The second age of ESG integration: from transparency to accountability
We are moving from an age of transparency to one of accountability. As the sustainable finance industry matures, it must make a better account of the environmental, social and governance (ESG) performance of its products and investments. And, with growing scrutiny of the value added by sustainable investment – by both market participants and by regulators – it has never been more important for the industry to build on solid foundations.
As with every part of the financial markets, those foundations comprise data and information.
As we move from transparency to accountability, we will need robust, high-quality and comprehensive ESG data if the sustainable finance industry is to disarm the sceptics and demonstrate its worth.
A decade after Paris
The signing in 2015 of the Paris Agreement marked the beginning of the integration of ESG within the finance sector. It was the start of the road towards net zero emissions, and explicitly called for financial flows to become consistent with that objective. Investors wanted to understand if their money was contributing to this effort.
Leading companies that weren’t already disclosing their emissions began to do so, signalling their first steps towards decarbonisation – albeit on a suitably long-term time horizon. Voluntary frameworks emerged, such as the Task Force on Climate-related Financial Disclosures, complementing older and partial disclosure systems like CDP and the Global Reporting Initiative.
Financial institutions followed suit, with pledges to reach net zero. And, following demand, they rushed to market with many low-carbon or climate-friendly investment products, for institutional clients and retail investors alike.
Scrutiny grows
However, many of those products rest on shaky foundations. Much corporate climate data is partial. Many companies, particularly smaller ones, and those in emerging markets, don’t disclose much, if any, ESG data. Companies are selective in what they report. Although around 80% of a typical company’s climate impact results from emissions in its value chain, few companies disclose their Scope 3 footprint.
This can lead to climate-labelled investment products that don’t do what they promise. We used our Scope 3 data to analyse one of the most popular climate-themed indexes in the market, one which claims to be ‘low-carbon’. We found that it selected four issuers included in the top 30 global GHG emitters when Scope 3 is included: issuers that are high risk from a climate standpoint. At best, the sponsors of products with similar shortcomings could find themselves accused of greenwashing, with reputational impacts. At worst, they could be penalised for mis-selling, with resulting fines and regulatory sanctions.
Financial institutions face even greater challenges when it comes to scrutiny of their net zero pledges. For instance, more than 675 firms have made commitments under the Glasgow Financial Alliance for Net Zero to decarbonise their lending and investments – but with little clarity or comparability across climate impact across different asset classes, such pledges are, at present, almost impossible to verify.
Regulators recognise the importance of this issue and are beginning to act. The EU’s Corporate Sustainability Report Directive will require companies to disclose material Scope 3 emissions. Scope 3 reporting is expected to be required under the UK’s Sustainable Disclosure Requirement. The US Securities and Exchange Commission recently stepped back from mandating Scope 3 report, but we believe it is a question of when, not if.
Held to account
But these regulatory efforts will take time. Inevitably, companies (and regulators) around the world will move at different speeds, leading to the disclosure of different ESG data, often in different formats. Quality will vary. Gaps will exist, between sectors and across geographies.
This is where ESG data providers add value. To ensure the rigour, robustness, quality and comparability of ESG data, extensive work is required: using reported data as the starting point, on which models are trained and backtested, enabling gaps to be filled and quality enhanced.
These processes, and the specialist teams of analysts needed to effectively manage them, can be built by larger financial institutions, or they can outsource this work to data providers. But make no mistake: in the new age of ESG accountability, without high-quality ESG data, financial institutions offering sustainable investment products and making sustainability commitments will be under intense scrutiny. They risk exposing themselves to accusations of misleading their clients and investors and to serious regulatory consequences if their pledges are not based on sound approaches and robust data.
Matthieu Maurin is CEO of Iceberg Data Labs, based in Paris. For more information, see: www.icebergdatalab.com
