ESG grounded in reality: greater scrutiny calls for robust risk assessment

There are two things on which it is easy to agree regarding Environmental, Social and Governance (ESG). First, with sustainability having become the focus of huge attention in recent years, it has stormed up the corporate agenda. Second, and less positively, it remains a messy area bedevilled by inconsistencies and in some instances, greenwashing.

Not only is there a lack of agreement over exactly what ESG covers, accurate measurement remains a challenge despite the emergence of rating agencies like Sustainalytics, Refinitiv, MSCI, RobecoSAM (now under S&P); and platforms and databases such as CDP, ESG Book, EcoVadis, NIMBUS and RepRisk. Among the attempts to make sense of it all is the wonderfully named Aggregate Confusion Project, an MIT Sloan Management School initiative to address the noise and unreliability around ESG data. This was launched after the discovery that while the correlation of credit rating data from the likes of Moody’s and S&P stands at a reassuring 0.92, ESG rating agency data correlation is much lower at just 0.54. A state of affairs that is far from ideal.

In theory, ESG can be used more systematically by investors and corporates to drive improvements in value chains. However, the tick-box approach that has been championed by the Financial Services sector (because that is what it is comfortable with) lacks nuance and can distort the focus on sustainability programmes by encouraging companies to pick off those aspects where they will be most favourably judged, with a view to gaining a higher rating. Often, this approach gives no consideration to economic impacts or to the synergies and trade-offs between the Environmental and Social components of ESG.

Without doubt, there is a need for reporting in a more structured and comparable way. And to that end it would be a good thing to see greater agreement on reporting frameworks and standards. Thankfully, there are moves in that direction together with growing momentum for integrated reporting.

In this evolving context, organisations must be mindful of the risks. Greater scrutiny of ESG claims means we will likely see a rise in allegations of greenwashing or around other ESG-related shortcomings.

How should corporations protect themselves? The answer hinges on keeping claims and perceptions in balance with operational realities. It’s vital not to panic and jump into an ‘ESG programme’ designed to meet the needs of rating agencies and investors. While reporting which presents the best picture of your company is important, getting priorities right internally is even more so.

Robust materiality and risk assessment are fundamental, and ideally strategic priorities and positioning should be set to cover a 5-10 year period. Clearly, shorter term targets and KPIs should be agreed within this framework. The evolving reporting demands of the ESG wave cannot be ignored but your primary focus should be on developing internal programmes that respond to wider stakeholder and commercial pressures.

The nascent E-liability accounting system is a useful step forward as it eliminates undesirable duplication in the counting of Scope 3 emissions in company value chains. As Harvard Business Review notes in a piece on accounting for climate change, “it also reduces incentives for gaming and manipulation.”

Some companies have engaged in ‘working the system’, what we might call the ESG equivalent of tax avoidance. Legal, yes. But is it ethical and in the spirit of sustainability?

There are also ways companies might accidentally trip up. Take Sustainability-Linked Bonds (SLBs) which allow companies to borrow money at a certain interest rate in return for achieving agreed sustainability target within a set timeframe. If companies fail to hit those targets, their cost of borrowing rises.

A win-win product for investors in that they either help companies improve sustainability or get a higher return on their money! But because SLBs don’t force companies to improve performance across ESG areas beyond the agreed outcome metrics, they might lead to allegations of hypocrisy or greenwashing if the borrower is a poor performer elsewhere. The risk radar must remain active at all times.

In terms of wider trends, ESG is becoming ever more of a global phenomenon, with investors in Asia-Pacific making strides to catch up with Europe and the US. KPMG predicts that the total assets managed by ESG funds in APAC will reach US $250 billion in 2025, a big increase from the US $101 billion under management in 2022.

That’s good to note. But at the corporate level, leaders and ESG professionals should have a solid grasp of the issues they face and set up programmes that improve performance in these areas. It bears repeating: if the perception being fostered is out of step with reality on the ground, whether deliberately or inadvertently, your business will come under heavy scrutiny, and worse, from the regulators.

 

 

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