Meaningful rankings of environmental, social, and corporate governance (ESG) factors are increasingly important for financial analysts, institutional investors, and the companies they follow. In fact, sustainability questions arise so often that some Canadian companies have started hiring ESG reporting or communication specialists.

“When you have so many inquiries from investors, management notices. It’s a chicken and egg situation,” says Hyewon Kong, director and associate portfolio manager for the AGF Global Sustainable Growth Equity Strategy. “Many times in the past, company management has said, ‘Nobody asks about these issues, so why should we bother to report on this?’”

Relative to European countries, Canada has been slow to recognize ESG issues. In the U.K., the 2006 Companies Act required companies to disclose ESG information. In January 2016, the Ontario Pension Benefits Act decreed that each Ontario-based pension plan must file its statement of investment policies and procedures, and state whether it incorporates ESG factors. However, the Companies Act stopped short of recommending which ESG standards to use.

Why Care?

This spring, The Analyst caught up with Kong at the AGF offices in Toronto to talk about the proliferation of sustainability standards. And she knows of what she speaks—Kong is an Investment Committee member of The Atmospheric Fund, and she co-founded and currently co-chairs the Toronto Responsible Investment Working Group within the Responsible Investment Association. She’s also a member of the Environmental Finance Advisory Committee of the University of Toronto.

The case for sustainability becomes clearer each year. “Companies with better governance have lower default risk, therefore, a lower cost of debt,” Kong says. “Companies with a poor ESG ranking have a higher cost of capital and higher volatility.”

A 2015 meta-study by Oxford University and Arabesque Asset Management looked at more than 200 studies, and found that 80 per cent of them concluded that a company’s performance correlated positively with its sustainability practices.

Research published by Dorfleitner, Utz, and Wimmer in 2017 showed that “firms with strong CSR [corporate social responsibility] significantly outperform firms with weak CSR in the mid and long run.” The authors wrote that their results “have broader implications for asset managers who can expect abnormal returns by investing in firms that exhibit a high CSR…and holding the stocks for a longer period.”

Early Warnings

There’s another reason to pay attention to ESG indicators: they’re typically seen as warning signs of overlooked systemic problems. In the months leading up to the 2010 BP Deepwater Horizon oil spill disaster, for example, “you could see the Health & Safety data were deteriorating,” Kong says. Some funds divested from BP because the company failed to heed these tell-tale warnings.

Credit risk assessment company Equifax makes its bread and butter through collecting and aggregating information on millions of consumers and businesses. Mitigating privacy and data security risk is part of good governance. As early as 2016, there were advance warnings of insecure systems at Equifax—months before the actual security breach. “The company did not address the flaws that were detected,” Kong says, adding that a company can’t simply ignore a problem because it’s not quantitative financial information.

Survey Fatigue

Sustainability has become such a popular criterion for investing that hundreds of different sustainability reporting instruments now exist. “These days, survey fatigue is one of the biggest headaches for sustainability practitioners,” Kong says.

Companies like the cachet of a high-profile ranking or being selected for an ESG index (see “ESG Initiatives,” page 17), and savvy companies adopt the sustainability criteria as key performance indicators. But not all sustainability surveys are worth the time and effort that a company’s reporting team must spend on them. Keeping up with requests to provide ESG information is “too onerous” for many companies, she says. “In the last few years, there have been initiatives to address survey fatigue.”

“Alignment and harmonization must be a key goal for…all those responsible for developing reporting instruments,” wrote the authors of KPMG’s Carrots and Sticks 2016 report. This highly influential report, updated every two or three years, provides continual assessment of progress in sustainability reporting instruments (a.k.a. reporting guidelines).

Comparable, Integrated, Standardized

The most useful ESG data permit comparison. Data also are integrated into existing systems and standardized.

“We want ESG data to be comparable across all companies within an industry sector so that we can choose,” says Kong. When analysts look at the Health & Safety data on the mining industry’s most dangerous activities, they should be able to see right away why one company’s activities are similar to its peers but its performance is an outlier.

Initiatives for integrating ESG data and reporting exist on both sides of the Atlantic. In the U.S., the Sustainability Accounting Standards Board was created to address the problem of survey fatigue. The metrics must be sector-specific and material, and must take into account the core assets of the industry.

In mid-2017, the Task Force on Climate-related Financial Disclosures (TCFD) released its recommendations, with an eye to helping companies understand what financial markets want from their accounting disclosures in order to measure and respond to climate change risks. “TCFD signalled to the market that there has to be a concerted effort on standardization, especially on climate,” says Kong.

The CDP group promotes standardization environmental impact disclosures, including Kong’s own AGF. “Now CDP data are being fed into Bloomberg,” says Kong, adding that this is a good thing. Investment teams can access ESG metrics for every security from their Bloomberg terminals, rather than having to switch platforms. “It’s centralized and integrated,” she says.

Evaluating ESG

These days, investment teams can conduct due diligence using Bloomberg, company filings, and sell-side research. It’s necessary to have a view of ESG at the highest level, too, Kong maintains. “We talk to the company management,” she says. “If we dig up evidence that some issues are not properly managed, we’ll talk to management” to understand why.

For example, if a company is in expansion mode, its positive ESG trend might reverse. We ask if top management aware of this and what management is doing to turn the trend positive again, she says. “Our questions go right to the C-suite.”

Kong suggests that current ESG practitioners should not get hung up on which sustainability framework is used. “We ask whether management teams of these companies are strategically thinking how to have a good system in place, and how to minimize their risk.”

She also looks at how each company tracks and manages key issues “because what gets measured is what gets managed.”

Future Directions

The near future will bring greater emphasis on cross-sector comparability and ESG-integrated financial reporting. Standardization is the way to go. Although there’s an alphabet soup of frameworks and their reporting instruments, investors and ESG practitioners should not lose hope. “Decades ago, we were wrestling with how to standardize financial reporting,” Kong says, “and we learned to surmount those obstacles.”

ESG Initiatives

ESG STANDARDS

CDP: The CDP (formerly the Carbon Disclosure Project) mandate is now well beyond carbon. The CDP is a U.K.-based non-profit organization that supports companies in their environmental impact disclosures.

GRI: The Global Reporting Initiative is a Netherlands-based independent standards organization that rates businesses and governments on issues such as climate change, human rights, and corruption.

IIRC: The International Integrated Reporting Council is a global coalition of regulators, investors, companies, standards setters, the accounting profession, and non-governmental organizations. The IIRC framework is intended to reflect developments in financial governance, management commentary, and sustainability reporting.

SASB: The Sustainability Accounting Standards Board is a U.S.-based standards-setting organization whose standards complement those of the Financial Accounting Standards Board in financial accounting.

TCFD: The Basel-based Financial Stability Board, chaired by Bank of England Governor Mark Carney, created the Task Force on Climate-related Financial Disclosures.

UNPRI: The United Nations-supported Principles for Responsible Investment is a network of institutional investors representing US$70 trillion in assets under management (as at August 2017). AGF is a signatory to the UNPRI.

ESG INDEXES AND RATINGS

DJSI: Dow Jones is a subsidiary of the publicly held U.S.-based firm News Corp. Dow’s Sustainability Index, launched in 1999, relies on corporate sustainability assessment provided by RobecoSAM, a Swiss investment company with a focus on sustainability investments.

Morningstar: Sustainalytics is a Netherlands-based privately held company that collects sustainability information on publicly listed companies and, since 2016, provides ESG ratings for Morningstar ESG indexes.

MSCI: The publicly held U.S.-based MSCI publishes many financial indexes and also delivers ESG ratings on 6,400 companies. In 2010, it created the ESG Index.