ABCs of ESG Part 1 – ESG investing: Boom or a bust?

By The Delphi Group’s Adam Schwarz, Senior Consultant, Sustainability and ESG Reporting, and Garrett Jones, Director, Sustainable Finance

ESG is everywhere. At a time when the climate crisis, diversity and social justice issues, and a global economy are converging, environmental, social and governance considerations are top of mind for all sectors and types of businesses.

We’ve been working in this space for a long time, and we have never had so many client questions about what the evolving ESG landscape means for them – and what they need to do to stay competitive. We’re here to help: this is the start of an ABCs of ESG series, where we will break down all the things you need to know and help set you up for success. 

This first installment is focused on ESG investing, which has been getting a lot of attention in the media lately. Let’s dig in…

What constitutes ESG (also known as sustainable) investing?

In a nutshell, it is investing in companies or an investment fund that tout superior environmental, social and/or governance performance. This could mean excluding certain companies or industries because of their ESG-related activities, or incorporating ESG factors when evaluating the risk and return of a company to be included in a fund.

ESG considerations are extremely diverse, and include climate-related business risk, boardroom diversity, and workplace safety, among many others. Not all ESG funds will factor in the same considerations, but superior environmental, social and/or governance performance can translate into decreased risk, increased returns and, in some cases, increased impact (more on that in a future blog).

Is ESG investing a big deal?

It’s becoming a big deal. The numbers don’t lie:

• At the end of 2021, assets in ESG-themed mutual funds and exchange-traded funds totalled US$2.74 trillion globally, up 34% from the year before, according to Morningstar. 
• The number of sustainable funds available to U.S. investors grew to almost 400 last year — up 30% from 2019 and a nearly fourfold increase over a decade.
• In Canada, assets in such funds doubled to $34.5 billion in 2021.

More and more everyday investors are looking to align their investments with their values, and institutional investors are considering a growing range of risks and stakeholder expectations. As climate risk and others become mainstream, ESG is increasingly mentioned in the same breath as long-term financial performance – it’s not just a PR game anymore. This bodes well for the future of ESG investing.

How are third-party ratings agencies assessing ESG investments? And do they help or hinder?

Ratings from organizations such as Sustainalytics, MSCI and S&P help investors gauge whether a stock is a suitable addition to an ESG fund or exchange-traded fund. Most fund managers rely on rating agencies for their data when they are building ESG investment funds. 

The challenge, as highlighted in a recent Globe & Mail article, is that these agencies use different methods to measure ESG performance, and this can result in inconsistency between ratings. In addition, in most cases the information being assessed is self reported, or based on what is publicly available. This creates inconsistencies between the data being reported.

A November 2021 report by the International Organization of Securities Commissions confirmed that “there is little clarity and alignment on definitions, including on what ratings or data products intend to measure.”

In terms of the regulatory landscape, it’s currently a bit of a ‘wild west’ situation. There isn’t a lot of clarity so ratings agencies are developing their own methodologies, leading to inconsistency – which in turn could drive hyperinflated pricing because of the inaccuracy or subjective nature of the ratings.

How is the ESG rating landscape evolving?  

ESG investing is on the rise. However, a lack of regulatory clarity and standardization has led to legitimate concerns about the potential for greenwashing, as well as mispriced risk and value.

Fortunately, we’re seeing a number of positive developments:

1. The International Sustainability Standards Board (ISSB), an offshoot of the International Financial Reporting Standards Foundation, was formed last year. The board issued its first draft rules for sustainability and climate-related disclosure in late March, which signals a move towards the standardization of ESG reporting, in line with internationally accepted accounting standards. Whether it will make ratings agencies obsolete and/or drive more consolidated ESG metrics remains to be seen.

1. The US Securities and Exchange Commission has created a climate and ESG task force that will target ESG-related misconduct. The Canadian Securities Administrators (CSA) also recently published guidance aimed at improving disclosure of ESG-themed funds. The guidance defines clear and consistent expectations for classifying funds with an ESG label, so fund managers can more accurately and transparently represent the ESG rigour associated with the investment fund.

1. In June of 2021, the European Commission launched the Sustainable Finance Disclosure Requirements (SFDR). The SFDR is a requirement for all sustainable finance products (green bonds, ESG funds, etc.) to follow a taxonomy for how these products are labeled as ‘green’ or ‘sustainable’. The EU is usually one step ahead when it comes to regulation, so the EU SFDR is a signal to the rest of the financial world that regulation of sustainable and ESG products is coming. The definition of fiduciary duty – a legal requirement for institutional investors that obligates them to make decisions based on maximizing returns and minimizing risk – has also expanded recently to include sustainability and ESG.

How companies can position themselves for success in this rapidly changing landscape

Companies are more likely to receive a high ESG rating with high-quality, fulsome disclosure, no matter what framework they use. Disclosing all material risks related to ESG is often a sign of good governance, and of a company that understands that long-term profitability is increasingly linked to managing ESG-related risks. 

The market pressure to disclose ESG risks is increasing. As disclosure-related regulation – such as the Task Force on Climate-Related Disclosures (TCFD) recommendations – comes into effect, companies that are transparent, disclose in alignment with their sector peers, and have verified disclosure information will be in a better position to protect and grow their valuations.

In addition, proactively engaging with ESG rating agencies is key to successful disclosures and favourable ESG ratings. Working with them to ensure they have the information they need to accurately rate your company is essential to achieving high ESG ratings. Accuracy, transparency and consistency will help you navigate the ESG waters and ensure your efforts create meaningful impact.

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Adam Schwarz is a Senior Consultant, Sustainability and ESG Reporting, and Garrett Jones is the Director of Sustainable Finance. For more information on how we can help you meet your ESG disclosure and net-zero goals, reach out to Adam directly at aschwarz@delphi.ca, or Garrett directly at gjones@delphi.ca.