Bringing clarity to ESG reporting

Investors are in a unique position to engage with companies to encourage better corporate behaviour around financially material environmental, social and governance (ESG) issues. Yet policymakers, regulators and campaign groups are increasingly worried that the ability of investors to engage with companies is being compromised by huge confusion over ESG standards, benchmarks and metrics. In the UK, the new Chancellor of the Exchequer, Rachel Reeves, has already promised regulation to address “the lack of transparency behind ESG ratings”. In the EU, the European Commission has published legislation to regulate ESG rating providers that is likely to apply from 2026 onwards.

Such problems make it difficult for investors – both individuals and institutions – to support the companies they favour from an ESG perspective and to avoid those they don’t. But more fundamentally, warns Nathan Fabian, Chief Sustainable Systems Officer at Principles for Responsible Investment (PRI), they undermine the ability of financial markets to incentivise goals such as decarbonisation – and to identify key risks related to climate change.

“We need to step back and see the bigger picture,” Fabian says. “If we want markets to have some level of self-determination in how capital is allocated, then allocators need information to work out if the businesses that they're investing in will be going concerns that produce cash flows.”

Keeping up with science

Alexandra Melhuish, Sustainable Investing Strategist at J.P. Morgan Asset Management, is also concerned. “One of the key challenges right now is whether certain climate benchmarks are still fit for purpose, because the science has moved on since they were created,” she says. “Our clients are increasingly looking to incorporate more forward-looking metrics in investment analysis.”

The good news is that companies reporting on large parts of the ESG agenda are at least starting to talk the same language. The IFRS Foundation’s International Sustainability Standards Board (ISSB) standards provide a consistent framework for businesses worldwide to measure, monitor and disclose their climate and sustainability-related risks and opportunities. In many geographies, national or supranational authorities have adopted those standards, or at least ensured their own standards align with them.

That’s true of the EU, for example, as well as the UK and countries including Australia and Brazil. In the US, meanwhile, the Securities and Exchange Commission faces various legal challenges over its own climate disclosure rules. Such reporting provides the investment industry with a starting point for assessing the performance of companies against ESG metrics. But from here on, the picture becomes murkier. For example, a growing number of ratings agencies use these disclosures to score companies on ESG, but because each agency has its own models, these scores vary hugely. Research by MIT Sloan found that while the credit ratings awarded by leading agencies have a correlation factor of 0.92 – meaning they are very consistent – the figure for ESG ratings is just 0.61.

Similar problems apply to ESG benchmarks and indices. Benchmarks such as the Dow Jones Sustainability Indices, MSCI’s ESG Ratings and the FTSE4Good Index Series measure the ESG performance of a subset of companies within a particular industry or region. Market indices such as the MSCI ESG Leaders Index and the S&P 500 ESG Index contain companies that meet certain ESG criteria. But in both cases, providers use different methodologies and criteria.

Regulators (and investors) intervene

The proliferation of such metrics has increasingly worried regulators. The EU has sought to police benchmarks more strictly, while the Financial Conduct Authority (FCA) in the UK has warned about poor quality and inconsistency. Faced with such problems, some fund managers are now doing their own thing. “The data has evolved but there are always going to be shortcomings,” says Melhuish. “There’s still a great deal we need to glean from companies through our own engagement and climate research which we incorporate into certain investment strategies.”

That work has seen two separate developments. First, J.P. Morgan Asset Management has launched a range of regional active exchange traded funds (ETFs) that apply company research and engagement conducted by in-house experts; these seek to outperform a custom MSCI universe of companies performing strongly on ESG and socially responsible investment criteria while meeting benchmark requirements aligned with the goals of the 2016 Paris agreement. Second, it has built its own regional climate transition benchmarks, based on a carbon transition score of around 70 metrics. The companies in the indices are evaluated based on a rules-based process to determine how they effectively manage emissions, resources and carbon-related risks, and are ranked depending on the characteristics of the underlying stock market indices.

Such initiatives provide fund managers with workarounds, enabling them to offer ESG-minded clients a more bespoke approach to portfolio construction and stock selection. However, the fact they are needed underlines the debate in the investment industry about the extent to which existing standards and benchmarks provide what is needed for informed decision-making on ESG.