The clamour surrounding ESG has never been louder. Confusion has never been higher. In particular, between moral imperatives that support the long-term health of the natural world; and measuring, categorising, and monitoring factors that reflect how entities interact with the natural world over time.
Without a doubt ESG has been a dominant theme for 2022 despite significant macroeconomic and geopolitical circumstances. The multitude of actions by governments, regulators, global standard setters, investors, executives, and the public at large during 2022 highlight that ESG is front of mind. As an analyst in the investment community these rapid developments have felt like a non-stop boxing match against history’s greats (Ali, “Iron” Mike, Manny “Pacman” Pacquiao to name a few).
So, in this piece, I try to thematically capture the key ESG developments across the globe in 2022 as means to better position myself, and analysts facing a similar challenge, for a 2023 which I believe will see an increase in intensity of ESG themes. This is by no means and exhaustive exercise. My concerns and expectations are sprinkled throughout.
Increased scrutiny from regulators
Global interest in “greenwashing” (proxied by Google Trends data) rose sharply in 2022 when compared to the trailing five years. And as public interest in “greenwashing” intensified sharply in the beginning of 2022 so did the scrutiny of regulators.
January saw the UK’s Competition and Markets Authority (CMA) launch its review of environmental claims made in the UK fashion retail sector, investigating marketing practices by the sector for “eco-friendly” products. This action builds on the “Green Claims Code” published by the CMA in October 2021, which set out guidance for businesses on making environmental claims when advertising goods and services in the UK. It is clear, in my view, that the principle of treating customers fairly and transparently will remain a central focus area as regulators introduce and evolve measures aimed at driving positive ESG outcomes. To this end the UK’s Financial Conduct Authority (FCA) issued for consultation “Sustainability Disclosure Requirements (SDR) and investment labels” in October 2022 with responses required by January 2023. Upfront the FCA states: “Consumers must be able to trust sustainable investment products. Consumers reasonably expect these products to contribute to positive environmental or social outcomes”. Likewise, the European Securities and Markets Authority (ESMA), launched its consultation in November 2022 to tackle the risk of “greenwashing” and enhance investor protection with respect to funds that operate under the auspices of ESMA and market themselves as “sustainable” or “ESG” funds.
Reflecting on the seriousness of the intent of regulators in reducing greenwashing, in May 2022, the German financial regulatory authority (BaFin) and the Bundeskriminalamt took further steps to gather evidence from the fund manager DWS as part of a greenwashing investigation, ultimately resulting in the resignation of DWS’s chief executive. Also in May 2022, the US Securities and Exchange Commission (SEC) issued its first fine ($1.5m) relating to the misstatement and omission of ESG considerations in making investment decisions for certain mutual funds to BNY Mellon Investment Adviser, Inc. Earlier, in April 2022, the SEC charged Vale S.A., a publicly traded Brazilian mining company making false and misleading claims about the safety of its dams prior to a deadly dam collapse.
Importantly, transparency (a necessary input to building trust) is not a new business tenant and is a critical anchor of strong corporate governance. Ironically, a lack of transparency has been the downfall of many a firm throughout the centuries. For example, WorldCom, Enron, and recently Wirecard and FTX.
It’s a show me story… but expect teething issues
Investors and analysts want useful reporting, allowing them to build conviction in a company’s investment narrative. Historically, financial factors have formed the bulk of those assessed in determining the value of a firm. But Kaplan and Norton highlighted about 30 years ago with the introduction of the “balanced scorecard” in “The Balanced Scorecard – Measures That Drive Performance” that financial measures are not the sole drivers of the value of a firm. ESG factors enhance a “balanced scorecard” approach in my view.
But as the importance of ESG factors has risen in prominence for the purpose of investment decisions by investors or capital allocation decisions by firms, so has the complexity and controversy. In my view, the credibility of a narrative is a function of the quantitative metrics that underpin it. The CRUF guiding principles set a useful baseline in terms of what good ESG metrics look like. Good is transparent, comprehensive, clear, relevant, consistent, and understandable. Added to this, many are calling for a common set of metrics across sectors and jurisdictions at a global level. The drive to converge accounting and financial reporting standards at a global level is an ongoing multi-year journey and it is likely the same will be true for the reporting of ESG metrics.
But some significant progress has been made in an extremely short period of time. One of the most important outcomes post COP26, was the introduction of an international ESG standard-setting body. The International Sustainability Standards Board (ISSB) was created in November 2021 and within four months released the exposure drafts: “IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information” and “IFRS S2 Climate-related Disclosures” for comment.
The CRUF responded. Firstly, the CRUF noted the need for caution over timing and strong due process in the formation of the standards given their fundamental importance in driving a globally aligned approach to the evolving ESG agenda. Secondly, the CRUF stressed the need to bed down key definitions, in particular “materiality” and “significance”, with a firm’s business model and strategy being critical frames to determine what reporting matters. This messaging is not new. Kaplan and Norton stressed the importance of reporting measures not solely because they are part of a framework or a box to be ticked, but because they “are drivers of future financial performance”. This approach in my view protects ESG from devolving into a compliance exercise. Thirdly, the CRUF stressed the need for sector-specific standards to improve comparability. Lastly, the CRUF emphasised the need to work closely with the International Auditing and Assurance Standards Board (IAASB) to ensure alignment of auditing standards and ISSB reporting requirements. Subsequently, in September 2022, the IAASB approved a project proposal to develop the overarching standard for assurance on sustainability reporting. The first exposure draft is expected in September 2023.
Good metrics need good data
The prevailing risks surrounding the transparency and congruity of ESG metrics is best reflected in ESMA’s information gathering exercise to better understand the market characteristics of ESG rating and data providers in the EU. Lack of coverage of a specific industry or a type of entity; insufficient granularity of data; and complexity and lack of transparency around methodologies were key findings of the exercise. ESMA’s conclusion that “the market for ESG rating and data providers is indicative of an immature but growing market” suggests that teething issues will be plentiful as market participants strive towards the ESG reporting “Holy Grail”.
Politicization of ESG a significant headwind
Alex Edmans, in his article “The End of ESG” summarises the challenge clearly in the following two statements in my view. Firstly, “Reasonable people can disagree about how relevant a factor is for both financial and social returns. Yet views on ESG often move beyond opinion to ideology”. Secondly, “If you view ESG as a political fight, you cheer the people who fight most aggressively. If you view ESG as understanding what drives long-term value, you celebrate the people who contribute most to your understanding, by helping you see both sides of an issue”.
The dynamics at play between states in the US regarding ESG is a prime example of the increasing polarisation of the ESG agenda in my view. Lawmakers in a total of 20 US states have introduced anti-ESG legislation in recent months, with the backlash concentrated in Republican states. Some states are setting net zero targets for the investment policies of their endowment funds, while others are boycotting organizations for not investing in fossil fuels.
The friction arising from this polarisation has the potential to delay and, in some instances, reverse the good progress that has been made to date at a global level. As a dominant developed market country (think of the moniker “King Dollar”) many countries will look to the US as a template to develop their own ESG policies. Consider the statements of the US’s own George Washington: “Example whether it be good or bad has a powerful influence – and the higher in Rank the Officer is who sets it, the more striking it is”.
In closing
The themes outlined above will continue to intensify in 2023 in my view. All stakeholders will need to apply a level of pragmatism on the ESG journey in the long run. Learning, unfortunately, is a messy process. And some players (governments, regulators, global standard setters, investors, executives) will bear high costs from missteps and be the example for others.
Kevin Harding joined Investec securities in 2017 as an Equity Research analyst covering African banks. Prior to joining Investec, Kevin was a Senior Manager in PwC’s Financial Services Risk and Regulation consulting practice in South Africa. He worked as part of a senior team, providing direction and support in the different phases of risk and regulatory projects for financial services clients, with a specific focus on the banking sector. Through these roles he gained specific knowledge and insight into the business and operating models underpinning financial services firms. Kevin is a chartered accountant, CA (SA).
Disclaimer: The views expressed in the blog are those of the author and do not necessarily represent the views of all CRUF participants. To read more about the CRUF’s views on this and other topics, please visit the ‘Our Views’ section of this website.