Data underlying ESG investing is complex and often not comparable.
Yet while some are calling for a uniform data framework to govern ESG assets, others argue implementing such a prescriptive solution could hamper innovation in this complex field.
So how can advisers navigate this quagmire?
Srinath Narayanan, chief executive of Project Energy Reimagined Acquisition Corp, a special purpose acquisition company with a focus on high-potential ESG targets, says ESG has become so big it will will soon be impossible to have all three elements sit under a single umbrella.
He speaks to FTAdviser In Focus about what lies ahead and how advisers may tackle the search for the most appealing ESG opportunity for their clients.
FTA: How can advisers best navigate the challenges posed by ESG investing?
SN: One of the first steps advisers have to take is identifying the core ESG factors that matter to their clients. There are different elements and characteristics that fall within the ESG spectrum that are weighed differently.
We’ve seen numerous ESG measurement systems and matrices that have been created by advisers, but nothing that broadly governs this practice.
As the ESG sector continues to grow, it will be almost impossible to have all three elements sit under a single umbrella because they are already becoming very different in nature.
The lack of consistency in ESG reporting across industries and between companies in the same industry has been a challenge for investors aiming to create fair comparisons or to get an accurate read on how companies are thinking about and managing ESG programs. For instance, in poultry or animal farming some view greenhouse gas emissions and abatements equally important as social issues around animal rights.
Similarly in transportation, coal or diesel as a pollutant in managing carbon footprint is equally important as employment labour policies, and human relations. The key is consistency across metrics and frameworks.
With a lack of uniform standards, ESG reporting guidance framework from the independent Sustainability Accounting Standards Board is broadly used by asset managers and industrial companies.
SASB’s approach to ESG is to categorise industries and sectors and then use nuances of each industry to define the materiality of specific sustainability accounting criteria. This assessment of materiality is a key differentiator from other frameworks.
As the ESG sector continues to evolve we will undoubtedly see more changes, especially as regulators look at more strict oversight of greenwashing and ESG data capture.
FTA: Should there be a universal ratings system or would that stifle competition in this complex area?
SN: A universal ratings system wouldn’t necessarily stifle competition. Defining a minimum set of reporting requirements across industries and capturing the nuances of ESG issues are important.
The challenge is broad application across all industries. The value chains and starting points for each industry are different and a scoring system needs to reflect that.
For example, container shipping companies follow a different value chain than that used by the automobile industry. Both industries leverage diesel, ethanol and methanol but in vastly different ways.
FTA: What could a universal ratings system look like and how would it work for advisers?
SN: Advisers need to have their own metrics for how companies fit into their guidelines.
A ratings system could have its benefits but the challenge is finding the starting point and ensuring that the system is tailored to the value chain and workflows of a specific industry.
Everyone thinks they need to be ESG compliant, when in fact it’s the overcompensating that is almost putting them in risky waters.For example, when looking at something like the retail sector, it is important to factor in all major production materials such as polymers and plastics and, most importantly, how and where they fall in the entire carbon value chain.
Advisers must also do their own due diligence in researching how compliant companies are throughout the production and distribution processes and in managing social issues around child labour and manufacturing practices across countries involved in manufacturing of the retail product.
FTA: What do you think the UK government has in store for ESG asset classification?
SN: The UK is trying to steer its independent path from the rest of the EU that follows the Sustainable Finance Disclosure Regulation applied since early 2021.
The UK’s Sustainability Disclosure Requirements are intended to create an integrated and streamlined framework that brings together sustainability-related reporting requirements for corporates and financial institutions, unlike SFDR which is heavily focused on asset managers.
The right move is not to align with a full ESG portfolio. Instead, determine if you’re involving yourself in the ESG arena because you genuinely want to do good and only invest in sustainably-focused companies, or if you’re focused on ESG solely for the returns.The SDRs are likely to change the nature of reporting requirements, given the introduction of double materiality in reporting.
For companies this would require disclosures on how sustainability issues impact their business and how the companies’ activities impact sustainable development in the society and environment beyond their immediate operations.
FTA: A recent report from the Bank for International Settlements has warned investing in a portfolio aligned with ESG values is near impossible and investors should focus on aligning their portfolios with either E, S or G principles instead. Would you agree?
SN: The BIS recently issued a warning that there could be a bubble in ESG and asset value.
As a result, valuations have gone way up around anything related to ESG because with the hyper-sensitivity around this area of the market, everyone thinks they need to be ESG compliant, when in fact it’s the overcompensating that is almost putting them in risky waters.
We’ve seen substantial growth among exchange-traded funds and mutual funds in particular, with the valuation of certain companies drifting unsustainably upward. This is where greenwashing is coming into the mix.
These inflated figures are far beyond what they actually should be and it’s becoming misleading for advisers and investors.
The right move is not to align with a full portfolio as the BIS warned. Instead, determine if you’re involving yourself in the ESG arena because you genuinely want to do good and only invest in sustainably-focused companies, or if you’re focused on ESG solely for the returns.
FTA: Should ESG factors be unbundled and how could they be regulated individually?
SN: There are pros and cons to both approaches. As the ESG sector continues to grow and become more specialised in its data and measurement factors, it will be almost impossible to have all three elements sit under a single umbrella because they are already becoming very different in nature.
Governance is fairly straightforward. It needs to be centralised in the decisions and the board of every company. In my opinion, governance is already becoming somewhat of an outlier in ESG pigeonholing.
Environmental, very simply, looks different for different companies and different industries, and as a result for different advisers and investors.
Social is playing such a large part in today’s society that it’s starting to be examined as its own entity. Each of the three has a completely different set of metrics and all three are becoming harder to manage and regulate as one unit.
I expect to see a gradual separation of the three of them in the coming years with companies and industries meeting minimum disclosure requirements across broader ESG while stressing more on ESG issues that is of higher relevance and applicable to their specific industry and business practices. I think that process is already beginning to unfold.
carmen.reichman@ft.com
