ESG has a trust problem

Smoke from cooling towers a coal-fired power station in Ratcliffe-on-Soar, UK, on December 2, 2021. Bloomberg

The relevance of environmental, social and governance factors in a company’s decision-making process – collectively known as ESG – in today’s business discourse is hard to overestimate. The term “ESG” was introduced in 2004, when a group of financial institutions published a report titled Who Cares Wins under the auspices of the UN Global Compact. A year later, the UN Environment Programme Finance Initiative produced the so-called Freshfield Report, which argued that ESG issues are relevant for investment decisions. These two reports provided the basis for the launch of the Principle for Responsible Investment at the New York Stock Exchange in 2006.

In the Middle East, a region that, according to the Brookings Institution, could be devastated by climate change, sustainability is much more than a fashionable buzzword; it is a fundamental public priority. Indeed, in 2020, the Dubai Financial Market launched its ESG index. In 2021, Abu Dhabi Global Market launched its sustainable finance initiative. In the same year, the Abu Dhabi sovereign wealth fund Mubadala established a responsible investment arm.

A recent survey by PwC indicates that companies need clear guidelines, country roadmaps for decarbonisation and a level playing field across industries, and that compliance with regulation and policies is at the top of their ESG agenda.

Over the past two decades, we have also witnessed the birth of specialised agencies that aim to fulfil a similar role to the one performed by credit-rating agencies: provide an independent assessment of the performance of a company along the environmental, social and governance dimensions. However, the methodologies developed by such agencies are still evolving towards a common standard and are far from being able to capture all the relevant interactions between economic activities and environmental and social factors.

While there is evidence that ESG ratings produced by different agencies for the same set of companies diverge substantially, such methodologies being proprietary and largely undisclosed, it is also difficult to establish to what extent they are theoretically sound and empirically robust. This harms not only the reputation of the individual company, but the credibility of the whole market as well. If it is difficult to distinguish who is trustworthy, then it is natural to assume no one really is.

Nevertheless, banks and asset managers have made liberal use of such ratings in an attempt to label their product as “ESG”, suggesting their funds are made of shares in companies with strong environmental, social and governance credentials. The result of this lack of recognised standards and of independent assurance, however, is that many “ESG” funds still hold major emitters and have substantial carbon footprints.

Authorities around the world are starting to take notice. The US Securities and Exchange Commission launched an investigation of Deutsche Bank last year, followed by a separate investigation by German authorities who raided the bank’s asset management division, DWS, in May. According to German prosecutors, the searches were linked to allegations of marketing investment products as more environmentally friendly than they really were. In the same month, the SEC fined BNY Mellon $1.5 million for “misstatements and omissions about ESG considerations”, and is investigating Goldman Sachs on the management of its ESG mutual funds.

ESG is, therefore, a critical dimension in today’s financial markets, but is blighted by vagueness of definition, improvisation in approach and lack of rigour. In other words, ESG has a trust problem. To solve it, it needs three things: clear definition, internationally agreed standards and trusted assurance.

First, ESG performance cannot be just a loose combination of targets, from emission levels to recycling percentages, from labour laws compliance to gender equality measures, as looking at some of the rating methodologies mentioned above could suggest. Rather, it is a measure of a company’s contribution to society’s objectives. Its ultimate rationale must lie not in nebulous encouragements to do good deeds in addition to a company’s main activity, but rather in aligning to the extent possible such activity to key public goals. Such a combination of public policy and private profit making, far from being a contamination of market-oriented economics or a limitation of free enterprise, is the only potentially successful avenue to meeting the monumental challenges of environmental deterioration and social unfairness we confront today.

The second piece of the puzzle is a set of internationally recognised standards. Recognising that this fundamental element was missing, in November 2021, the Foundation Trustees of the International Reporting Standards announced the creation of a new standard-setting board, the International Sustainability Standards Board, with the objective of developing a “baseline of sustainability-related disclosure standards”.

Within the EU, the Environmental Taxonomy provides a very strong candidate for a common benchmark as well as a concrete, if complex, set of criteria to assess alignment. The European Commission has, in fact, established six environmental objectives and a set of criteria for deciding to what extent an activity contributes to the achievement of such objectives. A “social” taxonomy is expected to follow to provide a complete coverage of economic activities over a timeframe up to 2050, the European Commission’s target year for a climate-neutral economy, with intermediate milestones for 2030. Although these are all promising developments, a global consensus on a well-defined set of standards is still missing.

Finally, there is the issue of trust. Given the lack of both agreed standards and consistent ratings, it is not surprising that many companies turn to third-party certifications in order to substantiate their claim to ESG alignment. In particular, sustainable label certifications are provided by governmental bodies and other NPOs, as they enjoy greater legitimacy and trust than for-profit companies. Such certifications, however, may be under government control or private, based on an open and consensus-based set of standards or on a proprietary approach, may or may not involve field visits, may or may not involve verification from accredited auditors and so on.

The UAE is not watching idly. In 2010, the Dubai Chamber of Commerce launched its first CSR (Corporate Social Responsibility) Label. In 2021, it launched four individual CSR label categories: workplace, marketplace, community and environment labels. In 2022, Abu Dhabi’s Environment Agency, as part of its 50-year environmental vision, started a green labelling programme that will award facilities a Green Industries label based on environmental criteria in four categories: management of resources, pollution reduction, compliance with agency requirements and innovative approaches to protect the environment.

To avoid the lack of standardisation and transparency that mires ESG ratings globally, an ideal ESG labelling should be sponsored by governments with a reputation for both business support and regulatory reliability. It should be based on internationally recognised standards and follow a consistent and transparent process supported by a state-of-the-art rating methodology.

The views expressed in this article are those of the authors and do not necessarily represent those of the European Investment Bank and RiskLab