Regulators are stepping up for quality and comparability in ESG data disclosures

2 Jun, 2020 02:51
source: Singularity Financial

Singularity Financial Hong Kong June 2, 2020 – by David Lee

For banks, insurers, asset managers including alternatives and quants, and asset owners – data integrity is now even more critical for evaluating the long-term ESG risks of potential clients, partners, and investments. However the current ESG data by corporates has been lacking in quality and comparability, making it difficult to use for investments.

Also the correlation of ESG ratings of top ESG rating agencies are low, the Aggregate Confusion Project from the Massachusetts Institute of Technology (MIT) explains: “It is very likely….that the firm that is in the top 5% for one rating agency belongs in the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”

Since 1995, sustainably invested assets in the US have grown 18-fold, according to US SIF Foundation. Globally, investors with $80 trillion in assets under management signed the UN-supported Principles for Responsible Investment, committing to incorporate sustainability issues into their investment analysis and decision-making. There has also been a groundswell of interest in sustainability frameworks and metrics: 600 ESG frameworks in use today; and as of 2016, there were more than 125 ESG data providers.

A study by the Alliance for Corporate Transparency, initiated by public interest law organisation Frank Bold, brings together civil society organisations and experts.

It assessed reports of 1,000 of the largest companies in the EU to provide evidence-based recommendations for legislative changes to drive the debate on the standardization of corporate sustainability reporting. Its main conclusion was that “at large, the quality and comparability of companies’ sustainability reporting is not sufficient to understand their impacts, risks, or even their plans”.

And US regulators also listed the below reasons for their recent offering of preliminary sustainability reporting recommendations for regulatory measures: 1) Investors need reliable, material ESG information for investment and voting decisions; 2) Issuers should directly provide material information about ESG issues to investors; 3) Requiring material ESG disclosure may level the playing field among issuers; 4) ESG disclosure requirements could preserve capital flows to US markets and to US issuers of all sizes; 5) The US should take the lead on disclosure of material ESG information.

Current EU NFRD leads to insufficient sustainability reporting data

EU Commission launched a review of the Non-Financial Reporting Directive (NFRD), after it found that it leads to insufficiently comparable or reliable sustainability reporting data. The public consultation is open until 11 June. The proposal for the revision is planned to be published at the end of the year.

Marie Lyager, policy officer, corporate finance at the European Securities and Markets Authority (Esma), explained about the upcoming revision: “Companies are left much freedom to decide how to implement the requirements for their reporting.

“Establishing binding and detailed disclosure requirements to underpin the general rules in the NFRD is a necessary step to ensure more relevant, reliable and comparable non-financial disclosure.”

Among the most frequently used reporting frameworks are: the Global Reporting Initiative, United Nations Global Compact, United Nations Sustainable Development Goals, OECD Guidelines, CDP and International Labour Organisation Standards.

Corporates can choose different reporting frameworks under the current NFRD.

Michele Lacroix, head of group investment risk & sustainability at Scor, who is also member of the EU’s Technical Expert Group on Sustainable Finance (Teg) and chair of the project task force on climate-related reporting at the European Financial Reporting Advisory Group (Efrag), pointed specifically to interlinkages between the governance of companies, their strategies, risk management, and metrics and targets.

Overly simple rating systems hinder investment decisions

Jay Clayton, chairman of the U.S. Securities and Exchange Commission (SEC), has criticized the industry’s reliance on a single rating for ESG funds data, describing this method as ‘imprecise.’  The SEC is concerned that, with the increasing popularity of sustainable, or ESG, investing, overly simple rating systems are leading to misinformed or even misguided investment decisions.

Sustainable investing advisor Sakis Kotsantonis and Harvard Business School Professor George Serafeim cite multiple reasons for the imprecision that Jay Clayton laments: the sheer variety and inconsistency of the data and how companies report them; the impact of how data providers define corporate peer groups on their ESG rankings; and the differing methods that ESG researchers use to impute the significant gaps in ESG data.

The SEC ESG Subcommittee offered preliminary recommendations for regulatory measures which could provide consistency to ESG investment policies and disclosures in light of the growing push by asset management stakeholders to implement ESG practices, which has become a particularly important consideration in light of COVID-19.

The board needs to ensure sustainability is integrated in corporate governance

Helena Viñes Fiestas, global head of stewardship and policy at BNP Paribas Asset Management, and member of the Teg, highlighted that sustainability needs to be integrated in corporate governance.

This, she said, means that the boards should disclose the sustainability of the company strategy, link it to the business model and governance of the company and set up measurable targets.

The revision of the NFRD will also include the definition of materiality, ie which ESG information is material to a business and requires disclosure.

Viñes Fiestas said that, in order to correct market failures, such as a non-effective carbon price, “we need information that is material to the company, that is material to its shareholders, that is material to policymakers and then to society and the environment”.

The EU has already established a so-called ‘double materiality’ concept, which addresses this point (see below chart).

It is importance to address ‘adverse impacts’ in investor regulation

To improve connectivity, the investor regulation and company disclosure regulation need to be directly linked, said Viñes Fiestas.

In this regard, she also pointed to the importance that the definition of ‘adverse impacts’ needs to be addressed.

In sustainability disclosure regulation, it says that principal adverse impacts should be understood as investment decisions and advice that result in negative effects on sustainability factors.

A member of the European Commission explained that the existing reporting frameworks don’t consider investor disclosure regulation and “none of them are directly fit for purpose”.

U.S. SEC ESG Subcommittee provided an overview of its current areas of research, which has taken the form of five separate workstreams.  Moreover, the ESG Subcommittee offered preliminary recommendations for regulatory measures which could provide consistency to ESG investment policies and disclosures in light of the growing push by asset management stakeholders to implement ESG practices.

For more details, please review our recent article regarding “SEC provides report on ESG practices in asset management space”.

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