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The Problem of Missing Standards

Patrick Ghali, Managing Partner, Sussex Partners, considers the challenges of benchmarking performance against ESG factors in the absence of commonly agreed metrics.

Investors love benchmarks to measure the value of their portfolios and the investments industry either aims either to replicate or to outperform benchmark returns. Either way, benchmarks are of primary importance and there is generally agreement as to which investment measures are the most appropriate to use. Unfortunately, for ESG investors things are not quite as simple with no clear consensus yet as to which metrics are the most useful or even how different ESG or impact factors should ultimately be measured.

Guidance from above

Let’s start with governments. The EU, by way of example, has identified six environmental goals (climate change mitigation; climate change adaption; the sustainable use and protection of water and marine resources; the transition to a circular economy; pollution prevention and control; and the protection and restoration of biodiversity and ecosystems), which form the basis of achieving its climate and energy targets by 2030 as well as the objectives of the European ‘green deal’.

However, the EU has also realised that in order to achieve these goals, a taxonomy is needed to provide the appropriate definitions as to which economic activities can be considered to be environmentally sustainable, so as to help create security for investors and protect against greenwashing. While this all sounds very well, and should indeed be helpful, the problem is that the EU has as yet published its taxonomy report for only the first two of these goals. What hope then is there for investors to ensure that what they are doing makes sense when they don’t even have governmental guidance yet, and when governments themselves are not clear on these aspects?

So let us consider indices, another investor favourite. With regards to indices, investors are spoilt for choice when it comes to recording traditional measures of return. However, when it comes to tracking ESG metrics, the growing body of indices available don’t provide much clarity as they all seem to pursue very different approaches. Indices can track 1,000s of data points, but a lack of uniformity not only creates confusion but also makes it incredibly burdensome to try and fully understand each provider’s methodology. The effect is to ultimately transfer the burden of choice onto the end investor who will be keen to avoid the very real risk of being accused of greenwashing. At a portfolio level this lack of standards further exacerbates the problem as consolidation becomes an almost Sisyphean task.

No silver bullet

How then should investors approach the measurement and monitoring of ESG factors and what can they do to mitigate the risk of being accused of greenwashing? Unfortunately, there isn’t, as yet, a silver bullet that solves this problem in one fell swoop. There are, however, a number of approaches that investors may wish to consider.

Rather than thinking in broad terms of pursuing an ESG strategy, it may be helpful to further break this down and consider the 17 United Nations Sustainable Investment Goals (SDGs). These provide much more granular detail and allow investors to home in with much greater accuracy on specific investment themes, enabling investors to tailor investments to topics that are of specific interest. Investors wanting to offset negative externalities created in the course of their daily business may wish to marry specific SDGs with their investments. For example, fossil fuel related industries may wish to target SDG 7 (renewable energy), and SDG 13 (climate action), whereas the textile industry may be more interested in (SDG 1 (no poverty), SDG 8 (good jobs), and SDG 13 (climate action), and so on.

The UN SDGs allows investors to pick highly specific investments and investment managers whereby measuring the impact can be much easier to achieve. With regards to manager selection, picking managers with a narrow and precise definable edge is generally much more valuable than selecting managers pursuing a wide approach to ESG, as the former require a very specific set of skills. These specialists often also have highly credible impact advisory boards which not only assist with the ESG evaluation and measurement, but also play a pivotal role in approving specific investments, ensuring that only those investments that adhere to the set goals are included in portfolios. Defining what needs to be measured and how to measure it is much easier if investors approach evaluation of these considerations on a more granular level. Breaking down ESG into more manageable SDGs can be a very helpful exercise.

Investors also have the option to appoint a specialist advisor to help them with the ESG/SDG parts of their portfolios (not the investment part), and to assist in the creation of a credible investment framework that doesn’t only work on day one but remains relevant and aligned to their ESG/SDG goals throughout the investment lifecycle. Part of their role should be to push investors to ask hard questions before making allocations, thereby ensuring that investors understand how their investment managers would act under different circumstances so as to avoid future problems or surprises.

The current energy squeeze is a good example whereby some managers appear to have suddenly put profit before previously advertised ESG or SDG goals. Advisors can help investors to critically think through different scenarios and avoid a situation where they are locked into an investment which suddenly no longer fits their ESG or SDG goals. Advisors should encourage their investor clients to fully engage with their investment managers to ensure the constant implementation of best practice ESG/SDG policies as these evolve as we all as the transparent and thorough reporting of these. External advisors can also act as a sounding board and a reality check in terms of what is and isn’t achievable versus investor expectations.

The role of these advisors isn’t usually to source investments, but rather to continuously refine the ESG/SDG investment framework, and to assist investors with the measurement and consolidation task in such a way that the portfolio can withstand scrutiny and remain fit for purpose in the long term. The problem of a lack of common standards still remains, however, as different advisors tend to have quite different approaches to both framework implementation and measurement. While this isn’t ideal, this shouldn’t fatally flaw the use of such specialist external advisors either, but it does mean that investors need to be willing to spend time in understanding the different approaches on offer, and how these best fit with their overall investment philosophy and goals.

Clear from the outset

It seems particularly important that investors should be clear from the outset as to the goals that they want to achieve, and that they tailor their approaches accordingly. An investor’s size, liquidity preference (e.g., listed stocks, versus illiquid private equity or direct investments) and desired level of granularity when it comes to measuring ESG/SDG factors (e.g., simple filtering for excluded stocks versus impact assessment along the full value chain) are crucial determining factors which can lead to very different frameworks and outcomes.

While it should become easier for investors as more general industry standards are agreed upon, the nature of the problem (i.e., the differing degrees of ESG/SDG measurements), and the level at which investors may wish to comply, will likely mean that some level of customisation of measurement approaches will remain.

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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