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Special Report

ESG: The metrics jigsaw

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ESG: The long quest for comparable data

What do India and Iceland have in common? One answer is patchy ESG reporting by companies, coupled with a growing band of concerned investors seeking to remedy the situation. As we outline in this report, Icelandic companies, arguably distracted by the fallout from the country’s banking system in 2008, are playing catchup. They are working with local institutional investors, themselves laggards in Nordic terms, to improve ESG reporting.

In India, where there is next to no focus on ESG, there is a growing realisation that externalities matter in areas like water management or rice production, which is highly water intensive. A small but growing band of investors is seeking to put ESG on the map.

And across the world, a growing band of institutional investors and other financial actors is seeking better and more comparable inputs to financials statements in areas like carbon emissions. Their aim is to improve understand- ing of the risk profile of investments and to allocate capital accordingly. While much focus has been on public equity, attention is increasingly turning to public credit markets as well as to private equity and debt.

Globally, the Task Force on Climate-Related Financial Disclosures (TCFD) has highlighted the need for greater standardisation in emissions-related reporting and has provided a roadmap to do so. The Greenhouse Gas Protocol’s Scope one, two and three framework provides a reporting framework, even if it gives scarce guidance about how companies are supposed to assess the trickier parts of that value chain – in Scope-three emissions, for instance, which include upstream and downstream emissions.

Some oil and gas companies have apparently assumed little or no carbon risk in their sustainability reporting, claiming that carbon capture and storage will take out a very large proportion of their emissions. The problem is that such technology is unproven and in its infancy. IFRS and local accounting frame- works impose comparable, verifiable and mandatory standards with criminal sanctions for those who break them. In comparison, there is no objective way to assess much forward-looking corporate sustainability-related data.

ESG rating companies, asset managers and index providers have responded to the lack of standardisation by developing their own frameworks to rate and rank stocks according to ESG metrics. Increasingly, credit managers and rating agencies are applying ESG frameworks to bond issues. Investors should not be surprised if these methodologies do not all produce the same outputs. It is up to them to understand and compare different approaches.

Indeed, a paper by researchers at MIT Sloan*, published this August, finds that while Moody’s and S&P credit ratings are 0.99 correlated, the ratings of five prominent ESG ratings providers are 0.61 correlated on average. “Measurement divergence” explains 50% of the overall divergence, according to the researchers.

While source data may be patchy and ratings incomparable, data is not sparse in its totality. Perhaps unsurprisingly, some are looking to data science to wade through the increasing quantity of sustainability data and to make sense of it. The trick will be to isolate noise from signal and to recognise the limitations and biases of algorithms developed by humans. Ben Caldecott of the Oxford Sustainable Finance Programme sees potential in geospatial data.

Many more CEOs and CFOs are taking sustainability much more seriously, thanks to regulations, peer pressure and the efforts of investors. Underlying the quest for greater transparency in corporate sustainability reporting is a desire to understand portfolio risks more clearly. As yet, the mismatch between corporates, investors and standard setters remains a significant one.

*Berg, Florian and Kölbel, ‘Aggregate Confusion: The Divergence of ESG Ratings’, August 2019. MIT Sloan Research Paper No. 5822-19.

Liam Kennedy, Editor, IPE

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