ESG stands for Environmental, Social & Governance practices that are referred to when measuring the sustainability performance of a company or investment. Today, large number of investors, companies & trading platforms are integrating ESG aspects into their investment strategies with the objective to better manage the assets beyond “conventional” business & financial performance. We now know that ESG related risks and performance play an important role in investment related decisions and are intimately linked to company’s financial performance & business viability.
The roots of ESG may be seen from Socially Responsible Investing. The difference between SRI and ESG lies in the fact that investing based on ESG criteria is considered to make financial sense as well. This view came to light with the UN PRI report of 2006 that consisted of the Freshfield Report and the Conference report “Who Cares wins” . The term ESG was first used in the latter and highlighted that ESG criteria must be incorporated in financial decisions. Responsible and sustainable investments were the terms additionally introduced.
At the start of 2018, responsible investing was at $30.7 trillion in the five regions of global markets, showing a 34 percent increase in two years. Responsible investment now commands a sizable share of professionally managed assets in each region, ranging from 18 percent in Japan to 63 percent in Australia and New Zealand. Apart from company investments, mutual funds, Exchange Traded Fund (ETF) are also adopting ESG metrics.
ESG frameworks typically include strategies such as negative/exclusionary screening, ESG integration in the business (decision making) process and Corporate engagement and shareholder action. Negative screening remains the largest strategy in Europe, while ESG integration continues to dominate in the United States, Canada, Australia and New Zealand Corporate engagement and shareholder action is the dominant strategy in Japan. Please refer for more details here
ESG based investment in Asia Pacific is often assumed to be in its infancy, but market participants are confident that momentum is growing and perhaps even to surpass other regions’ ESG progress. Read more here. Looking ahead to the coming years, the ESG metrics will see more traction on climate change where company’s performance is judged through efforts taken towards reduced carbon footprints.
There is not a standardized approach to the calculation or presentation of different ESG metrics. Investors, analysts and stock exchanges can employ a variety of analytical approaches and data sources to address ESG considerations, including use of weights for aggregation. The methodologies are often tiered where filtering is carried out of companies based on the financial performance first and then ESG criteria are applied.
In 2019-20, members of the World Economic Forum International Business Council (IBC), comprising approximately 120 large multinational firms, expressed a strong desire to demonstrate their ability to create long‑term value for all stakeholders. They recognized that this must come in the form of consistent and transparent reporting on both financial and non‑financial risks and opportunities to their businesses. At the behest of the IBC’s members, the Forum partnered with the Big Four accounting firms to identify a common, core set of ESG metrics and recommended disclosures for all companies to report on, across sectors and geographies. The objective was to ask companies to report on these metrics in their mainstream disclosures to provide a more accurate representation of a company’s performance, risk management capabilities and ability to generate long‑term value for all stakeholders. In this report The 17 SDGs were considered to support the framework for creating the metrics with references mostly referring to the Global Reporting Initiative (GRI) and Carbon Disclosure Project (CDP). More recently, the ESG disclosures were discussed under the subject of “stakeholder capitalism. See Global Business Leaders Support ESG Convergence by Committing to Stakeholder Capitalism Metrics
I told my Professor Friend about these praiseworthy initiatives on harmonization of ESG Frameworks in the growing “ESG market”
Professor heard me patiently and lighted his cigar. He asked “Dr Modak, Have you heard about PROPER?”
“Well, yes Professor” I answered.
Professors question took me back nearly 30 years when I was working as a Consultant to BAPEDAL, the Environmental Impact Management Agency of Ministry of Environment, Government of Indonesia. Those who have not red about PROPER, please visit.
PROPER or Program for Pollution Control, Evaluation and Rating was launched way back in 1995 as the first major scheme in Indonesia that was used as disclosure of information to the public on companies environmental performance. PROPER assesses the company’s environmental management performance with colour ratings (gold, green, blue, red, and black) using scoring methodology. A poor rating is expected to affect the market rating of the industry and lead to a bad image amongst the community. Essentially, PROPER utilized the response from communities and the markets to put pressure on the industry to improve its environmental management performance.
The idea on PROPER was supported by Pak Nabiel Makarim, Deputy for Pollution Control at BAPEDAL then. In 2013, a book titled Environmental Regulation and Public Disclosure The Case of PROPER in Indonesia was published by Shakeb Afsah, Allen Blackman,Jorge H. Garcia and Thomas Sterne. This book is a must read for those interested in the subject of ESG disclosures. See below.
I told Professor that I used to be a consultant to BAPEDAL during the PROPER days and had the privilege to work with Pak Nabiel Makarim who by then had become the Minister.
“Oh, Yes, Dr Modak, I do remember” Professor said. He looked outside the window and continued
“Like PROPER, many counties introduced rating schemes for public disclosure schemes e.g., Eco-Watch in the Philippines that is now part of the Philippines Environment Partnership Program. The major difference between the ESG disclosures of today and those by schemes like PROPER or Eco-Watch is that these programs were conceived and spearheaded by the national governments and not by the financial rating agencies or the Stock Exchanges. Push towards the compliance was the motive and not responsible investments”
Professor was right. I remembered the G-B-C relationship postulated in the policy research report authored by David Wheeler “Greening Industry: New Roles for Communities, Markets, and Governments”. Later on in my book Environmental Management Towards Sustainability, I expanded this relationship to include G-B-C-FI and more recently added the role of Judiciary i.e. G-B-C-FI-J. See below
Professor extinguished his cigar and as usual made some additional observations.
PROPER as a framework was simplistic in terms of indicators as compared to the monstrous ESG frameworks that we now get to see. Sometimes too much of information load leads to losing the focus, especially when the data elements are questionable or even dated. The scoring method that is generally based on benchmarks and standards cannot be global. It can be quite subjective especially in setting the weights for aggregation. All these limitation could lead to varying interpretation of the same data.
Professor was right. We know from theory of indices that indexing with large number of parameters leads to ambiguity (non-uniqueness) and eclipsing. (See the classic book on “Environmental Indices – Theory and Practice” by Wayne Ott). We also know that these issues arise even in the simplistic formulation of a 4 parameter Air Quality Index. So, God only will know what the analytics of 100+ ESG parameters is trying to say! Professor expressed his concern that he was not sure how much do the financial analysists know about the materiality of the ESG indicators and how much training they have received in the science of sustainability. Many ESG dashboard now claim to use Machine Learning and Artificial Intelligence (AI) to make the process and inferencing more intelligent– but this sounds so unnatural when we are discussing subjects like the natural capital! I am saying this in a lighter vein.
“So Professor, given these challenges, how would you arrive at an ESG rating of a company? Will you use for example the MSCI algorithm ?” I had to ask this question.
“Oh Dr Modak, let me give an example. The other day I was asked to opine whether to take stake in a medium size textile company with nearly 80% exports to EU countries. All I did was the following – called up the Member Secretary of the Maharashtra Pollution Control Board (I am on their technical committee), then checked on the website of the National Green Tribunal if there was a case and whether any case was active, spoke to the GOTs representative in India on company’s compliance to ecolabels asked by the European markets. Finally, my golf-mate introduced me to the Ex-General Manager of the company and we chatted about his experience and impression on Company’s management. A few more checkpoints of such sorts and that was it! I gave a go ahead recommendation to the investor, at least from my side. The investors had of course compiled a lot of other information already.“
“That’s rather a simplistic approach Professor. There is no elegance and not all are “connected” like you are”. I strongly disagreed “If more people of your sort start advising the investors, then the investments will never be “responsible” or sustainable? Besides, what will happen to the careers of thousands of our number crunchers i.e., the ESG professionals?
Professor got up from his chair and quietly left the room.
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Dear Dr Modak, I appreciate your narrative. I agree to one of the points raised by your professor – financial analysts’ knowledge on materiality of ESG and science of sustainability. I feel it may be true regarding climate change science also.
Your Professor Friend is brilliant, simple and elegant, and has lot of gut-sense. However, decision makers and resource managers always ask something “objective” to hang on to justify their decisions even though there is very little objectivity left in a numeric score that is derived from a complex, multi-dimensional matrix of numbers. They ask – just give me a number! Perhaps the value of an index or ESG rating of a company lies only on a relative basis; either with itself overtime or with other companies provided they all use the exact same methodology.