We believe the next revolution in ESG data will have three characteristics.
ESG data should be focused on ‘the future we want’, to use the language of the UN Sustainable Development Goals.
Assessing whether a company is on a path that is consistent with our transition to a sustainable world is even more important than its current environmental and social impact.13
Globally, over 700 companies have now either committed to setting a ‘net-zero’ target or a science-based target, which set the decarbonisation pathway a company needs to follow to remain in line with the Paris Agreement.14 200 have committed to use 100% renewable energy by a specified year.15 There is an opportunity to use the wealth of energy and emissions data now available from providers like CDP to track performance against these targets, rather than against industry peers.
Under TCFD, companies are asked to disclose ‘forward-looking’ information. To test their resilience to climate change, some companies take their greenhouse gas emissions today and see how they would be affected by a higher carbon price, and what measures they could take to adapt. ‘Green patent portfolios’ are also used as a proxy for innovative capacity – i.e., these provide some indication of products that the company is developing for a low carbon world. These are only first steps, but they could develop into a toolset for assessing transition.
Climate change may have obvious time-bound requirements, but forward-looking disclosure is not only relevant to environmental issues. We believe companies should be assessed against their progress on social indicators too. For instance, once more data is available it will be possible to track progress towards closing the gender pay gap.
2. Real-world impact
Today’s ESG data provide only a limited window into real-world impact.
One practical opportunity exists around the use of highly granular data collection or modelling. The FTSE European Public Real Estate Association (EPRA) Nareit Green Indexes, for example, apply sustainability performance as ‘tilts’ to adjust the weights of constituents in the underlying index. They claim to maintain a similar returns profile to the parent index. At the same time, green certification increases by 63% while carbon emissions per dollar of revenue drop by 40%.16
Better data is also now available on how physical and economic shocks affect companies. Historically, it has been difficult to assess the risks companies face from extreme weather events. Information is now available at much finer spatial resolution, making it possible to allocate risk to specific infrastructure, supply chains and business locations. Economic impacts arising from climate change are being translated to the company level through the use of vectors such as commodity price increases, physical supply interruptions or land use valuations.17
We believe approaches like this which more tightly couple companies to real-world impacts (and real-world impacts on the companies) will also go some distance towards capturing what a company does, and the benefits it provides to the economy and broader society.
3. Management in transition
As long-term investors, we want to know that companies have the capacity and intent to set a clear strategic direction and navigate turbulent waters.
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 valuable steps forward can often be achieved without altering the company’s business model or product offering.
Yet companies now face much tougher environmental constraints and societal expectations that threaten their license to operate. We need better data around setting and implementing ambitious targets. We also need metrics to assess the capacity of the management team to implement profound changes to the business and enhance preparedness for future disruption.
The challenges are manifold and interlinked. 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? Some of the most fundamental questions being asked of companies are around a shift away from unsustainable patterns of consumption.18 Is management articulating how it will act to reduce raw material consumption and shift to a more circular economy?
Tackling our sustainability crises also requires collaboration, advocacy and purpose. We should be looking for evidence that management teams are forging alliances with their suppliers to drive sustainability along the value chain, as well as pushing for ambitious minimum standards in industry bodies. Participation in high ambition initiatives and voting records could provide insight here. We should be tracking whether their lobbying activities are in line with their high ambition public statements on sustainability.
To fully assess management quality in transition, investors need sustainability goals to be as clear as financial management targets. This includes better data on whether ambitious targets have been set and are being implemented. Whether senior executives are incentivised in line with these targets would be another useful indicator. At the same time, we believe better data would complement rather than replace the need for deep, ongoing engagement with management.