While EU regulation is a positive development, which will bring greater standardisation to ESG reporting, investors, organisations and regulators must aim to go further
Larry Fink’s annual letter once again outlines the role of asset managers in combatting climate change and working towards net zero targets. His statements come off the back of a year when environmental, social, governance (ESG) investments grew fourfold, outperforming traditional funds, as investors became hyper aware of the role externalities and business resilience on future growth prospects.
In particular, Fink highlighted the importance of public disclosure on carbon emissions, enabling investors to differentiate between companies’ eco-credentials, identify greenwashing and ultimately achieve “true societal change”.
“Assessing sustainability risks requires that investors have access to consistent, high-quality, and material public information,” he said, recommending that large private companies adhere to similar standards.
He is absolutely right, of course, and here in Europe we are starting to see more private equity firms and their LPs take sustainability and ESG seriously and strive to understand how this can be tracked and reported in a meaningful way.
This movement has been given further impetus by the Sustainable Finance Disclosure Regulations, coming into effect in March, which now make it law to ‘comply or explain’ on a range of sustainability factors.
But while EU regulation is a positive development, which will bring greater standardisation to ESG reporting, investors, organisations and regulators must aim to go further. The objective of ESG investing is to ensure that funds are being funnelled towards solving the world’s biggest challenges, so measurement and reporting must align with that goal.
That means tracking both the negative and positive externalities that organisations create and moving from box-ticking to understanding real-world impact.
ESG reporting today: A tick box approach
Under most current frameworks, ESG reporting typically involves completing a list of requirements to confirm that firms consider various factors when investing. One leading example is the Principles for Responsible Investment (PRI), a voluntary framework which asks firms to make disclosures about the processes and structures that they have in place.
Questions might include: Do you have a sustainability policy? Or: do you have a dedicated ESG leader? The EU disclosure regulations will largely take a similar tick-box approach, while also considering certain key adverse outcomes.
A tick box style of reporting has its value, acting as a minimum standard if you are a responsible investor. It enables firms to understand how to encourage sustainable investment practices and the right processes and behaviours to avoid negative externalities.
However, where it falls short is that it purely looks at inputs, rather than the actual results of those policies and practices. So, a firm might have a sustainability policy, but how has that translated into reducing carbon emissions or resource efficiency in portfolio companies?
Reporting on outcomes: quantifying negative externalities
A step up from box-ticking is to look at outcomes, focusing on quantifying externalities in specific, numerical terms. This is fairly well-developed in the case of CO2
emissions, which many firms are now quantifying through the Greenhouse Gas Protocol (GHG), and which has already achieved a good level of standardisation.
The challenge here, however, is that many organisations are still failing to disclose their carbon emissions fully, particularly Scope 3, relating to supply chain impact. Issues like this need to be addressed, and obligatory reporting of Scope 3 introduced, if disclosures are to become meaningful and comparable for LPs.
Beyond CO2, outcomes -focused reporting is still very limited, although it should become more widespread next year, when the EU disclosure regulations will require firms to publish a Principal Adverse Impact statement.
This will involve outlining the adverse impacts of investment decisions on sustainability factors, relating to both the climate and the environment, and social and employee matters. Demanding more clarity around negative externalities, it will make it harder for organisations to omit or greenwash trickier subjects, while also giving more attention to social impacts, which are often overlooked.
Capturing materiality and positive impact
Yet in all the above standards, one key element that is still missing is materiality, i.e. ensuring organisations are focusing on externalities which are core to their business and where they have the biggest environmental or societal impact – as opposed to a range of generic ESG measures. For example, does a bank measure just its own carbon emissions, or does it look at how its lending contributes to the carbon economy through the emissions of its customers? Or, under social factors, does it consider how its executive pay levels contribute to inequality in society?
The other big downfall of current frameworks is an inability to report on positive impact. Traditional ESG is all about risk and processes, but real change will only come from finding solutions to the world’s biggest problems, whether in healthcare, education, renewable energy or reducing waste and pollution.
Reporting on positive externalities will ensure we move from a focus on outcomes, and minimising risk, to reporting on real-world impact. The UN Sustainable Development Goals are a good place to start in terms of defining organisational purpose against global challenges, but how do we show how – and how much – they have contributed? For example, how many lives has an organisation saved or improved through its products and services?
We must move past the idea of ESG as a ‘nice to have’ and treat it as seriously as we do traditional financial accounting
Various organisations are now in the process of developing ways to show impact. For example, The Impact Management Project, which provides a forum for a community of enterprises, investors and standard setting organisations, with the mission of developing a holistic standard for measuring and comparing impact.
Similarly, Impact Weighted Accounts, an initiative from Harvard Business School, aims to create a framework that quantifies a company’s financial, social, and environmental performance in monetary terms, thereby putting it on a par with financial accounting, and enabling comparisons between a range of different ESG factors and organisations. These projects are in their infancy but are ultimately where we need to get to.
Many private equity and other asset management firms are only at the beginning of their sustainability journeys and undertaking ESG reporting can initially seem like a minefield, even at its simplest level.
A tick box approach is a good place to start, but for us to move the needle in building companies that are solving the world’s biggest macro challenges, we need to set our sights on measuring outcomes and impacts.
Only then will sustainability become truly embedded in investment decisions, and in the work that private equity firms do to build value, sustainability and resilience in portfolio companies. We must move past the idea of ESG as a ‘nice to have’ and treat it as seriously as we do traditional financial accounting.
Reynir Indahl, founder and managing partner, Summa Equity