This blog is the first in a series where Route2 will examine issues related to responsible investment and ESG data.
Within this blog series we will also introduce readers to the approach Route2 is taking to resolve these concerns through our FTSE 350 Value2SocietyTM (V2S) index and company rating project.
We will also examine the limitations of ESG data, the state of disclosures across the FTSE350 and highlighting the modelled results from our company rating project.
About Route2
Route2 collaborates with businesses, investors, and governments to help measure and improve the total positive and negative impact business activities have on society – the Value2Society™ (V2S™). We forge links between business performance and sustainability through our Value2Society™ Accounting Software and strategic advisory.
Combining disclosures and modelled data
This project will involve Route2 using a combination of corporate sustainability disclosures and modelled data to provide a detailed and holistic assessment, evaluation and rating of the companies in the FTSE 350 index.
Offering a new market signal that will direct investment to more sustainable companies is paramount. Route2 will achieve this by:
Firstly, through applying a comprehensive set of sustainability indicators and ranking the companies within the indices we will provide a more complete perspective of a company’s performance than provided through traditional ESG approaches.
Secondly, by creating re-weighted baskets of securities based on the V2S view, we will help guide investors assess and integrate companies’ non-financial impact with their financial reporting.
Finally, we will investigate the characteristics and performance of these baskets, with an aim to match the stock market returns of the parent index over the long-term.
The sustainability problem and the rise of ESG reporting and investing.
During 2023, the accelerating threats of climate change and the biodiversity crisis remain the most urgent challenges confronting the world in this critical decade.
A recent study by Swiss Re estimates that as much as 18% of global GDP is at risk from the impacts of climate change. Even more starkly, the WEF estimates that more than half of world GDP ($44tn) is at moderate or severe risk due to nature loss.
In response to these threats, businesses are facing increasing scrutiny from investors who, in turn, are under pressure from regulators concerning the important role that finance plays in aligning investment with the net-zero transition and the operational transformations required for businesses to contribute to a sustainable future.
The increasing importance in ensuring investment flows into businesses that are taking steps to resolve these challenges has been reflected by an increase in sustainability reporting, alongside a significant shift in the allocation of capital. Over the past 20 years the number of companies filing Global Reporting Initiative (GRI) standard corporate social responsibility reports has increased 100-fold, and in the 5 years leading to the end of 2021, assets under management of ESG designated funds grew by 150%. PWC estimate this trend will continue, with asset managers expected to increase their ESG-related assets under management to £33.9tn by 2026 from $18.4trn at the end of 2021.
Moreover, evidence suggests that equity analyst’s earnings forecasts for more polluting firms systematically undershoot their actual financial performance, where this pollution is connected to monetary costs. This means there is a potentially important link between applying a robust ESG investment approach that quantifies and incorporates these externalities into firm value and achieving long-term investment goals that are beneficial for all stakeholders.
Greenwashing fines: the ineffectiveness of ESG data
Whilst these developments might appear positive with respect to aligning investments and the incentives of businesses to shift towards a sustainable future, issues surrounding the nature of non-financial-reporting and the ESG methodologies have recently surfaced.
Environmental, social and governance (ESG) reporting is related to measuring the impact of the environmental, social and governance related factors of a business. These impacts affect the businesses’ surrounding systems and stakeholders, which include the employees, society and the environment. If quantified correctly, Investors should use this non-financial information to get a more holistic view of company operations, their supply chains and the downstream impact of their products and services to assess a company’s contribution to society and identify material risks and opportunities that are not uncovered by their financial reporting.
By integrating these ESG metrics, non-financial factors such as negative externalities that have traditionally been excluded from corporate reporting and investor calculus should – in theory – be brought into the decision-making process of capital markets, resulting in more efficient market outcomes that also contribute towards addressing the sustainability threats that we face.
Examples of these negative externalities are waste, and pollution generated within organisations’ operations and supply chains, including the greenhouse gases released that are contributing to climate breakdown, but are currently not adequately regulated and consequently contribute to the sustainability challenges organisations and society at large are facing.
Inconsistent approaches to ESG investing
However, the terminology and practices associated with ESG investing vary considerably. As a result, what is measured and reported as part of these assessments is critical to understanding the effectiveness of the reporting in representing the business’s operational sustainability, and therefore also the utility of the corresponding ESG data used to guide investments.
The effectiveness of ESG measurements – in linking what a company reports with their underlying impact – is at the heart of the current ESG debate.
At the end of 2022, ESG branded funds came under increased scrutiny as news of greenwashing fines and fund downgrades under the EU’s SFDR classifications started trickling through from various asset managers.
As of early December 2022, according to Bloomberg, the total of funds removed from the EU’s top ESG Article designation of 9 (products with explicit sustainability objectives, those that are the most demanding in terms of their commitment to ESG principles), had reached $125 billion.
These events raised concerns around the limitations of the nature of corporate sustainability reporting and the underlying ESG data these funds use.
Indeed, these concerns are also borne out by the resulting aggregate impact from company operations. During this same period of increased sustainability reporting and investing there has been a concurrent increase in carbon emissions, environmental damage has accelerated, and social inequality has widened. But what is creating this disconnect?
A combination of issues around the ESG data, the methodologies employed and the perspective of what they should be measuring is leading to problems within the creation and regulation of sustainable investment products and consequently a misallocation of capital.
As the urgency of tackling the sustainability related issues increases, there is an increased urgency of ensuring these disconnects between non-financial information and the links with sustainability are resolved.
Look out for the rest of our blog series:
In this blog we have touched on the importance of corporate non-financial reporting and the rising interest in ESG investing. However, we also saw how an increase in reporting has not resulted in a tangible improvement in resolving sustainability issues and introduced some of the main criticisms of the current methods.
In the next blog, we’ll discuss the reasons in more detail, and will elaborate on the main criticisms causing the disconnect and why they arise.