Overcoming the teething problems of ESG

Every once in a while, when a new phenomenon surfaces in the investment landscape, the rhetoric ignores the inherent challenges. ESG is no exception.

Our annual surveys single it out as a foundational trend, for sure. Every investor group has embraced it – wholeheartedly in Europe but less so in America and Asia. It is gaining momentum everywhere. But it is not plain sailing, as many investors are discovering.

To start with there is no widely accepted understanding of what the individual components of ESG mean. There is a tendency among companies to rely on user-friendly definitions when it comes to setting up their ESG stalls. Second, there is also a tendency to exaggerate their ESG footprints, as there is no mandatory requirement to compile the necessary data. ‘Greenwashing’ is not uncommon.

For their part, regulators are creating templates that would minimise it. The recommendations of the Financial Stability Task Force are being studied by national regulators. They enjoin companies and their investors to provide climate-related information in their annual filings, along with actions taken to mitigate climate-related risks.

Article 173 – a provision in France’s energy transition law – has gone a step further by requiring mandatory carbon reporting for companies as well as pension investors. Other countries are expected to follow suit.

However, identifying and modelling ESG risks is even more challenging. The task entails making numerous assumptions at each stage: the creation of climate change scenarios, and the identification of risks, their likelihoods and their impacts on asset allocation. Assumptions are stacked up like a wedding cake.

The good news, however, is that an enormous effort is now being made in creating a workable template for measurement and reporting purposes. More importantly, pension investors are also developing modelling expertise that is essential in identifying risks and opportunities. A new infrastructure of data and expertise is now emerging. Investing will never be the same again.

I have expanded on this theme in my article in today’s FTfm (18th February 2019). If you are a subscriber you can access it here.

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