ESG Investing and Disclosure Flow

The EU’s sustainable finance plans have four key elements. First is the taxonomy that defines which activities are sustainable. Then there is the Corporate Sustainability Reporting Directive (CSRD) requires companies to report on their sustainability activities. Asset managers then use this information to report on the sustainability of their products. As per the Sustainable Finance Disclosures Regulation (SFDR). In turn, financial advisors use this information for their discussions with their clients (end-investors). These discussions establish an investor’s sustainability preferences as per the MiFID (Markets in Financial Instruments Directive) suitability test.

The flow seems perfect and should be the order in which regulations roll out. . However, currently, there are wrinkles in the flow. The Taxonomy is delayed because there is a debate on whether nuclear and natural gas are sustainable. Company reporting will not become operational before 2023. And the technical details on how asset managers report on the sustainability of their products won’t apply before 2023. While all this is sorted out, asset managers are required to show how a number of their products are aligned to the EU taxonomy, and the alignment data is not available. From August 2022, advisors will have to assess their client’s preferences based on asset managers’ reports, which are likely to be incomplete or have missing data.

While all this gets sorted out in due course, companies, investment firms, and financial advisors will need to gear up to meet the requirements. You may wonder that all this is for the EU, so why should Indian companies bother. But, many of the investment firms that do business in India also do business in the EU. So, they will have to adopt the EU norms and, by extension, will implement them in other parts of the world too. And that includes India!

Carbon VaR

Value at Risk (VaR) is an old concept. It is a statistic that quantifies the extent of loss a firm can incur in a specific time frame. It is a measure of risk that a firm faces. Carbon emissions are also a risk that companies face. Hence, the concept of value at risk can be extended to carbon (GHG) emissions. 

Carbon VaR measures the impact of a rise in carbon prices on the company’s profitability. The effects of rising carbon prices can be complex and change dynamically. 

  • Companies costs will rise as the amount of emissions from the company and supplier increases.
  • The rise in costs can be offset only if the selling prices rise at an industry level
  • Increased selling prices could lead to a fall in demand depending on the consumers’ sensitivity to prices. This could impact the company’s profitability. 

Carbon VaR considers these linkages to estimate the impact on a company or industry’s profitability. Thus, the shift to net-zero will require a company to assess the effects of carbon prices on their profitability and arrive at better decisions.

The Seven Myths of ESG

A recent paper by researchers at the Rock Center for Corporate Governance at Stanford debunk several myths around ESG. Given that companies use ESG in decision-making, and regulators are increasing their focus on ESG, the paper is timely. I summarise the seven myths:

  1. We Agree on the Purpose of ESG: Despite the near-universal push for ESG, consensus does not exist about the problem ESG is expected to solve. There are three lines of thought: (a) it helps reduce the short-term behaviour of managers; (b) Capitalism is focussed excessively on shareholders, and ESG helps shift the focus on stakeholders; (c) ESG is synonymous with corporate responsibility.
  2. ESG Is Value-Increasing: It is widely believed that ESG improves outcomes for all. Research shows that the outcomes are varied (either producing long term benefits or increasing costs) and very dependent on the setting.
  3. We Can Tell Whether a Claimed ESG Activity Is Actually ESG: It is often difficult to tell whether the initiative is ESG. Many ESG activities are closely aligned to a company’s existing business model and indistinguishable from standard business decisions to maximise shareholder value.
  4. : A Company’s ESG Agenda Is Well-Defined and Board-Driven: According to the authors the decision-making process is not as well defined. A study by PriceWaterhouseCoopers shows that only two-thirds of corporate directors said that ESG is linked to their corporate strategy, and only a quarter felt that the board understood ESG risks. Another study showed that a little over half of directors and executives felt that their boards understood ESG risks.
  5. G (Governance) Belongs in ESG: ESG advocates describe the “G” in ESG as involving board quality, appropriate compensation, accountability to ownership, and ethical business practices. While these are required of a company that pursues ESG, they are also required of companies that place little or no emphasis on ESG. The need for governance quality is universal among organisations.
  6. ESG Ratings Accurately Measure ESG Quality: Despite perception to the contrary, ESG ratings developed by third-party agencies have only a weak (if any) association with corporate outcomes such as performance, risk or, failure thought to be indicative of ESG quality. Each rating provider uses a different number of input variables, and measuring them and combining them is a significant challenge. 
  7. Mandatory Disclosure Will Solve the Problem: Many believe that more disclosure will solve market participants’ problems in assessing ESG quality. While the output of this effort might increase information quality at the margin, the cost of doing so will not be trivial. Increased reporting also opens up companies to litigation. 

A clear understanding of the underpinnings of ESG enables better ESG decisions and reflecting on them is essential for ESG practitioners.

Labour and ESG reporting

Image: Pop & Zebra / Unsplash

While much of the focus on ESG in recent times has centred around the environment, labour has not received the kind of attention it deserves. While Health and Safety has been a common theme in most sustainability/ESG reporting, several other issues deserve a closer look. Much of the corporate reporting on these issues tend to be in narratives rather than quantitative. Analysing the non-financial reports, thus, becomes quite a struggle. For a start, some of the decent work indicators that ILO looks at 

  1. Employment opportunities: Proportion of non-formal employment; employment generation activities in the organisation and nearby areas
  2. Adequate earnings and productive wage: Average wages; Minimum wage as a percentage of median wage;   
  3. Decent working times: measured as the number of working hours; days of paid leave
  4. Combining work, family and personal life: Maternity protection; paternal leave
  5. Work that should be abolished: Child labour, forced labour
  6. Security and stability of work: Work tenure
  7. Equal opportunity and treatment in employment: Occupational segregation by gender; Female share in middle and senior management, the Gender wage gap
  8. Safe work environment: Occupational injury rate –fatal and non-fatal, time out due to work-related injuries
  9. Social security: Pensions and social security
  10. Social dialogues, workers’ and employers’ representation: Collective bargaining and union coverage; days not worked due to strikes and lockouts

There is a need to build standards around non-financial reporting of labour-related issues. Labour is an essential cog in the “S” of ESG and needs more attention and focus.

Corporate Boards and Net Zero

The shift to net zero is urgent, and boards have a critical role in guiding companies. Yet many of the board members have little training or background in sustainability. The boards need to reskill – something that we highlight in our book Shift: Decisions for a Net Zero World.

The table below presents a worrying picture. There is a need for a generational change in the board composition. Companies need to bring in a newer generation that thinks more about sustainability. There is also a need for board members to reskill themselves to be relevant. Board members need training on many aspects of ESG and sustainability. They need to understand the measurement and management of risks embedded in current ways of doing things and the reputational challenges involved.

The “G” in governance needs more a more skilled board team. That will help push the shift to net zero.