlying social demand, says Remy Briand, head of ESG at MSCI.
Asset management firms, too, are being evaluated for their ability to offer ESG and impact investments. In January, more than a dozen institutional plan sponsors and investment consultants formed the Institutional Investing Diversity Cooperative to increase data and transparency within investment teams in the asset-management industry.
In addition to the sustainability ratings it provides for funds, Morningstar also offers a ratings system for asset managers to evaluate how well they incorporate ESG factors into their investment processes.
“It’s a practice-what-you-preach moment for the industry,” says Amy O’Brien, global head of responsible investing at Nuveen, a global investment manager.
Why Companies Shouldn’t Tie CEO Pay To ESG Metrics
It may sound like a good idea. But it likely won’t achieve the results proponents want.
Executive pay has been the poster child for everything that’s wrong with capitalism. Chief executive officers are paid millions, while some of their employees make minimum wage. Bonus targets often tempt executives to take short-term actions that mortgage their company’s future.
But change is afoot. A rapidly growing trend is for executive pay to be tied not only to financial numbers, but to environmental, social and governance (ESG) targets as well. Two recent studies found that 51% of large U.S. companies and 45% of leading U.K. firms use ESG metrics in their incentive plans.
The rationale seems obvious. First, many advocates have claimed that good ESG practices will boost a company’s bottom line, so incentivizing ESG performance also will improve financial performance. This may be why even private-equity investors have started to mandate ESG targets.
Second, it is commonly believed that rewarding performance is the best way to ensure performance. Conversely, if a company won’t pay for an outcome, that is a telltale sign that it doesn’t actually care about it. Companies are making grand promises about diversity, decarbonization and resource usage—but these promises are hollow if they don’t affect CEO pay.
As an ESG advocate, I should applaud this trend. But as essayist H.L. Mencken is often paraphrased: Every complex problem has a solution that is simple, direct, plausible—and wrong. And this may be the case with ESG targets.
Let’s start with the second argument—that rewarding performance ensures performance. The evidence shows that paying for targets encourages executives to hit those targets. But it doesn’t necessarily encourage them to improve performance.
The crux of the problem is that you can’t measure many of the performance dimensions that you care about—“not everything that counts can be counted,” as stressed by sociologist William Cameron (and commonly misattributed to Albert Einstein). For example, paying executives to meet earnings benchmarks leads many of them to cut research and development to do so.
Importantly, the problem of “hitting the target, but missing the point” occurs for any target—whether financial or nonfinancial. Binary thinking often equates “financial” with “short-term” and “nonfinancial” with “long-term.” But nonfinancial targets can be short-termist.
Paying teachers according to test scores encourages them to teach to the test even at the expense of teaching students to develop critical thinking skills. Rewarding CEOs according to average employee pay may encourage them to outsource or automate low-paid jobs, or focus on salary rather than meaningful work, skills development and working conditions.
These unintended consequences might be even worse for ESG than financial targets. One challenge is that, for financial performance, only a couple of measures might be relevant. But ESG performance is multifaceted.
Companies have a responsibility to many stakeholders—employees, customers, suppliers, the environment, communities and taxpayers—and for each stakeholder, many dimensions are relevant. Either the contract includes only a couple of ESG measures and the CEO ignores others, or it includes most of them and the contract becomes so complex that it loses any motivational effect.
A second problem is measurement. For a financial target such as earnings-per-share, there’s consensus on how to measure it. But that isn’t the case for an ESG metric. Should ethnic diversity be captured by the number of minorities on the board, in senior management, or in the workforce—or other factors such as the ethnic pay gap, or the proportion of minorities who get promoted from each level? Even ESG-rating agencies disagree significantly on how to measure ESG performance, so any measure might be perceived as unfair or ignore important dimensions.
Finally, let’s turn to the first rationale, which holds that boosting ESG performance will always boost financial performance. The evidence is far less conclusive than often claimed. In fact, only performance related to material ESG dimensions (those that are relevant to the company’s specific business model) ultimately pays off; boosting immaterial factors doesn’t.
Thus, if ESG targets are to be used, they should be selected carefully based on materiality. Instead, they’re often a knee-jerk reaction to the demands of pressure groups or whatever issue happens to be the order of the day.
So what’s the solution? I believe the answer is to scrap all bonuses—on both financial and nonfinancial targets—and instead pay CEOs like owners, with long-term shares they can’t sell for five to seven years and must retain beyond their departure. Since material ESG factors ultimately improve the long-term stock price, this holds CEOs accountable for material ESG issues—even if they aren’t directly measurable.
Indeed, evidence shows that long-term pay plans improve not only financial performance, but ESG performance as well, and the relationship is causation, not just correlation. Long-term equity also is simple and transparent—there’s no need to decide which ESG factors to include and which to leave out, how high to set the targets, and how much extra pay to give for hitting them.
Companies should still set ESG goals and report on whether they are meeting them. A CEO already has strong reputational incentives, and intrinsic motivation, to meet a publicly announced ESG goal—so you don’t need pay to ensure a target is hit.
But there’s a big jump between simply reporting on performance and linking pay to it, as the latter amplifies the risk of manipulation. As Goodhart’s Law suggests, when a measure becomes a target, it ceases to be a good measure.
Having said all that, let me offer one caveat: ESG pay targets might be appropriate in some companies if the above concerns are muted. For example, in an energy company, decarbonization is arguably much more important than any other stakeholder issue, so there is less of a concern about overweighting a single ESG factor. Moreover, there is relatively little disagreement on how to measure direct greenhouse-gas emissions.
But those are the rare exceptions. ESG targets aren’t the ubiquitous panacea often claimed. The best way to ensure that CEOs create long-term value for both shareholders and society is to pay them like long-term owners.
India To Set Rules To Encourage Companies Shift To Green Energy
India is making rules that will encourage companies to switch entirely to renewable power, a key step toward decarbonizing the nation’s fossil fuel-dominated economy.
The new regulations will allow companies to purchase renewable electricity from state distributors at “green tariffs,” Power Minister Raj Kumar Singh said at the virtual BloombergNEF summit on Tuesday. Hurdles for businesses seeking to buy clean power directly from generators will also be eased, he said.
Accelerating use of clean energy in offices and factories, the largest power consuming segment in the country, will be key to achieving targets to cut emissions per unit of the GDP. It will also help the companies improve their environment, social and governance — or ESG — scores by reducing their carbon footprint.
Those opting for green power will be allowed open access — when they aren’t tied down to the local distributor — within 15 days, instead of having to wait for months, Singh said. That would force state utilities to either meet the demand or risk losing their high-value customers.
Providing time-bound open access, though a “welcome move,” may be fraught with challenges, according to Debasish Mishra, a Mumbai-based partner at Deloitte Touche Tohmatsu.
Industrial buyers pay the highest prices for grid electricity and help utilities subsidize poorer consumers. Cash-strapped distributors, already facing precarious finances, often resist losing these customers to other suppliers.
“High open-access charges can often create barriers for consumers to directly access green power,” Mishra said. “And as per law, that’s under the jurisdiction of state electricity regulators who would want to balance the interest of the incumbent utility.”
Separately, India will promote offshore wind projects to get to its 2030 goal of 450 gigawatts of renewables capacity, a near fivefold expansion from current levels. That would include 280 gigawatts of solar and 140 gigawatts of wind capacity, the minister said.
Singh cited scarcity of land as one of the challenges for ramping up wind power and said offshore projects will help deal with the issue. The cost of such projects will initially be high and the government is exploring capital subsidies to help developers, he said.
India will fall short of its renewable capacity goal of 175 gigawatts by the next year due to “some hiccups,” Singh said, potentially linked to the pandemic. The country has had to extend deadlines for renewable projects due to difficulties in importing equipment and getting workers at construction sites.
Crypto’s Place In The ESG Investing Zeitgeist: Trusted Data And Aligned Incentives
The theme for this two-part series was “Blockchain meet ESG,” an exploration of the challenges and opportunities that confront the crypto and blockchain communities as investors and businesses increasingly demand compliance with environmental, sustainability and governance objectives.
A total of 14 guests over the two days helped us dive into how blockchain technology can help communities collectively address climate change or boost financial inclusion, and how the technology might overcome its own ESG challenges, such as Bitcoin’s carbon footprint and the crypto industry’s relative lack of diversity.
These issues have become more urgent for the crypto industry as public attention has grown on the heavy energy usage within Bitcoin’s and other protocols’ proof-of-work mining systems. These were especially aroused by Tesla CEO Elon Musk, who walked back the company’s initial intention to accept bitcoin for its cars, citing environmental concerns.
As Wall Street banks and asset managers put ever more resources into ESG investment vehicles and as the Biden Administration puts environmental and other concerns at the center of its regulatory agenda, these matters will only become of greater importance to the crypto industry.
Industry insiders are trying to flip the debate. With the right deals and policies in place, Bitcoin mining could be used to underwrite the rollout of renewable energy infrastructure, for example. And blockchain technology could help resolve what is arguably the biggest barrier to the effective deployment of ESG mandates: a consistent record-keeping system to accurately measure their impact.
The technology could also help align incentives within an economic ecosystem so that all profit-seeking participants are motivated to achieve outcomes that serve the public good.
This first episode, recorded on Monday, May 24, tackles the complexities of counting, tracking, and reporting ESG, including climate accounting, sustainable investing, Wall Street’s ESG movement, blockchains for ESG tracking and tokenizing ESG.
You’ll Hear From The Following Guests, Each In Short 5-10 Minute Segments:
* Massamba Thioye, co-chair of United Nations Framework Convention on Climate Change, and Martin Weinstein, founder of Open Earth Foundation, discussed the planet’s carbon accounting needs. They offered a high-level view of the humanity-wide challenge of how to consistently measure our collective ability to meet the Paris Accord’s 2050 targets for carbon neutrality and of how blockchain technology could help.
* Kevin O’Leary, the Chairman of O’Shares ETF chairman and investor on CNBC’s “Shark Tank” show, explained how increasingly powerful ESG committees are making institutional investors more picky about the assets they funnel money into. He shared some of his ideas on how the Bitcoin community can better adjust to this new reality.
* Mark McDivitt, CEO of Context Labs and former global head of ESG at State Street, ran with the mantra of “what we can measure we can manage” to argue for sophisticated blockchain-based models involving multiple calibrations and analyses to ensure that environmental data is trustworthy enough for investors.
* Cristina Dolan, the CEO of InsideChains, spoke of her work for a forthcoming book about data science and ESG demands, in which she and co-author Diane Barrero Zalles, detail the need for standardization and how this technology might help.
* Marc Johnson, senior associate at Rocky Mountain Institute, highlighted his organization’s work using a blockchain model for tracking cumulative carbon emissions and reductions at each stage along a supply chain.
* And Paul Brody, global blockchain leader at Ernst & Young, outlined a vision for how tokenization based on trusted environmental and sustainability data can generate digital assets that economically incentivize both investors and the businesses that issue them to consistently strive for positive ESG outcomes.
Nordea Asset Management Adds Dark-Green ESG Strategy To Offering
Nordea Asset Management is offering a new dark-green equity-based investment product for investors keen to make a simultaneous impact on the climate and society.
The fund will be managed by the team behind Nordea Bank Abp’s climate fund. Demand for that product has recently swelled to 8.3 billion euros ($9.9 billion), prompting the bank twice this year to try and slow the pace of inflows so that it could continue to manage the product efficiently.
The new Global Climate and Social Impact Strategy seeks “to deliver attractive returns by investing in businesses that provide meaningful solutions to address pressing social and environmental needs,” Nordea said on its website on Tuesday.
“New consumers care not only about what the products are made of, but how they are made,” Thomas Sorensen, co-manager of the fund, said. “That’s why we look for companies that marry purpose and profits.”
The product is classified as an Article 9 investment under the European Union’s Sustainable Finance Disclosure Regulation, or SFDR, Nordea said.
U.S. Companies Say Climate Change Is a Problem—But Still Lobby Against Solutions
A new report from sustainability nonprofit Ceres finds that most large companies aren’t putting lobbying muscle behind climate goals.
While more than 80% of the largest U.S. companies have set emissions reduction goals, less than half engaged with lawmakers to advocate for science-based climate policies — and more than 20% have lobbied against them, according to report released Tuesday by sustainability nonprofit Ceres.
“Claiming credit for making operational climate change commitments while undermining the necessary policy measures to achieve those very commitments poses significant reputational and financial risks to companies,” the report’s authors wrote.
Ceres’s analysis comes as climate concerns are playing a larger role in capital markets and shareholder actions. So far this year, companies around the globe have issued $297 billion in green bonds, a 152% increase year-over-year, according to data compiled by Bloomberg.
Shareholders also have been increasingly forceful in demanding change, including from fossil fuel titans Exxon Mobil Corp. and Chevron Corp., which were each the target of successful resolutions demanding climate-conscious changes to corporate strategy.
“This is a work in progress,” said Steven Rothstein, managing director of the Ceres Accelerator for Sustainable Capital Markets. “The good thing is companies are highlighting their climate needs. Investors are shouting it from the rooftops in every way they can, and now it has to go deeper.”
Ceres’s report included 96 members of the S&P 100 in 2019, with four companies excluded due to later mergers and other consolidations. The group scored the companies on how they assess, systematize, advocate for, and engage with science-based climate policies in disclosures and documents such as annual filings, as well as on their advocacy and trade group memberships. A science-based climate target is one aligned with the Paris Agreement goal of restricting global warming to below 1.5 degrees Celsius, which will require reaching net-zero emissions worldwide by 2050.
Almost three-quarters of companies in the report describe climate change as a material risk in their regulatory filings, while nearly 90% have tasked their boards with overseeing climate and ESG topics. “What makes me optimistic is that so many companies are recognizing that climate is a crisis and they’re taking bold steps,” Rothstein said.
One lobbying group, the U.S. Chamber of Commerce, came under particular scrutiny from Ceres due to its “oppositional climate change track record,” according to the report. Close to 75% of the companies Ceres analyzed are members of the Chamber, but only one — Apple Inc. — left the lobbying group over its climate stance. Earlier this year, the Chamber reversed its previous stance on climate policy and said it supports a “market-based” approach to reducing emissions, such as a carbon tax or emissions caps.
Rothstein calls these “good initial steps,” but “not enough” to get to net zero.
Matt Letourneau, a spokesperson for the Global Energy Institute at the U.S. Chamber of Commerce, said that the lobbying group is proud of the work it’s doing “to bring meaningful, achievable solutions to the global climate challenge.”
“The business community is at the leading edge of innovation and investment in the technology necessary to reduce emissions, and will be an important voice in the international and domestic policy dialogue,” Letourneau added.
Ceres’s report also comes as Democrats in Congress try to cram many of their domestic priorities, including climate policy, into a budget reconciliation bill they hope to pass later this summer. Rothstein hopes legislators will include funding for projects such as retrofitting homes for energy efficiency and building out electric-vehicle charging networks, he said.
Fund Managers Struggle To Keep Up With New Guideposts For ESG
Many of the world’s biggest asset managers say they’re increasingly struggling with some of the rules guiding the $35 trillion market for environmental, social and governance investing.
Much of the confusion revolves around defining the “S” in ESG.
The guideposts are generally seen as confusing and this is “going to become a bigger issue going forward,” according to Rick Redding, chief executive of the New York-based Index Industry Association.
He points to a survey by the IIA, which shows that 56% of 300 investment professionals in Europe and the U.S. — some managing more than $1 trillion — say they’re having a hard time keeping up with edicts intended to steer capital into ESG assets. At the same time, 85% say ESG is a high priority for them.
“The ‘S’ is becoming the problem,” Redding said, referring to socially responsible investing. “What we are seeing is potentially different regulatory approaches to ‘S’” across various jurisdictions, he said.
The concern is that “you have a lot less quantitative data available,” which makes it hard for investors to back up their strategies with numbers, Redding said.
Andy Howard, who helps oversee more than $920 billion as the global head of sustainable investment at Schroders Plc, says he’s hoping for clearer European Union rules to help guide the industry. Investors in the bloc already have a green taxonomy.
They’re now waiting for a social taxonomy to help them define and measure the social risk in everything from how a company treats its workers, to its exposure to child labor as well as basic parameters like equality.
But that won’t be ready for a while. For now, a so-called subgroup appointed by the EU is still exploring what should go into a social taxonomy, with a report on their findings due at the end of this year.
Mairead McGuinness, the EU’s financial markets commissioner, says the bloc’s work to produce a social taxonomy will include taking a “forensic look” at supply chains, how businesses treat their employees and issues of diversity and inclusion. More details about this work should be available before 2022, she said at a recent Bloomberg summit on sustainable investing.
Redding at IIA says that countries and regions look set to apply different standards for how they expect their asset management industries to approach the “S” in ESG.
“North America has really good data for gender and board participation,” he said. “But in parts of the world, it is just not there.” He also notes that the underlying assumptions behind social considerations can vary greatly.
“Things like gender diversity, it just doesn’t mean the same thing in some parts of the world,” he said.
Howard at Schroders says investors can’t afford to ignore the social dynamics of the businesses they help fund. “In the end, social trends or challenges underpin the performance of companies,” he said.
The problem is measuring it. “‘Society’ is a broad term and spans a huge range of issues,” Howard said.
Nathan Fabian, chief responsible investment officer at the Principles for Responsible Investment and chair of the EU Permanent Sustainable Finance Platform, says it’s clear that “the ‘E’ is more advanced than the ‘S’ when it comes to rules around ESG investing.”
But Fabian says the pandemic has added a sense of urgency to coming up with an adequate rulebook.
“We are running late on achieving the SDGs (the United Nation’s sustainable development goals),” he said. “And the pandemic has shown how deep the inequalities in society have become.”
When It Comes To ESG, Companies Often Find It Hard To Stand Out
One Reason: Various metrics are rolled up into one number, making it hard to differentiate.
Companies have a lot of good reasons to pay close attention to environmental, social and governance factors: attracting talented employees who want to work at a place that is making a positive impact on the world; responding to regulators who are demanding more ESG-related transparency; and pleasing major investors who are pushing them to be sustainable for the long haul.
But there’s at least one thing that being ESG-minded may not do: help a corporation stand out from the crowd as much as other actions might.
That’s the big takeaway from our latest analysis of the Management Top 250, an annual ranking produced in partnership between the Drucker Institute and The Wall Street Journal. It uses the central principles of Peter Drucker to assess a company’s “effectiveness,” which the late management scholar defined as “doing the right things well.” The 2020 list was published in December.
In all, we evaluated 886 large, publicly traded companies last year through the lens of 33 indicators that fall into five categories: customer satisfaction, employee engagement and development, innovation, social responsibility and financial strength.
To form our rankings, firms are compared in each of the five areas, as well as in their overall effectiveness, through standardized scores with a typical range of 0 to 100 and a mean of 50.
In our most recent research, we wanted to see where companies were setting themselves apart, thereby shedding light on the richest opportunities for firms to build a distinct reputation or brand identity.
The runaway winner was innovation, where the spread between the highest-scoring company in our universe ( Amazon.com Inc. at 135.9) and the lowest ( Apartment Investment & Management Co. at 36.5) is a whopping 99.4 points.
In fact, because several other companies in addition to Amazon score over 100 in innovation—literally off the charts—this is the one category in our rankings where the 886 firms are not within the bounds of a normal distribution. You can picture this as a fat tail to the right, throwing off the shape of the bell curve.
A Tight Span
All of the other categories—including social responsibility, where our ESG metrics are housed—have normal distributions.
Nonetheless, the configuration within social responsibility is striking. It has by far the narrowest span—50 points—between the highest-scoring company ( Microsoft Corp. at 78.9) and the lowest-scoring firm ( Seaboard Corp. at 28.9). The differential is 67.3 points in customer satisfaction, 73.4 points in employee engagement and development and 76.3 points in financial strength.
A review of historical data makes clear that this isn’t a blip. We discovered that this relative tightness in scoring for social responsibility stretches back consistently to 2012, the earliest year for which we have metrics.
None of this is to play down how essential the social-responsibility category is to our model. Indeed, it has correlated more strongly with total effectiveness over the years than have any of the other four areas.
What’s more, a 50-point gap between the highest- and lowest-scoring companies in social responsibility is hardly trivial. In statistical terms, that’s five standard deviations—roughly equivalent to the difference in height between National Basketball Association center Joel Embiid, who stands 7 feet tall, and Muggsy Bogues, who, at 5-feet-3, was the shortest player in league history.
At the same time, our findings do highlight some important nuances when it comes to the way ESG is measured. The first is that the various components and subcomponents of ESG are often rolled up into a single metric, just as we do in our model, and that tends to wash out differences among companies.
“You really need to dig in and look at the E separately from the S separately from the G,” says R. Paul Herman, the chief executive of HIP Investor, which along with CSRHub, Sustainalytics and several others provides the social-responsibility data that we use in our rankings. If not, he says, “it can all blend together.”
Another issue is that companies are, in many cases, rewarded by ESG trackers for having a policy in place for, say, emission reduction or not using forced labor in their supply chain.
Because it’s easier for corporations to put something on the books than it is for them to follow through and make sure that these policies are being carried out, that also results in a clustering of ESG scores. Meanwhile, some ESG ratings give companies credit for disclosure, even when the substance of what they’re disclosing isn’t terribly impressive.
“Much of it is process-based, not performance-based,” says Tensie Whelan, director of the Center for Sustainable Business at NYU Stern School of Business.
There are signs that this is changing, however, as the ESG field matures. And as the metrics increasingly reflect who is actually taking care of people and the planet in ways that are meaningful, we suspect that companies will distinguish themselves all the more—some for better and others for worse.
Yes, You Can Align Your Pursuit of Early Retirement With ESG Ideals. Here’s How.
Interest in ESG investments has exploded over the past few years among individual investors who are concerned about the impact of their investments, helping drive short-term outperformance. But some observers question whether such investments can deliver the longer-term market-beating returns that would likely be required by investors who are pursuing financial independence or looking to retire early.
Cody Garrett, a certified financial planner at Houston-based Measure Twice Financial, isn’t surprised that environmental, social, and governance investments have piqued the curiosity of his clients who are FIRE adherents. “The philosophy behind financial independence is aligning financial objectives with personal values,” he says. That closely mirrors the mindset of many ESG investors. “The FIRE community is waking up to what their investments are supporting and how their money is being used.”
But does restricting investment options to socially responsible assets hinder FIRE plans, where the ultimate goal is to maximize returns for the long haul?
Garrett says no, and he has some tips for aligning a FIRE portfolio with ESG tenets:
ESG for the right reasons: ESG funds are often overweighted with growth stocks that tend to be more ESG-compliant, such as big tech. These funds handily outperformed the broader stock market during the pandemic, Garrett says, though he warns that the lead may not be sustainable as value stocks recover.
That said, he believes large market cap-weighted ESG funds will likely remain closely correlated to their non-ESG counterparts. Why? As ESG funds make exclusions, they push more assets into the biggest companies by market cap, including big tech, which can help their performance relative to non-ESG funds, Garrett explains.
“I think a lot of people are tempted to move into the ESG space because they’re attracted to the short-term gains made over the last year or so,” Garrett says. Yet he cautions investors against the temptation to chase returns. “What happens if ESG ends up underperforming, are you, as an investor, going to change your mind?” he asks. “The decision to use ESG should be a decision to align your money with personal values, not merely a financial choice.”
Choosing funds. There is no consensus definition of an ESG asset. A particular company could excel in environmental issues while falling short at corporate governance. What’s more, ESG funds set their own criteria of inclusion or exclusion.
To know for sure whether investments match individuals’ values, investors have to take a look under the hood. The fund’s prospectus will explain its methodology, and Garrett recommends looking at Morningstar’s sustainability rating, which is “continually improving, so there’s more consistency,” he says.
Ditch the one-size-fits-all approach. When considering the individual goals and values that bring people to the FIRE movement, the advice they receive is often strikingly generic: Put your money in a low-cost index fund and wait. The strategy is sometimes known as “VTSAX and chill,” referring to the Vanguard Total Stock Market Index Fund Admiral Shares commonly used by FIRE investors.
ESG strategies are inherently more varied, and Garrett encourages his FIRE clients to branch out and build a portfolio that better reflects their individual values.
When building out the equity portion of an ESG portfolio, Garrett recommends a “core and explore” strategy. Practically, that means a core investment representing about 90% of the equity portfolio that includes broad ESG index funds. These funds are typically based on broad-market indexes and exclude stocks that don’t meet their ESG criteria, like petroleum companies, for example.
For Garrett, the remaining 10% of the equity portfolio represents a chance for clients to explore specific funds or sectors they are passionate about, such as alternative energy or funds that invest in women-led companies.
ESG Investors Question Their Own Methods After Grim Climate Report
A landmark report from the IPCC prompts leaders in sustainable finance to consider a longer-term focus and new ways to measure investments.
The damning United Nations report on global warming delivered a reality check for the investors betting that markets can limit the damage.
The assessment by the Intergovernmental Panel on Climate Change, released on Monday, should prompt investors to “review their commitments to tackling climate change and to take action,” said Fiona Reynolds, chief executive of the UN-backed Principles for Responsible Investment.
Often that kind of reflection sends more money pouring into environmental, social and governance investments, raising concerns that financial markets’ short-term outlook might end up undermining claims of sustainability. Between 2018 and 2020, for example, European asset managers had to strip the ESG label off $2 trillion in allocations, as stricter rules were devised.
Sebastian Mernild, one of the co-authors of the IPCC’s report and a professor of climate change at the University of Southern Denmark, says the message to the finance industry is that tackling global warming requires a longer perspective. “We are looking into 2060, 2100,” Mernild said.
“Every time we increase the global mean temperature by half a degree, then we will face a more extreme climate. That will have severe consequences for us. It will be very costly.”
Praxis Mutual Funds, one of the oldest socially responsible investment firms, which manages about $2 billion, said the IPCC report shows the need to move faster in the short-term and invest in green debt that can have greater real-world impacts. “It changes the calculus,” said Chris Meyer, manager of stewardship investing research and advocacy. “We will need to have a sharper focus. This report shows that investors aren’t moving quickly enough.”
Schroders is among the fund managers that have committed to establishing a pathway to net zero. The adoption of these goals hasn’t yet led to lowered emissions, as the IPCC report makes clear. “Finance alone cannot solve the climate threat. This is ultimately a question of every group making significant and sustained steps to cut emissions,” said Andy Howard, the head of sustainable investment at Schroders. “Anyone looking at the same picture and data must surely reach a similar conclusion.”
With the scientific consensus now making clear that the average global temperature is very likely to rise at least 1.5° Celsius above pre-industrial levels by 2040, investors may need to pay even more attention to their contribution to limiting warming. That’s where temperature-alignment metrics come in. These grade portfolios based on their holdings’ projected greenhouse gas output.
It can be helpful “in evidencing what is a fair share that a given company needs to be doing to meet the carbon budget and how exposed companies may be to value impact from the transition,” said Christopher Kaminker, head of sustainable investment research and strategy at Lombard Odier Group.
Among asset managers to have released such data is Axa SA, which is doing better than most. But even after cutting its exposure to greenhouse gas emitters, its portfolio still implied a temperature increase of almost 3°C by 2100. At that level, scientists warn that large parts of the planet become uninhabitable, entailing mass extinctions of species. Yet knowing the number at least provides a picture of the real-world fallout of an investment strategy.
Elsewhere, U.K. insurer Aviva Plc and Japan’s $1.7 trillion Government Pension Investment Fund have published data on warming potential. New York-based BlackRock Inc., with $9.5 trillion of assets, plans to do the same for some of its funds, and the practice looks set to spread in the years ahead.
It could be a clear step toward embracing the science more seriously, which some argue has been lacking in the asset management industry. Still, critics of implied temperature metrics say there’s a lack of reliable emissions data to make the computations and the metrics rely on assumptions.
Many strategies chasing ESG returns still fail to take into account the economic impact of climate change, according to an analysis by the head of strategic research at Nordea Bank Abp. The research finds that the biggest risks lie in the hottest parts of the world, many of them emerging markets.
“There has been a disconnect between what academics have found and what the financial industry has based its views on,” said Steen Winther Blindum. His report, “How Climate Change Affects Return on Your Investments,” builds on existing research to show how countries most exposed to global warming face the biggest declines in gross domestic product. “We know if GDP is affected, then there’s also an impact on the returns of these risky assets,” he said.
“The reason we started this work was because we saw a lot of portfolio managers were seeing opportunity in these regions because they looked cheap,” Blindum said. At least for those who don’t consider the toll of climate change. “We wanted to remind people that maybe you should look a little more carefully into this.”
Academic work linking an overheated planet to the loss of economic wealth has yet to be acknowledged by much of the asset-management industry. There are a few exceptions, and Blindum says the biggest managers such as BlackRock have started to incorporate more climate science in their ESG models. But many are still guided by short-term profit models that are ill-suited to the threat posed by global warming.
Banker Bonuses Tied To ESG Metrics Are On The Rise In Europe
European bankers will soon have to show they’re contributing to a cleaner environment, a better society and good governance — or face a smaller pay package.
In the latest sign that ESG is reshaping finance, most of the 20 major European banks surveyed by Bloomberg said they were either working on, or already had, a model that links staff remuneration to a firm’s performance on sustainability metrics. That’s as European regulators explicitly add ESG risks to pay guidelines, with the change due to take effect by the end of 2021.
Nicole Fischer, who advises German financial institutions on pay at Willis Towers Watson, said the industry is now “in a transformation phase where ESG is being anchored firmly in remuneration.”
The development opens another avenue through which policy makers in Europe are trying to redefine capitalism. The ultimate goal, ideally, is to make it financially attractive to be good. But measuring sustainability is far from straightforward, which the finance industry itself has acknowledged. That means bankers’ pay will in future partly rely on a variable that’s harder to quantify than profit, which might make it easier to game.
Despite the absence of common detailed standards, some of the world’s biggest banks say they’re already working ESG goals into their remuneration policies.
At HSBC Holdings Plc, executive directors need to cut the bank’s carbon emissions and help clients do the same, failing which 25% of the grade that determines their variable pay packages through 2023 will be impacted. Last year, when environmental issues made up a smaller share, Chief Executive Officer Noel Quinn and Chief Financial Officer Ewen Stevenson both scored 85% on that particular metric.
UniCredit SpA said 10% of its pay scorecard for top and senior management depends on the bank’s ESG ratings and on how satisfied customers and employees are. This year, the Italian bank extended sustainability metrics to include so-called material risk-takers, such as investment bankers. UniCredit’s ability to reduce its impact on the environment and develop more ESG products and services will feed into the size of the bonus pool.
For staff at some banks, not having their pay hinge only on profits has its benefits. Last year at La Banque Postale SA, where bonuses for the wider organization are tied to both sustainability and earnings, “the other business objectives weren’t met because of the Covid crisis,” said Adrienne Horel-Pages, the French bank’s chief sustainability officer. She said “the only reason” the workforce got a bonus was because of the bank’s ability to remain in the top quartile of ESG rankings given by rating companies.
The ubiquitousness of ESG as a financial strategy was underlined yet again on Thursday amid news that Goldman Sachs Group Inc. had agreed to buy the asset management arm of Dutch insurer NN Group NV, to expand the Wall Street firm’s presence in Europe and give it better access to the market for sustainable investing.
Another of the Bloomberg survey’s findings was that banks, by and large, aren’t intending to go on hiring sprees to add ESG expertise. Instead, most responded that they expect to rearrange and retrain existing teams to dedicate more people to sustainability.
At La Banque Postale, for example, Horel-Pages said she’s only bringing in one or two people from outside the bank as part of a plan to add eight people to her team. The rest will join from other departments.
Inevitably, banks will face some skepticism as to how well their ESG metrics actually promote good governance, social justice and a greener planet. That’s as scientists warn time is running out to save the world from a climate disaster, leaving no room for error in the corporate and political response. At the same time, the financial industry itself said measuring ESG performance is fraught with uncertainty.
At a Financial Stability Board workshop in May, participants from banking, insurance and asset management said they take “ESG, reputational and diversity-related factors” into account when assessing performance and setting pay. But they also said such sustainability criteria aren’t easily quantified. And without proper governance structures, they “could be potentially engineered such that variable remuneration reaches a desired level.”
The workshop participants also acknowledged that while ESG criteria are likely to play a bigger role in the future, implementing a longer-term outlook is “challenging” because some competitors may play by different rules and follow shorter-term incentive structures.
Regulators are aware of the challenges. A 2019 review by the European Banking Authority found that while banks in the region supported corporate clients through green loans and bonds, their own planning time horizons, linked partly to remuneration, curtailed their ability to tackle climate risks.
The EBA’s updated remuneration guidelines, which take effect at the end of this year, make clear that firms will be expected to build ESG into staff pay. But even here, there’s room for interpretation, as the language indicates.
“The institution’s remuneration policy for all staff should be consistent with the objectives of the institution’s business and risk strategy, including environmental, social and governance risk-related objectives, corporate culture and values, risk culture, including with regard to long-term interests of the institution, and the measures used to avoid conflicts of interest, and should not encourage excessive risk taking,” the EBA said in its final draft report on the guidelines, published July 2.
European Union transparency rules which took effect in March mean banks will also have to publish information on how they factor ESG risks into remuneration. Such information is usually disclosed in annual reports, meaning many banks will probably wait until early next year to provide it.
According to some members of the finance industry, though, the incentive to incorporate ESG metrics stems from more than just regulations. Banks perceived to be laggards may face public backlash, which has the potential to dent returns.
“Firms that reflect ESG in pay do a better job of looking forward and recognizing risks early on,” said Ingo Speich, head of sustainability and corporate governance at Deka Investment. “Sustainability is a value driver.”