As investors pay increasing attention to companies’ track records on environmental, social, and governance issues such as executive compensation, trillions of dollars have flowed into the ESG investing industry.
Assets in so-called ESG funds have risen 38% globally in the past year alone, to $2.7 trillion by the end of March, according to Morningstar Direct. While Europe still dominates with 82% of the market, a burgeoning class of U.S. financial products promises investors an ROI aligned with their values.
This month, the Center for Financial Reporting and Management’s (CFRM) annual conference brought together high-level ESG investing thinkers with a wide range of perspectives on the direction of the industry. Among them were SEC Commissioner Hester M. Peirce, a Republican appointed by former President Trump; Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), which has developed the leading framework for ESG data; Andrew Behar, CEO of shareholder advocacy nonprofit As You Sow, AJ Lindeman, who leads index and ESG quant research at Bloomberg; Karen Wong, who leads ESG & Sustainable Investing for State Street Global Advisors; and Wall Street Journal Senior Columnist James Mackintosh, an ESG investing skeptic.
“I wanted to bring all these perspectives together and have a structured discussion around ESG disclosures in order to gain new understanding and figure out how to move forward,” said Associate Professor Panos Patatoukas, L.H. Penney Chair in Accounting and faculty director of CFRM, who organized the ESG accounting conference.
In Part 1 of this two-part interview, we asked Patatoukas to synthesize some of the major discussion points around ESG measurement and disclosure, as well as reporting standards and assurance by external auditors.
Part 2 of the interview, publishing July 1, will address the SEC’s proposed ESG rules, valuation and investing, as well as divestment versus engagement—two different investor approaches to pressuring companies to change their ways.
Haas News: There’s a growing backlash against ESG investing. Recently, some politicians and business and financial leaders are dismissing ESG as “woke capitalism” and even “a scam” (Elon Musk). They argue these issues aren’t relevant to investors, whose job is to maximize returns. Is this an existential threat to the industry?
Panos Patatoukas: Will political rhetoric get in the way of progress and meaningful change? I just don’t believe that. ESG becomes de facto relevant when you have so many investors who want to invest with their values and don’t want to be misled. The reality is that this growth has been driven by demand from investors. With respect to ESG disclosures, improved access to higher quality data will allow investors, especially individual investors, to invest with their values and will mitigate the risk of greenwashing.
What is greenwashing, in terms of financial products?
Greenwashing is the result of the lack of clarity in the ESG setting. Let’s say you have a preference for “green” companies and you are willing to pay a premium to get access to a green fund. Let’s now consider the possibility that the index fund manager is actually deviating from the presumed investment objective and they are actually investing in green and not-so-green stocks. Labeling the fund as a green fund could be misleading, especially for individual investors that are not fully attuned to fund characteristics and may not be fully aware of what they actually own when they invest in this particular fund. This goes to the core of greenwashing issues. And the problem is that many of these ESG products are marketed to individual investors as a way for fund managers and advisers to charge management fees in excess of what they would make in a plain vanilla, non-ESG product. But because of bad data or limited access to good data, investors effectively may be getting the same old thing packaged in a different way. Transparent financial products that allow you to invest in alignment with your values at low management fees should be accessible to everyone, but we are not there. Not just yet.
Why is it so hard to get there?
Let’s first talk about E+S+G measurement. I think everybody understands that environmental activities are very important, corporate governance matters, and social issues are becoming increasingly important. Where people really disagree is: How do we define, measure, and verify the different types of carbon emissions? What are the corporate activities that fall under the “S” of ESG and how should we measure those? What is important to measure on governance and what constitutes good or bad governance?
Because there’s a disagreement in terms of what adds up to ESG, there is disagreement on the measurement of those dimensions. That shows up in the weak correlation on ESG ratings across rating agencies. If it was 100% clear as to what it is we’re trying to measure, the correlation across agencies would be much higher.
Some people argue that E, S, and G issues cover so many different things as to be meaningless. What do you think?
Pooling environmental, social, and governance together into one single measure is problematic. These are different things that might be interacting with each other and that may even trade-off against each other. For example, you could think of a company with “bad” governance, with an entrenched CEO who has all the power and the shareholders who don’t have much voting power, but on the other hand, that same CEO might prioritize reducing the carbon footprint of the organization. So those things would be in opposition. And within each one of these dimensions—environment, social issues, and governance—there are going to be strengths and weaknesses. It’s not always the case that you can offset a negative in one area by doing something good in another. The practice of pooling different activities together to generate a single ESG score is a bad practice, in my opinion, since it’s missing the granularity of the underlying data.
So all this uncertainty about measurement must also make it difficult to define what companies should be required to disclose.
There are different views not only on how much companies should be required to disclose, but who should be responsible, and to what extent, for the assurance of the reliability of these disclosures. What I mean by assurance is external auditors attesting to the validity of the data, which is already happening when it comes to financial activities. Disclosures without assurance may not be reliable. What’s going to change the game is assurance of ESG data, because when auditors attest to the validity of the data, they can be held liable and take on the risk that what they’re signing off on is actually true and verifiable.
What became clear in our discussion is that there is real demand for more consistent, comparable and decision-useful information. We call that “material’ information, which means any information that may impact a reasonable investor’s decision making. Material ESG data need to be verifiable and audited. If we can agree on the definitions, and we agree on the measurement, and we have external auditor assurance, that will completely change the field. That will be a real revolution, or an evolution, depending on how you want to see it. We can end up in a market setting where everyday investors will have access to more accurate data based on which they can make informed decisions and invest with their values. The accounting firms can play a significant role in the transformation that’s happening and accelerate the convergence of policy, regulation, and technology that’s rewriting the ESG investing playbook.
At the conference, Janine Guillot, CEO of the Value Reporting Foundation and former CEO of the Sustainability Accounting Standards Board (SASB), explained that they’ve merged with others to create a global baseline of ESG standards through the International Sustainability Standards Board (ISSB). These standards have already been adopted by 65% of S&P 500 companies. Is this getting us closer to standardization?
The SASB started a decade ago as a private, nonprofit organization with the mission to develop and disseminate industry-specific sustainability accounting standards that help businesses “disclose material, decision-useful information to investors.. This is the framework that seems to be the frontrunner, and stewardship of the SASB Standards is now passing to the International Sustainability Standards Board.
However, the SASB framework is, in essence, a disclosure template that has helped companies and investors develop a common language around ESG issues. So adopting the SASB standards doesn’t necessarily mean that the data that companies disclose is meaningful. The point here is that a higher adoption rate of a sustainability reporting framework, like the one developed by SASB, is not necessarily a measure of success of the sustainability accounting standard-setting process.
So how do we define success in sustainability standard-setting? Well, it would be interesting to systematically evaluate whether the adoption of sustainability standards will ultimately have a real impact on emissions, new technologies, productivity, and social welfare. Higher adoption rates among corporations and fund managers and more licensing fees to private standard-setting organizations for using their sustainability reporting framework does not necessarily translate into a more sustainable and equitable future for everyone.