Is ESG it Still in Its Infancy? I don’t believe so.
Momentum is building around ESG. Policy makers, asset managers and business are now more willing to integrate ESG thinking in their investment strategies. Furthermore, President Biden is changing the national narrative and created momentum around ESG actions and climate risk urgency.
What are the main challenges in ESG investing? Among the top challenges for a ESG broader adoption by companies and capital markets, is that top leadership are not yet fully behind ESG investments. Only 28 % of Fortune 500 companies have fully adopted ESG strategies (PWC 2021). Part of the problem is that larger corporation are still struggling quantifying potential ROI as well as balancing ESG with the company strategy and growth targets. Furthermore, in order for capital markets to price ESG risks and opportunities effectively, standardized data and measurements are needed. We’ve seen promising advances made recently in terms of metrics creation, but there is still a lack of high-quality, complete, and comparable ESG data that can be used to assess and price a company’s exposure to ESG risks and opportunities. New methodologies and models are also needed, as traditional methods of valuing and pricing assets, which are based on historical data do not suffice in today’s world affected by climate change and social activism. More work and greater collaboration is also required among ESG market participants to understand the mechanisms by which climate and societal risk drivers interact with the economy, the financial system, and society.
What Are Policy Makers Doing? It is clear that momentum is shifting toward more regulatory action on ESG disclosures, and businesses can take proactive steps now to be better positioned for success as data and reporting get more regulated and standardized. Both the EU, and the US are starting to propose stronger ESG laws (via the European Green Deal, and President Biden Climate Financial Risk Executive Order as well as the Corporate Governance Improvement and Investor Protection Act) whereby corporations, asset management firms and other financial institution will need to benchmark, measure, disclose, track over time, and demonstrate their ESG commitments. Additionally, the US Federal Reserve has fully joined the Network for “Greening the Financial System”, a global group of central banks and supervisory entities that are working together to develop climate avoidance risk tools for the financial sector. What’s also noteworthy, is the recent launch by the Security and Exchange Commission (SEC) of its ESG Taskforce, to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need. Finally, we are seeing proposals from international foundations and regulatory bodies (such as IFRS, the Network for Greening the Financial System) around sustainability reporting and the creation of best practice database in the world of financial supervision of climate-related risks. This is fostering the creation of a community of practitioners, for better ESG information and data to make progress on disclosure.
The Disaster Cost Momentum: All the policy changes, and climate action impetus are happening because climate induced disasters are causing greater economic pain to all. These climate disasters have almost doubled since the 1980, as I explained in the 2014 World Bank report on natural disasters. This trend will unfortunately worsen, and disaster leading to shocks will occur in regions previously unaffected by disasters. Just to quantify the recent cost of these events in the United States, the image below produced by NOAA, through their “billion-dollar disaster report” showcases at least 20 disaster events that caused over US$ 1 billion each in damage and losses in 2020. While this is striking, it does not capture the comprehensive direct and indirect cost of these disasters. According to NOAA in 2020, disaster events caused about 100 billion US$ dollar in damage. I believe the number is at least double if not treble that figure if all indirect cost is factored in. Furthermore, If we look at 2021, this year is going to be far worse than 2020. Just to give you an example, the 2021 Cold Front that took place in Texas in February, was estimated to cost the economy up to 20 US$ billion in damage. According to more recent modeling calculation, the Cold Front is estimated to have caused as much as 200 billion in damage and loss (double of the damaged caused by all disasters of 2020 as calculated by NOOA).
Divestment from Carbon Intensive Industry is Happening: Directors of ethics and engagement of large pension funds and university endowment have made it public that they will divest from major oil companies like Shell and Exon mobile if they don’t meet their de-carbonization targets. This ESG corporate activism is rapidly spreading across the US and boards of large financial institution will have to take action or pay the consequences. In Europe the situation is even more advanced where large UK and German asset managers and owner of millions of oil companies shares will influence are leveraging their boards votes to aggressively inveluence de-carbonization efforts. Coal, cement, food and petrochemical EU corporations are also under pressure from the regulators and the investors to disclose their ESG compliance or risk losing contracts and facing potential litigations in court. According to global trackers of the divestment trend, on the Oil and Gas sector alone, over the last 10 years, 1300 investors (including university endowments, pension funds, asset managers, insurances groups etc.) have divested almost 15 US$ trillion on the ground that these companies did not meet the minimal ESG standards. Harvard University (with a US$41.9 billion endowment) is one of the big players that in Sept. 2021 communicated that they will let all existing investments in the fossil fuel industry to expire, de facto ending their investment in the carbon intensive industry.
Conclusion: While the lack of reporting, measure, and standards for ESG are the top barriers to ESG effectiveness, based on the existing policy discussion and analysis, it is clear that the scale of the transformation society is now facing offers tremendous opportunities for investment. Most policy makers and an encouraging number of executives, believe ESG is a strong corporate value driver and increasingly so given the environmental, social and board pressures emerging. Additionally, the perceived cost and risk of not acting on ESG now (driven by climate risk) is becoming hard to ignore as it also affects the leading companies reputationally. Finally, I would argue that Investors, lenders, regulators and rating agencies need to work together to standardize the range of ESG metrics and reporting to better understand and define the diverse social and environmental risks, exposure and vulnerability. Ultimately, I believe consumer pressure will be the game changer here, as large segment of consumers (particularly the younger generations) will stop buying from companies that treat employees, communities and the environment poorly.