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Why We Need to be More Precise with ESG Definitions

July 21, 2022

Gabriela Herculano


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Why We Need to be More Precise with ESG Definitions

Environmental, Social and Governance -- ESG -- has become a household acronym. ESG approaches have driven a surge in sustainable investing. This has been a defining theme of the last decade and is a remarkable development. But what should have been cause for celebration, however, has increasingly become cause for concern.

Does ESG equate to scorecards?

Brian O’Hanlon from the RMI, previously the Rocky Mountain Institute, made a crucial point when he said, “You can have the best framework in the world, but unless it’s widely adopted, its utility will be limited." We are not lacking support of ESG, but the concepts that ESG represent have been translated into opaque scorecards.

With a plethora of ESG rating systems in the market, the divergence of scoring between providers is eminently material. Investors looking to align their portfolio with climate goals could find that their holdings look substantially different whether they use, say MSCI, Refinitiv or Sustainalytics data.

There are three clear reasons for this divergence: scope, weight, and measurement. Scope pertains to the indicators chosen to represent E, S and G -- for example, gender equality. Measurement is the metric used to measure these indicators -- for example, the number of women on the board versus the gender pay gap. Finally, weight is the relative importance given to each scope in producing the overall rating.

ESG should not equate to the use of scorecards. Investors and asset managers should be free to choose to lead with E, S or G indicators, to exclude or include activities, to mix backward looking or forward-looking metrics. However, fund managers must be transparent and specific on their approach and methodologies.

Correlation vs Causation

“Correlation is not causation” is a popular concept covered in statistics classes. While some companies that are seen as strong corporate citizens may exhibit correlation with issues like equal pay, senior management compensation, or corporate governance practices, to prove that these specific corporations are driving advancements in those goals requires the use of a tangible metric. The issue of how to quantify that impact has been a hot topic, but it is time for funds that claim to have positive ESG characteristics to use a tangible metric to demonstrate that impact.

Full disclosure, I am co-founder and CEO of a London based green fintech. We put a lot of effort into developing a methodology that is rules-based and data-driven, and that allows us to find climate change solutions and the companies behind them. Unlike ESG scorecard-based funds, we provide evidence for causation of the impact generated by the companies in our universe.

The focus of our first equity indices is decarbonization. Here, we demonstrate this causation using a forward looking metric termed "Potential Avoided Emissions," which measures the megatons of CO2e that are not emitted into the atmosphere because high emissions activity has been replaced by a low-carbon solution. For the companies providing these solutions, decarbonization is a revenue generating item. They are therefore providing the tools to drive the rest of the economy to Net Zero.

Rewarding companies that have intrinsically low carbon footprints does very little to move the needle. Companies like Microsoft, Apple and Google correlate with low GHG emissions, but is their raison d’etre the decarbonization of our economy? We see companies like PayPal, Mastercard, Best Buy, Nike, Burberry, L'Oreal, Coca Cola, and many more all heavily represented in ESG sustainable indices, but these companies are not going to drive us to Net Zero, nor would they claim to. It's not their primary goal.

We will fail to maximize the impact of well-intentioned capital if we don’t enhance our taxonomy and nomenclature. If the purpose of a fund is to represent companies that score really high according to an ESG scorecard, it should say exactly that. On the other hand, an ETF promoting veganism may have top constituents like Amazon, Google and Microsoft -- while they might be great corporate citizens, are those companies really causing and advancing veganism?

ESG as a Goal Versus ESG as a Screen

Fund providers of ESG products must be upfront in making the distinction of whether a fund has ESG as a goal or ESG as a screen. But we must go further. In climate change investments, there are two extreme approaches in "ESG as a goal," where the companies generate a positive environmental outcome: funds that engage and hope for transformation, versus funds that focus on innovation. The connection between the underlying constituents and the goal of decarbonization of either approach must be demonstrated.

Investment managers do not need to wait for regulation to force disclosure on methodologies. Investment managers should clearly state the purpose of a fund, not just offering a mere description of the strategy it has or the index it tracks, but how the underlying constituents advance the ESG objective.

Saying what’s in the tin is not enough – funds should disclose what their tangible metric for impact is, and how that metric can demonstrate and track the advancement of that impact. Finally, fund managers should state whether they negatively screen or not. In other words, does a fund include “offenders” that it expects to convert, or excludes certain sectors and activities? As part of the screening of companies, does the fund apply holistic ESG screens (such as UN Global Compact) to vet all constituents?

The EU Sustainable Finance Disclosure Regulation (SFDR) was put in place in March 2021, with a goal of combating greenwashing. EU regulators are putting effort to mitigate ESG-washing by requiring financial products to disclose methodologies and data. More differentiation will likely be brought to market by new players, while investors will increasingly look through in much more detail and progressively allocate more capital towards the most impactful, thoughtful products that are truthful to their goals.

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