We’re hearing louder calls for action to slow the pace of climate change, caused, in part, by the unavoidable reality of changing temperatures and increasingly severe weather events. The markets take notice when business as usual is disrupted by these events, as it was in Europe this past summer—the continent’s warmest summer on record—and in South Asia, where monsoon-related flooding caused $40 billion in damages. Consequently, the topic of ESG (environmental, social and governance) is surfacing more frequently in board rooms and business discussions.  

It’s also a critical topic among investors, for whom risk avoidance is a priority. And while it may be a front-of-mind topic in the industry, it’s not a new topic. The meaning and objectives of ESG have been debated for years and certainly since the 2004 publication of “Who Cares Wins,” the report that discusses ESG in relation to financial markets.  

Aaron Yoon, assistant professor of accounting and information management at Northwestern University’s Kellogg School of Management, addressed the application of the ESG framework in investing in a recent talk on the future of ESG. A Kellogg Insight piece captured several key takeaways from Yoon’s talk.  

ESG Investing: Hot or Not?

“ESG investing has just exploded,” according to Yoon. He points out that assets under management with entities that joined the Principles for Responsible Investment initiative grew to $120 trillion in 2021. This means that “roughly three times the entire U.S. market cap has committed to incorporate ESG information into their decision-making process.”  

His assessment is supported by a recent Bloomberg story about an asset management unit of Goldman Sachs that attracted over $1.6 billion for its Horizon Environment & Climate Solutions I fund – an Article 9 product that must adhere to Europe’s strictest standards for environmental, social and governance under the Sustainable Finance Disclosure Regulation 

And in September last year, Dow Jones published research indicating that “sustainable investing is the number one growth opportunity for investment professionals.” But the research noted that investors are still challenged by a lack of reliable data on ESG practices from companies. And investors who can obtain the information they need often find that it doesn’t allow for comparison.   

The Challenges of Assessing ESG Performance

Yoon also acknowledges that company ESG reports fail to provide clear indicators of ESG performance: “All of these reports are unaudited and contain information that is voluntarily disclosed in order to promote companies.” But this is likely to change, with regulators and other entities also realizing the need for better and more comparable information.  

The International Sustainability Standards Board’s (ISSB) IFRS Sustainable Disclosure Standards seek to achieve the comparability that investors and other stakeholders want. There’s evidence that the ISSB is progressing toward its goal, with the CDP recently announcing that it will integrate the ISSB’s climate-related disclosures standard (IFRS S2 Climate-related Disclosures) into its reporting platform. Considering that more than 18,700 of the world’s largest companies representing half of global market capitalization disclosed climate, forest and/or water impacts through the CDP in 2022, there’s room for hope where comparability is concerned.   

Additionally, Europe’s Corporate Sustainability Reporting Directive, which went into force on January 5, 2023, will require large and listed companies (including some non-EU businesses) to disclose, among other things, Scope 1, Scope 2 and, in some cases, Scope 3 greenhouse gas (GHG) emissions. They will also need to disclose their impact on water and marine resources, as well as biodiversity and ecosystems, and report on their treatment of employees and supply chain workers. Reports must be certified by an accredited independent auditor or certifier. 

And in April this year, the U.S. Securities and Exchange Commission (SEC) will release its regulations on climate-related disclosures for large, publicly traded companies in the U.S.  

The CDP offers one of the better remedies for investors’ information woes, especially since investors (and suppliers and customers) can request disclosures from specific companies using its platform. 

What Are We Trying to Assess?

Yoon points out that we haven’t reached consensus on what we’re trying to assess when we’re looking at ESG metrics. “Is it impact on the world? Or the impact of the world on the company’s bottom line? Is it value, or risk, or avoiding negative events?” The honest answer is probably “all of the above,” but the use of different scoresheets for different goals only complicates the assessment effort.  

Some reporting frameworks do a better job of accommodating the different lenses through which ESG activities are judged by incorporating the concept of double materiality. This construct provides inward- and outward-focused perspectives by looking at the impact that a company has on climate change and the environment, as well as the impact that climate change has on the company. It may not be the answer to the problem, but it does make room for more than one set of criteria.   

Going Back to the Fundamentals of Value Creation

As Yoon mentioned, one of the difficulties investors have faced is the tendency for companies to be selective in their presentation of ESG information. That’s simply human nature at work: For example, no one deliberately selects their worst photo for their company ID. But investors can’t limit their risk exposure when they’re given only the information a company wants them to see.  

Yoon says that the future of ESG investing lies in the ability to identify opportunities for value creation. So, businesses need to put their most attractive metrics aside to focus on the ESG activities that are relevant for value creation. Materiality assessments will help them do this. These assessments engage stakeholders in determining which ESG matters are most consequential for a business, so it can concentrate its efforts in the right areas.      

Better Information Yields Better Outcomes

ESG reporting requirements are primarily about the need for greater transparency. And while the requirements create challenges for companies, many of these challenges can be managed with tools and data that contribute to a company’s reporting capabilities.  

The ESG framework seeks to provide a more honest, comprehensive look at business conduct, so investors, lenders and consumers can make more informed decisions. It’s certainly hard to argue against better information, and when it leads to corrective action, as it should, our environment and future generations will benefit.

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