Stock-taking ESG –Recommendations, Do´s and Don´ts
The financial market is in a perfect storm of data points, trying to figure out their ESG risks and corresponding financial risks. With new regulatory requirements on ESG transparency and reporting and accelerated supervisory attention on greenwashing, the demand for qualitative data and valuation models is far from satisfied.
Can we expect a shakeup in ESG investments? Probably. In this article, we share recommendations based on our experiences working so far with a variety of financial companies.
How well do various market players identify suitable products that correspond to customer sustainability preferences?
Are companies aware of the potential risk of greenwashing?
Only in the last week, Advisense was invited to address these and other current issues at two events, one being the Sustainability News Day arranged by BG Institute in Stockholm and one internal seminar hosted by a large bank for a group of around twenty investment and fund management companies.
In 2022, global rating firm Morningstar stripped 1,200 funds with 1 trillion USD under management from their ESG label. Recently, several banks have been fined the equivalent of hundreds of millions of SEK for misleading advertising related to sustainability and greenwashing.
During recent market downturns, so-called article-8 products have seen an outflow, whilst long-term investors stay put with article-9 products according to data from the magazine Economist. The Stockholm Stock Exchange has unfortunately experienced a “green nightmare”, according to Aktiespararna. In 2023, the share price of twenty-four renewable energy companies dropped by an average of 41 per cent.
Can we expect a shake-up in ESG investments? Probably.
In 2024, new regulatory requirements on corporate sustainability reporting (CSRD) and a host of underlying standards for sustainability reporting (ESRS) are coming into play. Relating to this, few have missed the Taxonomy Regulation, a cornerstone of the EU’s sustainable finance framework and an important classification tool for environmentally green assets.
The financial market is now in a perfect storm of data points, trying to figure out how to best measure their ESG risks and corresponding financial risks. The range of ESG indices and rating tools offered on the market is growing. ESG data, applied to keep up with sustainability disclosure requirements under the SFDR, has led to an increase in data points claiming to classify assets or financial products as either compatible with article 8 (promoting environmental or social sustainability) or article 9 (contributing to environmental or social objectives through sustainable investments). The observers maintain that there is a shortage of qualitative and reliable data from first-hand sources.
According to Amelia Botshinda, Sustainable Finance Specialist at Advisense, it is important to understand that the Sustainable Finance Disclosure Regulation (in its current form) is not about classification. It is a transparency tool that requires each financial market participant to set and be transparent about what indicators and threshold values constitutes a ‘promotion’, ‘contribution’ or ‘sustainable investment’ in their view. However, as SFDR is currently in consultation, this might be changed in the future.
Trade-offs?
Strategic ESG work involves trade-offs and conflicts of interest. Risk reduction versus strategic potential. Value creation versus ethical reports. To take a current example, could the billion investments in green steel involve a deprioritisation of social responsibility, if or rather when, undeclared labour and dumped salaries happens?
Another paradox is the trend towards greenbleaching. If regulatory requirements and associated demand for information and reporting are perceived as too cumbersome, companies may opt to downgrade their green credentials and ambitions.
Supervisory attention
What may additionally drive attention to potential risks related to ESG is the greenwashing strategy of the Swedish Financial Supervisory Authority which will run until 2025. The strategy involves examining how companies under supervision implement new rules. It also focuses on improving access to sustainability related information and transparency of ESG ratings and ESG data providers. Additionally, it assesses how information about sustainable financial products is provided, among other things.
Based on our experience working with a variety of financial companies, we can offer some general recommendations on critical risks within ESG governance (don´ts) and strategies (do´s).
Don’ts
Rating tools based on unclear models – Steer away from using ESG ratings where quality assurance of data, model components and threshold values are uncertain. Between leading global ESG ratings, the rating of one company can differ as much as 71 per cent according to a research report (inför fotnot – example Sustainalytics vs. Vigeo Eiris[1]).
Insufficient resources – Implementation without allocation of resources is not a good position to be in. but is not uncommon. Ensure sufficient and competent resources when implementing internal and external regulations, or when following up. Given the current focus of the Swedish FSA and its joint work with the European Securities and Markets Authority, opting out on this can result in extensive compliance risks and costs.
Unachievable objectives – Financial institutions should avoid setting over ambitious objectives that are difficult to meet and demand extensive information.
Do’s
In terms of observed challenges and recommendations, a couple of issue areas stand out as warranting more attention across the market:
Consistency – Ensure consistency between the investment strategy of the product, selection of underlying investments, internal rules, the provision of information, reporting and marketing.
Clear measurements – Choose few and clear indicators and apply these consistently to evaluate appropriate investments, for following up the performance over the holding period and for reporting results.
Control environment – Carry out controls in the first and second line of the investment process in order to make sure the investment guidelines, sustainability claims, and internal rules are in line with your external communication.
Governance – Ensure the roles and responsibilities are clearly defined in order to deliver as promised in your external communication. Invest in competence development and allocate sufficient resources.
What we see is that market participants often rely on third-party data providers with large portions of estimated data, due to the lack of fully implemented reporting requirements for underlying companies. Many financial institutions therefore overcompensate for the lack of first-hand information with large volumes of data without understanding exactly what the data points say or how to use them. There is no right answer on what data to look at in order to ensure that an investment is “green” enough to include financial products with sustainable claims. This makes it hard for asset managers to find the right balance between maintaining high ESG ambitions and giving sufficient disclosures on their financial products, which is a fundamental part of avoiding greenwashing risks.
Amelia Botshinda
An important discussion for the board and investors revolves around setting goals, determining what the company aims to achieve, and formulating a corresponding strategy and plan. Clarity is key and it is a basic prerequisite for successful implementation and results. The way forward will require clearer metrics for investment performance, preferably with fewer and clear indicators on ESG, used consistently to assess and monitor investments.
[1] Dimson, Marsh and Staunton (2020) Divergent ESG Ratings, The Journal of Portfolio Management November 2020, 47 (1) 75-87; DOI: https://doi.org/10.3905/jpm.2020.1.175