The making of subprime in sustainability
If public announcements from global financial institutions are to be believed, 2018 may be remembered as the year when the primary goal of business became more than business. On 16 January, BlackRock, the world’s largest asset manager with $6.3 trillion under its management, in a letter warned CEOs (chief executive officers) of companies whose stock it owns to pay close attention to their environmental, social and governance (ESG) performance or risk losing BlackRock’s support. Two weeks later, a group of institutional investors, led by Vanguard, managing assets over $15 trillion made a similar announcement about the need for companies to focus on their interactions with society.
ESG research involves scrutiny of non-technical business aspects such as greenhouse gas emissions, social impact of business operations and the selection criteria for board members—all of this is new to the data-driven world of financial analysis. ESG consideration has created new demand from financial institutions for readily available ESG data. Without a regulatory requirement for ESG disclosure, such data is not available in the public domain. This, however, has not stopped the data industry from soliciting, bundling and selling information under the broad definition of ESG. Despite the growing importance of ESG in the global financial system, there are questions on the reliability of ESG data being used by asset managers. There is a material possibility that investee companies considered prime in the ESG rankings by asset managers may in fact be subprime. Resemblance of these conditions to those in the run-up to financial crisis of 2008, when perceived prime loans held by banks turned out to be subprime, cannot be ignored. What is at stake in 2018 is not the housing market of an economy but possibly the sustainable future of the human race itself.
Gravy train of ESG data
A July 2017 report by a G20 study group reported that 92% of the 250 largest companies in the world issue ESG reports. Unlike financial data disclosure which is mandated by laws, ESG data disclosure is voluntary, driven only by guidance from the reporting standard. Reporting companies see ESG reporting as an easy-to-access marketing platform to financial institutions. A typical annual ESG report costs less than $25,000 to develop, a small fraction of the overall marketing budget for most reporting companies. While there is reputational risk in misrepresenting ESG performance and such practices are rare, the management of companies has complete discretion on disclosure. The urge to selectively disclose on ESG is strong.
Tax and audit firms dominate the ESG report writing space, possibly bundling financial and ESG reporting services to their client’s benefit and their own. ESG data is not subject to the checks and balances that a regulated financial disclosure is put through. An ESG report is therefore a collection of narratives and metrics provided by the business, stitched together to show the company in control of its ESG performance and with aspirations to get better. Third- party assurance on ESG reports is voluntary. Where assurance is conducted, use of assurance report is restricted only to the management of the company and the standard of scrutiny is lax.
Data providers amalgamate ESG data from disparate, readily available information sources such as corporate responses to proprietary questionnaires, sustainability reports and third parties. A 2016 industry publication recognized over 20 compilers of ESG data worldwide. Sustainalytics, a leading firm in this space, reported 120 ESG analysts working for it in 2016 and MSCI ESG Research, its main competitor, reported 140 analysts on its staff. There is no generally accepted methodology for ESG evaluation and rating. Data providers rate companies based on their own criteria and sell the data to asset managers for a fee. The arbitrary nature of ESG ratings is exemplified in a study by CSRHub, a private aggregator of ESG information, that compared ESG ratings by Sustainalytics and MSCI. The study found that for over two-thirds of the rated companies, ESG rating given by Sustainalytics to a company did not match the ESG rating given by MSCI to the same company. Credit ratings on the other hand from S&P and Moody’s, the top two credit rating agencies, for investment-grade companies reportedly show a correlation of 90% or more.
Among all the ESG data stakeholders, asset managers—the end users of ESG data—are probably the most significant. They are also the most distant from ESG data in the value chain and possibly least inclined to fuss over it. Asset managers lack both in-house skills and the data to analyse ESG risk. Conventional wisdom in the industry does not consider ESG issues material to financial analysis. Aspects such as water, air, land and social licence to operate are seen as perpetually available with a modest access fee. Risk of long term, material disruption to this access is not foreseen. In private, ESG is seen as the asset owner’s agenda, to be complied with for business reasons. Without the skills, the means or the motivation for ESG analysis, asset managers outsource ESG data, take it at face value and simply add it as a bolt-on. Possibly the only thing that piques an asset manager’s interest in ESG data is how much of it is available and on how many companies. To that request, the data industry is eager to oblige, for a fee.
There is no doubt that the global effort to integrate ESG in investment decisions is sincere at many levels. The risk is that the investor-industry complex, in its self-righteous march towards responsible investing, will lose sight of the fundamental issues on ESG data integrity. To measure true progress towards a sustainable and secure future for the human race, there is an urgent need to develop a global ESG data capture and disclosure framework that is robust, transparent and verifiable.
Rupam Raja is a partner with a global environmental consultancy and has worked extensively on environmental risk in emerging markets. These are his personal views.
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