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The real impact of ESG

10 October 2023

Despite the growth of environmental, social, and governance (“ESG”) funds, assets under management outstripping traditional investing over the past 20 years (growing by circa $40 trillion, per Reuters) environmental and social problems are not going away. In fact, by some measures, the problems are getting worse.

There are a few reasons why this is the case.

Although ESG had been on investors’ radar for decades, the actual integration of ESG into investor decision-making took place only in recent years. Investors who had previously assessed risk through the lens of historical returns, market cycles and financial metrics were thrust unequipped into the world of environmental and societal considerations.

As the financial services industry rushed to meet this rapid evolution in criterion by developing new mandates, rating systems and regulatory frameworks it was perhaps inevitable that air pockets would be left within this new foundation. Increasingly, there is the sense that as an industry, we have tried to run before we could adequately walk. The industry-wide approach to ESG lacks consistency of definition, process, and rigour. This has led to widespread confusion, some resistance to engage in ESG, and even large settlement payments for ESG misrepresentation.

Until we have a global reporting standard, investors will continue to measure different things and report in non-comparable ways.

The most significant development to address this challenge has been the Sustainable Finance Disclosure Regulation (“SFDR”) which was designed to determine how ‘green’ an investment product is, and how much information must be disclosed to prove it. However, even this regulation has been adopted without consistency, and many financial entities began treating it as a labelling mechanism. This has rushed financial players to move towards classifying investments under Article 8 (promotion of ESG factors) or Article 9 (sustainable objectives), without always having the rigorous processes and knowledge to support such claims.

But one of the most significant reasons that we have failed to make progress, is because as an industry our current approach to ESG measurement is too narrow. It is designed to help investors make better decisions based on how environmental, social, and governance related issues might impact the financial performance of a company. But what about the negative or positive impact a company has on the world? 

Our view is that ESG needs to do both.

A pertinent example of this shortcoming can be found within the screening tools and datasets that asset managers rely upon to make informed decisions regarding their investments’ credentials, and subsequently report to their investors and the public.

This became a pointed issue earlier this year when Tesla – the world’s largest electric vehicle car manufacturer – was removed from the S&P 500’s ESG index. At the time, the S&P pointed to a perceived lack of a low-carbon strategy as well as those for areas such as codes of business conduct, racial discrimination, and poor working conditions.

At the time of writing, the S&P had awarded Tesla an ESG score of 37, out of a possible 100.

This becomes even more interesting when considering some of the higher-scoring companies according to the S&P’s rating system. For example, British American Tobacco has a score of 85 while Philip Morris International, the company behind leading cigarette brand Marlboro, scored 84. Even Chevron, America’s second-largest fossil fuel company, ranked higher than Tesla with an ESG score of 43.

Our approach to ESG needs to evolve   

There is a meaningful difference between ESG and Impact strategies (impact with a capital ‘I’), and with Impact investing just surpassing $1 trillion according to the GIIN, pure Impact strategies will not move the needle alone. We believe investors need to consider the impact every company has, positive as well as negative, not just those selected to belong to an Impact fund.

We should not only consider how sustainability issues might create financial risks for the company, as by just managing these risks we are not going to resolve our current global challenges. To drive change, we also need to look at a company’s impact on people and the environment – does a company’s product promote better health outcomes, can packaging be recycled, and can we be sure that there is no presence of modern slavery in the supply chain (currently estimated globally at 50 mln according to ILO)? 

Moving beyond the current state of ESG, which is mainly focused on financial materiality, we also need to integrate this viewpoint of impact materiality. Each aspect is valid and warrants scrutiny, but we feel that the method of review needs to encompass both factors, become more nuanced in its evaluation, and trigger companies to move the needle, to increase its positive impact and decrease its negative one.

The most recent regulatory regimes such as Corporate Sustainability Reporting Directive are based on this approach and are a welcomed development to ensure investors and companies take a broader view of ESG and also ensure that it is communicated to the world in a standard, comparable manner.

The next two to three years are not expected to get any easier for asset managers, with more regulation and increasing stakeholder demands around the corner. Consequently, there is a danger that the increased burden on investors relative to the slow progress in demonstrating its value will spark increased pushback from the investment community, something that has already proven to be contagious. The negativity formed in some corners of the US has already started to spread into Europe.

In the absence of a global standard, we must do what we can to readdress this issue and help investors understand how ESG is being defined, what processes are in place, how high-quality data is being gathered and importantly show evidence of both ESG performance and impact.

We are optimistic. Advanced private equity firms are already moving from basic ESG to proving impacts with scientific evidence and even impact assessments. Regulation, particularly those stemming from the EU will ensure this is adopted as standard in the future.

Do not get frightened by the complexity. In the end, we did not get into this business to avoid complex problems, and this is the biggest of our lifetime.

How can Apex Group help?  

We offer the broadest range of ESG and Sustainability services in private markets and verify all ESG data that we collect, giving us the most accurate ESG benchmark database.  Our ESG software and deep advisory knowledge ensures we can support investors, managers, and companies at each stage of the investment lifecycle.

Our services include:

  • Investment strategies including Impact
  • ESG policy and implementation
  • Global ESG regulatory compliance
  • Digital investor and company ESG assessments
  • Carbon measurement and reduction pathways
  • Nature-based solutions.
  • Supply chain and circular economy
  • Sustainability improvement roadmaps
  • Business model transformation

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