Patchwork to Framework – Standardising ESG Investment Disclosures

by Joseph Charuy 4 years ago 6 min read

Over recent years, there has been a growing consensus within the investment community that Environmental, Social and Governance factors are ‘decision-useful’. Outperformance during the pandemic has increased the hype. [1]

Demand for ESG investment products has grown globally as investors have realised that sustainable practice does not necessitate a drag on performance – rather, the opposite. Morningstar research released in 2020 has shown that most ESG strategies have beaten their [2] non-ESG benchmarks over one, three, five and 10 years. The resilience and broad outperformance of ESG products during the recent market downturn has demonstrated the financial materiality of ESG factors and how they can positively impact an investment’s bottom-line.

As more investors take sustainable views on what drives value, ESG data has become increasingly important for their ability to allocate capital most effectively. A recent survey from Brown Brothers Harriman estimated that nearly 74% of global investors plan to increase their ESG ETF allocation over the next year [3].

Unfortunately, the scope and often intangible nature of ESG factors mean that information is often immaterial, incomparable, inconsistent, and costly to gather across firms, industries, and geographies (if available at all). Standardisation ESG data disclosures is necessary, therefore, to make it easier for investors to meaningfully evaluate and compare companies’ ESG practices and risks.

At such a pivotal time for ESG investing, patchy disclosure framework remains the elephant in the room. Whereas traditional products can rely on the Global Investment Performance Standards (GIPS) to establish transparency and comparability, [4] none-such standard framework exists for ESG, and significant challenges in describing and understanding investment products with ESG-related features persist.

Where Are We Now?

Market participants have attempted to clarify ESG-related factors for years in order to better-value ESG products. As of 2016, there were more than 125 ESG data providers according to the Global Initiative for Sustainability Ratings. [5]

According to KMPG, [6] data providers generally fall into four distinct groups:

(1) Providers who publish guidance for voluntary ESG disclosure, often with company feedback;

(2) Providers who request data from companies using questionnaires and then based on the answers issue reports or ESG ratings; _

(3) Providers who compile publicly available ESG data about companies and issue ESG ratings based only on that publicly available information; _

(4) Providers who create assessments of companies based on public and/or private information to sell to investors.

Frustratingly, even though various local, proprietary reporting standards exist, any implementation by a U.S. company of an ESG disclosure framework remains voluntary as of now. In the UK and the EU, the consideration of ESG risks when making investment decisions has been formalised as an investor duty by law, however both jurisdictions specify that this is only with respect to ‘financially material’ ESG factors, rather than those affecting stakeholders more broadly.

This lack of an overarching compulsory framework has yielded little in terms of consistency and universal meaning when attempting to understand and integrate financially-material ESG data into investment decision making processes.

Why Have We Been So Slow to Adopt a Standardised ESG Disclosure Framework?

A number of factors have prevented effective disclosure standardisation. Firstly, the complex nature of the data desired – ESG factors are often intangible and inherently non-financial. As such, measurements are complicated and subjective. The financial materiality of a single characteristic may also vary by firm, sector and geography.

Any robust framework must successfully accommodate significant levels of nuance in order to be useful to investors. As such, designing and establishing standardised reporting protocols will be costly and require significant consultation.

A historical barrier which has prevented effective disclosure standardisation of ESG factors is the idea that ESG investing violates the fiduciary duty of investment managers, as investments intended to benefit third parties (e.g., “society”) contravene the duty of loyalty to clients. [7] Until recently, market participants have had no obligation to create standardised disclosure frameworks for ESG factors as this investment style was widely deemed inappropriate by the above logic. As investing ideologies have evolved, the subsequent lack of ESG factor accommodation in existing frameworks has become more and more pronounced.

What’s to Gain From a Standardised ESG Disclosure Framework?

Various market participants stand to gain from a global standard in ESG-related data disclosure.

A standard reporting framework would increase the inherent value of positive ESG factors for firms by reducing costs associated with incompleteness and inaccuracy of data. Currently, a public company can be the subject of an ESG assessment without knowledge that it occurred or an opportunity to give input or correct misperceptions. As firms would be required to provide a benchmark level of information, ESG data would become more financially material. Furthermore, a standard reporting framework would allow firms to correct any negative misrepresentations of their ESG characteristics resulting from the current patchwork of inconsistent data sources. Conversely, standardised ESG disclosures will help to correct market integrity issues, such as ‘greenwashing’ – the process of conveying a false impression or providing misleading information about how a company’s products are more environmentally sound. [8]

Investment managers and clients will also benefit from standardisations in ESG disclosures. Currently, many feel burdened by large amounts of unstandardised data which can lead to information overload, worse investment decision making and worse risk-adjusted returns. As more managers are mandated to buy ESG products, better quality ESG information is increasingly desirable and necessary for managers to fulfil their fiduciary duties. Standardised disclosure standards will also benefit active managers by encouraging product evolution in the ESG space – allowing for more choice and higher quality offerings as asset managers become better-equipped to meaningfully evaluate and compare companies’ ESG practices and risks.

Ultimately, and most and importantly, humanity at large is set to benefit from standardisations in ESG disclosures. Better quality data will hopefully catalyse global attempts to allocate resources and capital towards positive and sustainable causes, such as carbon offsetting and inclusion and diversity.

What to Expect Going Forward – Patchwork or Framework?

The case for standardising ESG investment disclosures is clear and will continue to gather support from market participants as ESG products gain in popularity.

In response to growing demand, reporting standards giant CFA Institute recently released a consultation paper proposing a new standard framework for ESG-related disclosure. Their proposed standard will seek to establish “uniformity in the definition of ESG-related features and disclosure requirements … so that investors can more easily understand the features offered by a particular investment product and make comparisons among investment products.” [9]

In the US, the Securities and Exchange Commission is also taking notice. An urgent recommendation published in May [10] has asserted that the time has come for the SEC to address the issue of standardisation in order to meet investor need for relevant, material, decision-useful ESG disclosure.

Nevertheless, a global framework may be further away than many investors hope. Proposals by the SEC have hit a stumbling block as committee members have appeared sceptical of the urgent recommendation and called into question “why the past fifty years of discussion on the topic has not crystallized into a universally applicable set of material ESG items”. Members have instead proposed to “keep using our tried and true disclosure framework, which is rooted in materiality and is flexible enough to accommodate a wide range of issuers, each with its unique and ever-evolving set of risks.” [11] Traditional SEC framework, whilst useful for understanding and comparing traditional investment products, is less useful when considering less-tangible, yet as financially material, ESG products.

Current lack of standardisation in disclosure standards threatens to undermine the materiality of available ESG data and may lead to erosion of trust in the industry in the long run unless the current ‘patchwork’ approach is replaced with something more substantial.

Whether this year, next year or five years from now, I am confident that a standardised ESG investment disclosure framework will materialise. The consensus within the investment community that sustainability will play a vital part in investing practice going forwards is overwhelming, and a strong disclosure framework will be integral in making this possible.

As Sam Cook famously wrote, it’s been a long time coming, but I know a change gon’ come, oh yes it will.

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Joseph Charuy

Final Year Undergraduate Student at the University of St Andrews, Studying Finance