Week 41: ESG data is not capturing real-world impact

In this issue: ▸ ESG data has real limitations ▸ ESG is not capturing real-world impact ▸ Despite its flaws, everyone’s looking to ESG ▸ Carbon emissions to triple with soaring battery demand

Dear all,

I hope you are well and ready for a new edition of ‘ESG on a Sunday’.

Last week, I wrote about the need for a systemic change in order for us to transition to a sustainable future. It’s extremely complex, of course. The transition requires a multitude of factors interacting across entire spectre of societies, economies and financial sector.

This week, I will focus on how ESG fits into all of this and what role it can, should and will likely play.

ESG data is a prerequisite for real transformation

Access to ESG data enabling us to assess how companies and countries manage, develop and transform environmental, social and governance issues into tangible actions with clear outcomes is a prerequisite for a real transformation. 

The interest and growth in sustainable investing is an area that appears to have gained greater momentum since the COVID-19 crisis. The buzz in political and business circles is all about making our society more resilient and better equipped to deal with global crises.

It is as much about your personal health, as it is about the health of your wealth, and the health of your community, the company you work for, the government, and our planet.

As important, it is about making our world more resilient to crises that affect us all.

Last week, the OECD released its 2020 business and finance outlook report, Sustainable and Resilient Finance. The report delivers a consequential and timely conclusion: 

ESG scoring and reporting has the potential to unlock a significant amount of information on the management and resilience of companies, but will require agreed global data standards and regulations. Over $30 trillion in recent years has poured into sustainable investments in some form of Environment, Social and Governance (ESG) investing. More than twenty-five percent of publicly listed companies around the world are now ESG measured and rated.

In this article in Forbes you can find a very good overview of the lie of the ESG land. 

ESG data has real limitations

This article from Financial Times tells it like it is: The risk is that current ESG data puts the spotlight on what is available, rather than what is most important.

We need a new generation of ESG data that is tied to a future where high quality companies are aligned with planetary and societal needs. ESG data today focuses on useful, but incremental improvements.

Reality is that coverage remains patchy. Data are only currently available for some metrics, for some firms in some geographies. Indicators for social issues are relatively weak, at a time when societal challenges have never been higher on the agenda.

Current sustainability narrative focus on the need for transformation and unprecedented shifts in the way that companies operate. But there is a disconnect here. Take the climate emergency. Last year’s greenhouse gas emissions data for a company’s operations is a commonly used metric. Yet a more complete picture of how the company is doing would depend on understanding its supply chains, interactions with customers, opportunities to innovate and more.

Climate is of course only one critical sustainability issue that investors need to consider. This article will give you a dirty little secret of the problem with ESG, in the context of financial-ESG engineering.

ESG is not capturing real-world impact

Many data providers have responded to this complex picture by providing ever more sophisticated combinations of metrics to assess sustainability. Yet they do not agree on which factors are most important.

Composite ESG scores, currently provided, risk creating further distance between an investor’s understanding of a company and its real-world impact.

It can create a false sense of confidence among investors who don’t really understand what lies behind the numbers, and therefore don’t really understand what they’re buying. The equivalent in financial analysis would be to evaluate the quality of a company by looking only at its balance sheet.

What current ESG data is good for

Current ESG data is better suited to highlight the worst performing companies.

This is so because a common use of ESG data is ‘negative screening’, excluding firms or entire sectors from investment portfolios, often on ethical or religious grounds (for example, tobacco, alcohol, munitions, and gaming).

Another common use case is limiting exposure to poor labour conditions, corruption or other issues in the supply chain.

In contrast, there is much less data available to help identify positive opportunities for sustainable investment.

Despite its flaws, everyone’s looking to ESG

Everyone on the financial markets is looking for a single point of truth from ESG data. MSCI and Bloomberg, for example, now provide thousands of metrics and scores, either within their own platforms or via an API.

But ESG data is currently much better at telling us how a business operates, rather than about what it does. So it’s safe to say that ESG data will not give us companies that produce the goods and services aligned with the future we want to transform to.

Today, it is possible for a company to get strong ESG scores by incrementally improving environmental performance to a level at least as good as its peers. These steps forward are of course valuable, but they can often be achieved without altering the company’s business model or product offering.

We need better data and metrics

Companies now face much tougher environmental constraints and societal expectations that threaten their license to operate. And so, we need better data around setting and implementing ambitious targets.

We also need metrics to assess the capacity of the management team to implement changes to the business and enhance preparedness for future disruption.

Are management, for instance, well placed to manage a complex transition in line with the Paris Agreement, switch to regenerative agricultural production methods, and remove plastics from their supply chain? Does the company pay its fair share of tax?

You can see here why it is important here. Some of the most fundamental questions being asked of companies revolves around a shift away from unsustainable patterns of consumption. Is management articulating how it will act to reduce raw material consumption and shift to a more circular economy? 

ESG data must go much deeper

A significant weakness in current ESG data is that it provides single data points for companies.

Financial analysts do their best to break up companies into their subdivisions, geographies and products, which companies provide at mixed levels of detail.

Something similar is needed in the ESG space, to provide, for instance, separate scores for Amazon’s cloud computing business and its e-commerce operation (you can read my ESG analysis of Amazon here).

In addition to helping investors assess the risks and opportunities, this would also create competition within the companies to excel against ESG metrics. Companies are increasingly able to provide a chain of custody for their supply chains, from raw material through to the consumer. Whether enabled by blockchain or simply encrypted data, third party verification of this information could provide deep insight for ESG.

Similarly, it will soon be possible to assess performance at the product and company, seeing the real-time emissions from a vehicle fleet. Companies could be scored both on their openness to third party verification as well as on the real world environmental and social impact of their performance.

Accountancy firms already verify company ESG data alongside financial accounts. They will need to develop new tools, or they will face increasing competition.

Third party verification of ESG data is next big game in the global financial industry. 

Just another stock bubble?

Meanwhile, ESG investment engineering is evolving continuously, and interesting new investment strategies are popping up  every week. Here’s one interesting approach.

In general though, we need to be very careful how we treat, use and present ESG data in the investment context. Otherwise it might end up as just another stock bubble.

Let’s not forget the real world and latest developments that will in many ways alter ESG investing and force it to to ask itself a crucial question: Are we making any tangible improvements on the ground?

Carbon emissions to triple with soaring battery demand

On to a slightly different topic. This article about carbon emissions from soaring battery demand has garnered a lot of attention. But the topic is really important.

As the article explains, soaring demand for lithium to power modern technology and innovation such as electric cars, laptops, and tools will see carbon emissions triple in the next five years, according to new research.

Mineral consultants Roskill said emissions coming from mineral concentrate production, shipping, and refining of lithium is unsustainable on its current course. This coincides with the Irish recycling body WEEE Ireland pleading for consumers to recycle their old batteries.

Lithium and cobalt are key to producing rechargeable batteries that power devices such as laptops and power tools. But Roskill said that the lithium industry has been rocked by allegations of excess water usage at brine operations, chemical contamination of local environments and poor relationships with local indigenous groups.

That’s it for now. Next week’s newsletter will be all about “Green Bonds”. They're designed to fund projects that have a positive environmental impact.

But are green bonds being used to mask environmental destruction? More on this next week. 

I wish you a great week! 

Best regards, Sasja