There is still a fundamental gap between what corporates disclose about their sustainability practices and what investors want to know, as Romil Patel reports.
Corporate reporting about sustainability and social responsibility is becoming standard practice. For evidence, consider a 2017 KPMG report: of 4,900 companies from nearly 50 countries, about three-quarters issued responsibility reports.
From an investor’s perspective, transparent reporting is one of the most important contributions companies can make in order for markets to price companies on risks efficiently. For asset managers, incorporating ESG considerations goes back to the beginning of the value chain, and it starts with companies reporting data.
“The rise of data is excellent because there’s more and more demand from investors and actually from beneficiaries to understand what companies are doing, so transparency is to be encouraged and there’s definitely a demand-led rise in data,” says Andrew Parry, head of sustainable investing at Hermes Investment Management.
On the other hand, he notes, data is a means to an end and not an end in itself. This means that investment managers must take a step back and ask qualitative questions rather than solely relying on quantitative data – in other words, truly gauging the purpose of a company in order to understand the materiality of each of the ESG risks.
This is a crucial step because while data does indeed help paint a picture of a company, there is still a fundamental gap between what corporates disclose and what investors want to know.
“Compared to the development of financial reporting, the evolution of non-financial reporting has been rapid and fragmented,” the World Business Council for Sustainable Development (WBCSD) and the Climate Disclosure Standards Board (CDSB) said in a 2018 report.
Johnny Russell, global equities portfolio manager at Nikko Asset Management, says: “The data is not standardised, there is no legal backing – companies are not forced to disclose it so there are differences to the data as to how it is quantified or legally disclosed when compared to the pure accounting profession. That means that the data is not as clean and cannot be as relied on as, say, pure financial data would be.”
Issues including ‘greenwashing’, selective disclosure of information and huge differences in global ESG standards mean investment managers must go beyond the data and quantify company claims – consider it a ‘sniff test’.
“Does the actual behaviour of the company align with the data that you are seeing, because data can also be manipulated,” says Parry. “That is why we think good ESG investing is always about deeply integrating it into your thinking and into your understanding of how value is created over the long term for shareholders, not just from short-term data points.”
The West versus the rest
From an emerging markets perspective, the key challenge is overcoming the vast differences in ESG standards with the West, namely poorer data coverage, disclosure, governance and sparse annual reports in comparison to their developed-market counterparts.
“In Europe, we have the EU directive regarding non-financial reporting, so we have more of a push in that direction – that you have to report on material non-financial information,” says Petra Pflaum, chief investment officer for responsible investments at DWS.
“In Europe I would say with the EU action plan, we are on the right track. But in other areas like emerging markets, there is still room to improve and this makes it more difficult to run a purely ESG-dedicated emerging markets strategy, because the ESG quality of companies is poorer than other in other regions. That is why we are pushing those companies in management meetings as well. This will be a trend going forward.”
She warns: “If you don’t adapt and report on what you are doing, one day you won’t be on the shopping list of fund managers because they won’t be allowed to invest in that. We are not there yet, but it is coming.”
Initiatives such as the Climate Action 100+ (a group of 289 global investors, with almost $30 trillion in assets under management, engaging with large carbon emitters to achieve the goals of the Paris Agreement) shows that major investors are pushing carbon-intensive companies in the right direction.
Between December 2017 and June 2018, 18% of the Climate Action 100+ focus companies officially support or have committed to implementing the Task Force on Climate-related Financial Disclosures’ (TCFD) recommendations. This represents a threefold increase in corporate support for the recommendations since the launch.
Efforts from the Carbon Disclosure Project (CDP) to integrate TCFD recommendations into its 2018 climate change questionnaires for companies worldwide are a leap forward for data disclosure. As a consequence, more than 6,000 companies (representing over 50% of global market capitalisation) will disclose their climate risk in a standardised way, according to Jane Stevensen, engagement director to the TCFD at the CDP. It is a sign of progress.
No mean feat
Historically, impact investing – where investors combine social goals with generating competitive financial returns – was the focus of development banks, churches, foundations and others.
Now considered a hot topic in the financial industry, its rise has added another dimension to reporting.
Swedish national pension fund AP7 appointed KBI Global Investors (KBIGI) to an environment-related equity mandate announced earlier this year.
The pension fund, which has 460 billion Swedish krona (€45 billion) of assets, invested an initial €75 million in the KBIGI Water Strategy, part of the Ireland-based asset manager’s newly launched green impact equity mandate. Specifically, the investment targets Sustainable Development Goal (SDG) 6, which is clean water and sanitation. The mandate’s key aspect is the creation of bespoke metrics to measure the sustainability impact of investments.
“They [KBIGI] get one chunk of €75 million to start with,” says Johan Floren, head of ESG at AP7. Should KBIGI be successful – “We had a very thorough process choosing them, so we are convinced they are very good at what they are doing,” adds Floren – AP7 will increase the allocation to €150m.
The problem with combining financial and sustainability goals into a listed equity portfolio where companies do different things in different parts of the world is, what are you going to measure?
“When it comes to impact investing, the challenge there is that within these companies, the reporting is pretty good on conventional metrics – whether it is CO2 or water,” says Floren. “But we are interested in developing impact measurements, so it is not just output but what is the utility for society?
“It is a massive challenge and nobody has solved it, so we are humble about the challenge we are taking on. But we want to be a part of it, and we have put it into our contracts that we should collaborate with the managers that have gotten the mandates to develop impact metrics and methodology around that.
“Reporting that helps us in this development is what we are going to look for.”
In March, KBIGI (which has around €800 million in water assets) launched an SDG impact measurement tool, which awards a positive, neutral or negative impact score based on the percentage of an investment portfolio’s revenue that is aligned with the SDGs.
“All we really need from companies is to break down their revenues in their annual report,” says Eoin Fahy, head of responsible investing at KBIGI.
This breakdown is ideally done by each SDG item, showing what percentage of revenues contribute to each of the SDGs – or at the very least, says Fahy, showing what percentage of revenues come from different business lines.
“We can now report and say that 68% of the revenues in our water portfolio are contributing to the achievements of the SDGs,” adds Fahy.
He says that many investors want to understand how they can marry up investments with the SDGs, and KPMG evidence that suggests SDGs will continue to grow in prominence in corporate reporting over the next two to three years is promising.
The SDGs provide a multitude of themes and trends that institutional investors can look at for business opportunities and therefore contribute to positively, as well as address any areas their business operations impact negatively. They occupy the unique position of being able to address both sides of the equation.
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