Cohesion on ESG Standards Still Elusive, Despite Biden Win

Over the past five years, active managers have seen increased interest from investors in ESG—environmental, social, and governance issues—and recent history is likely to accelerate that trend. President-elect Joe Biden campaigned on a very ambitious climate change agenda, and he has said that he plans to re-enter the US in the Paris Climate Agreement as early as February. At the same time, the past year was marked by a new awareness of inequality and injustice, following the tumult of the coronavirus and racially-charged protests in America.   

So firms expect to enter a new era of heightened focus on ESG investing, but however high the hopes for ESG products under a Biden administration, the relatively young field remains riddled with data issues; a lack of cohesion on disclosures, practices, and interpretations; and sometimes drastically varying company ratings. Investment professionals say it will take a lot of coordinated effort across the industry to remedy these shortcomings, as the stakes in understanding ESG issues and their effects seem to grow higher all the time.

“Before Covid-19, I think that environmental and climate change issues were probably first among equals [the other equals being social and governance factors]—rightly so, because it’s really something that affects everybody, no matter if you’re rich or poor, if you live in North Africa or the eastern part of the United States; nobody escapes from it,” says Mike Chen, director of portfolio management and sustainable investing at PanAgora Asset Management, a Boston-based quantitative asset manager. “But what Covid has done is made more prominent the inequality that exists in our society in so many dimensions. Not just gender, but racial, in income, in housing.”

“We’re definitely getting inquiries from potential investors, from potential clients, asking, ‘Can we come up with products that are more focused on social issues?’ Or, ‘How do you think about that?’ So I think that ESG is having a moment. And, because of Covid, because of racial tensions, I don’t think that moment is going to disappear once Covid is over,” he adds.

Chen says that a central tenet of ESG is its values-based approach to investing. But this approach opens up ESG’s very definition to interpretation. Different regions care about different topics and in different ways. This has been demonstrated particularly in Europe, which is the most advanced part of the world when it comes to ESG practices, according to the Morningstar Sustainability Atlas. Hong Kong is the highest-scoring non-European market, and the US ranks in the second quintile of global sustainability leaders, despite being the world’s second-largest carbon emitter.

Competing standards are definitely an issue in the industry for ESG, because it makes it possible to have the perception of greenwashing. And this goes back to the point of language.

Frances Barney, BNY Mellon

The annual report, last released in April 2020, lacks a strong emphasis on the “S” and “G” factors, as it examines country indexes primarily through the lens of the Morningstar Portfolio Carbon Metrics. The report notes that material issues—for example, that greenhouse gas emissions are most relevant in oil and gas, while data privacy and security issues take precedence in enterprise software—vary by industry.

However, as the events of 2020 illustrated early on, some criteria—for example, healthcare benefits, paid time off, and independent boards of directors—matter across the board. Speaking to WatersTechnology last year, Thomas Kuh, then head of index at Truvalue Labs (prior to its acquisition by FactSet), used the term “Dynamic Materiality”, which is a term coined and trademarked by Truvalue and indicates that every company, industry, and sector has a unique materiality signature that changes over time based on factors like emerging technologies and new regulations.

The shape-shifting nature of materiality explains many of ESG’s shortcomings. Issues that persist include a lack of standards around these datasets, their noisiness, that there’s a lack of history (most of these datasets only go back five to 10 years), and these signals’ behavior can change fairly rapidly. And there are instances of greenwashing, where a company markets itself as operating sustainably but with flimsy proof. And while the term “greenwashing” evokes environmentalist imagery, it can also apply to the social and governance realms. For instance, a company may claim to have racial and gender equality in its workforce, and while this may be true when considering lower-level employees in the organization, all its decision-makers in the C-suite are white men.

The reason that environmental issues may have attracted the spotlight of the ESG movement so far is that metrics like carbon emissions, water pollution, and resource use are relatively easy to quantify, albeit still imperfectly. Social and governance factors, which rest upon fuzzier concepts like employee and community sentiment, culture, and pay policies, are much more difficult to turn into accurate metrics.

“You want to pay people a living wage; you want to provide healthcare benefits; you want to have good governance, less carbon exposure—these are common definitions, broad areas where people agree. But within the agreed-upon broad areas, there are a couple things, right? How do you measure these issues?” Chen says. Returning to carbon, he says of the persistent lack of measurement standards, “Do you just measure scope 1? Or do you actually measure scope 2, or even scope 3? And what data sources do you use? Those are still outstanding questions.”

When a company reports its carbon footprint, much of that data relies on carbon scopes 1 and 2. These two measurements include onsite emissions from facilities owned or controlled by the company, as well as emissions from purchased energy. A third measurement, carbon scope 3, encompasses the entire value chain of a company’s resources and products down the line until they decompose and become atmospheric gas. Roughly, scope 3 is equal to about three times the combined impact of the other two, and is more difficult to accurately assess.

The Best of Intentions

During a webinar in mid-December, the global head of frameworks at UBS Evidence Labs, Jeremy Brunelli, applied alternative data and proprietary models to dig into some of Biden’s bullish plans for ESG investments.

As Biden has mentioned instituting solar tax credits, the group used its US Utility Solar Weather Model to gauge the percentage of sun on any given day—called sun traction—using satellite data, and understand where there’s potential for solar investment. The Evidence Lab is combining that with data from its US Solar Equipment Monitor to understand the market share by company of solar panel installation, so that as the firm follows Biden’s sentiment on solar tax credits, it can likely predict locations for installations and which companies will benefit from them.

Brunelli said that Biden has also talked about $300 billion of R&D investment in key tech areas such as electric vehicles, as well as a plan to install across the country 500,000 charging stations for electric vehicles by 2030. While both these plans indicate a favorable outlook on national ESG projects by the incoming president, it’s less clear whether the next four years will have much bearing on issues of competing standards and data quality that plague the investing field.

Frances Barney, head of global risk solutions at BNY Mellon Asset Servicing, says that first adopting a shared, common language with regard to the definition and objective of ESG would offer a sorely-needed sense of transparency and confidence in how the financial industry approaches ESG issues and investment strategies.

I don’t think it’ll ever—and it shouldn’t ever—be all uniform for every entity around the world. Customization is an important part of it.

George Mussalli, PanAgora

Currently, there are multiple standards for ESG, including the Task Force on Climate-related Financial Disclosures, the Sustainability Accounting Standards Board, and an initiative by the International Business Council of the World Economic Forum and the “big four” accounting firms (Deloitte, EY, KPMG, and PwC) that was introduced in September.

“Competing standards are definitely an issue in the industry for ESG, because it makes it possible to have the perception of greenwashing,” Barney says, adding that there’s a valid concern among asset managers that existing frameworks and investment strategies don’t always describe their objectives effectively.

“And this goes back to the point of language—if we’re not talking about the same thing, then it might be that everybody is acting with the best of intentions, and they have a target or aspiration for a particular investment approach that they’re not particularly committing to, but does the name imply [another] particular strategy? What exactly is the intention?” Barney asks.

While it’s a somewhat philosophical dilemma, it is a fundamental one, she says. And it isn’t made easier by the fact that the last year muddied the concept of materiality. Before Covid-19, Barney says she hoped for greater recognition of the interconnections between all ESG factors and fundamental investment analysis.

“The pandemic has painfully demonstrated that there is an interconnected web between social issues and financial issues and economic issues and health issues and labor relations and diversity, equal access, and to economic resilience,” Barney says. “You’re one disaster away from having something that is perceived to be immaterial becoming catastrophically material.”

While it’s generally agreed there will be some forthcoming level of global cohesion around ESG, striking a balance of customization and uniformity remains necessary, says George Mussalli, chief investment officer and head of equity research, also at PanAgora Asset Management.

“I don’t think it’ll ever—and it shouldn’t ever—be all uniform for every entity around the world. Customization is an important part of it,” he says. As an example, individuals and entities within a pension fund might have certain goals and want those goals reflected in their investment decisions, and the fund manager might have to meet several of these individual goals at once.

Mussalli also would caution against pushing for lawmakers and regulators to take away opportunities for choice and innovation.

“I think it’s a healthy process to throw in a lot of different ways. I think the better outcome will be organic, where over time, it will gel into something where you’ll see different pods of investors gravitate toward different things,” Mussalli says. “It’s never a good thing when a government entity says ‘We know better.’ Between asset managers and asset owners we can figure it out better than a government entity telling us what to do.”