Green Finance Advisor of Friends of the Earth (HK)
There is an increasing number of corporates proactively talked about the key words like “sustainability”, “carbon emission”, “environmental”, “diversity”, and they are concerned how they perform regarding their ESG data and ratings. Not only because there are more evidences on ESG financially relevancy, i.e. companies with high ESG ratings had on average higher profitability and lower tail risk, but also more investors continue to integrate ESG considerations into their investment process.
While there is a significant improvement in general ESG disclosure and awareness, the demand for more ESG disclosure is likely to rise as new regulations are taking effect and voluntary reporting standards are becoming mandatory in some countries. For example, the Task Force on Climate-related Financial Disclosures (TCFD) reporting became mandatory for UNPRI signatories in 2020. Locally in Hong Kong, SFC recently issued a Consultation Paper that proposed amendments to the Fund Manager Code of Conduct (FMCC) addressing climate-related risk and it referred to the Recommendations of the TCFD to foster a “more consistent disclosure framework and minimize the industry’s compliance burden”.
In Europe, there is Sustainable Finance Disclosure Regulation (SFDR), which proposes the investment institutions to report on their portfolio companies on extensive ESG datapoints and could be as early as March 2021. In addition to the obvious and widely reported ones like carbon emission, board gender diversity, anti-corruption and anti-bribery policies, the other required data are gender pay gap, excessive CEO pay ratio, water emissions, deforestation etc. Some of these data points may require alternative data or proxy as those risks maybe unexplored or emerge at the macro level that need information external to the corporates.
These reporting requirements are putting a lot of pressure on the investors and they will certainly reach out to the corporates soon for these disclosure gaps. Many corporates have set up their sustainability departments and working groups with involvements from their finance, legal, investor relations and even C-suite executives. Some of them are also working closely with corporate advisors and data providers to help them with the reporting requirements. Dear corporate issuers, are you prepared?
Green Finance Advisor of Friends of the Earth (HK)
Many will look back on 2020 with mixed feelings, having been a very abnormal year with back-to-back disruptions from social unrest followed immediately by Covid-19 in Hong Kong. Not only have we been forced to adopt new ways of going about our daily lives, but these new ways of living may also even become standard practice in the new normal of living under heightened awareness of the threat of another future pandemic unfolding, and to say this past year has been an aberration in the continued progress of development of the human civilization would be an understatement.
However, interruptions often act as a springboard toward greater innovation to leapfrog the archaic modus operandi that society has so often become too comfortable with. Just as the bubonic plague in medieval Europe laid the seeds for the European Renaissance two centuries later which established the European golden age, Covid-19 may be the catalyst that springboards ESG investing in a paradigm shift to become the new normal.
In review of 2020, ESG investing indeed gained steam, where in the US ESG equity funds have experienced larger inflows during 2020 at +$28 billion than in the previous five years combined at +$25 billion. The AUM of ESG focused funds increased from $260 billion at the beginning of 2020 to $310 billion, whereas all other equity funds including active, passive, and ETFs experienced an outflow of $270 billion year-to-date in 2020. ESG funds also outperformed the S&P500 with the average ESG-focused fund returning 13.5% YTD vs. 11.6% for the S&P500. (Kostin, D.J., Snider, B., Menon, A., Hammond, R., Hunter, C., Conners, Cormac., and Calcagnini., Lily., 2020).
Between 2012 and 2019, investors generally assigned a valuation discount to Environment and Social E&S scores, although this discount became smaller and is now even at a slight premium as a result of rising ESG-focused fund inflows. However,
this valuation premium remains statistically insignificant as compared to fundamental metrics such as long-term growth prospects and balance sheet strength. Indeed, with the incoming Biden administration, whose key initiatives include renewable energy and climate-related spending, the trend towards ESG adoption is set to further strengthen.
Good news aside, there remain many challenges in measuring ESG, namely the fact that the definition of ESG itself is extremely broad and ambiguous, making it difficult to assign a single rating to a company or compare sustainability across industries and sectors; and while the volume of ESG data has spiked, the quality of the data remains ambivalent. Policy intentions rather than quantifiable metrics continue to dominate the majority of available information and disclosures across companies lack uniformity. While the availability of numeric metrics has risen in the past few years, they still comprise only 25% of the criteria used in most ESG analysis. (Kostin, D.J., Snider, B., Menon, A., Hammond, R., Hunter, C., Conners, Cormac., and Calcagnini., Lily., 2020).
In a recent report on ESG Investing published by the Organization for Economic Cooperation and Development, the authors also highlighted the challenges of current market practices where the bewildering ratings, investment terminology and individual metrics present a fragmented and inconsistent view of ESG risks and performances. Some of the key difficulties in the full adoption of ESG investing include lack of standardization of the data that is disclosed or collected, as well as the difference in methodologies adopted by different providers in their respective calculations of ESG scoring.
The OECD teams suggests the following five key areas to improve usability and adoption of ESG into investment evaluation:
1. Ensuring consistency, comparability and quality of core metrics in reporting frameworks for ESG disclosure.
2. Ensuring relevance of reporting through financial materiality over the medium and long-term.
3. Levelling the playing field between large and small issuers related to ESG disclosure and ratings.
4. Promoting the transparency and comparability of scoring and weighting methodologies of established ESG ratings providers and indices.
5. Appropriate labelling and disclosure of ESG products to adequately inform investors of how ESG is used in the investment process and asset selection.
(Boffo, R., and Patalano, R., 2020)
While 2020 may not have been a year to remember, there are certainly things to be thankful for, and the increasing trend of ESG adoption is certainly one of them. Let us hope that it doesn’t take another drastic global event such as the Covid-19 pandemic to act as a catalyst for ESG adoption, but that the momentum we witnessed in 2020 will be sustained and full ESG integration will not be a thing of the too distant future.
· Boffo, R., and R. Patalano (2020), “ESG Investing: Practices, Progress and Challenges”, OECD Paris, www.oecd.org/finance/ESG-Investing-Practices-Progress-and-Challenges.pdf
· Kostin, D.J., Snider, B., Menon, A., Hammond, R., Hunter, C., Conners, Cormac., and Calcagnini., Lily., (2020), “2021 US Equity Outlook: Roaring ‘20s Redux”, Goldman Sachs Global International Research