Financial institutions face an array of conflicts and conditions in determining the environmental and social impact of investments and assets and how to report  them for regulatory or corporate purposes.

Environmental, social and corporate governance (ESG) frameworks are underpinned by the UN’s 17 Sustainable Development Goals (SDGs), which are intended to be a “blueprint to achieve a better and more sustainable future for all” through addressing challenges such as poverty, hunger, health, education, biodiversity and climate change.

While a handy blueprint to demonstrate the ESG performance of a company, business model or investment strategy, the SDGs themselves demonstrate the size of the challenge in measuring impact on the environment and society, given how disparate and even contradictory the aims are.

For example, climate action is generally the aim that receives the most attention in the media and elsewhere. Therefore, most financial institutions will wish to place efforts to curb carbon emissions front and centre of their sustainability proposition. 

Banks may for example announce that they are no longer financing the fossil fuels industry, either in lending or investment. Institutions that continue to invest in this area however can argue they are helping to provide cheap and reliable energy, which could have far-reaching benefit for the 580 million people in Africa without access to electricity. Addressing this can in turn improve healthcare, education, sanitation and generally improve the quality of the life of people otherwise living in extreme poverty.

Divestment from fossil fuels may therefore appear to address climate change but little else. If developing economies are unable to harness natural gas resources for basic domestic purposes such as heating and cooking, the result may be that people instead burn wood, resulting in widespread deforestation.

This underlines the challenge for financial institutions in quantifying the ‘impact’ that their money is having. With the exception of a very select few areas, there will always be an argument to be made for both the positive and negative impact that an investment will have.

“Measuring the impact of investments is notoriously difficult to achieve, but that doesn’t mean we shouldn’t try,” says Elree Winnett-Seelig, head of ESG for markets and security services at Citi.

“It should start with identifying the correct indicators and metrics for the impact you are trying to measure. The next step is to establish the baseline and realistic interim targets against which the firm would report.”

Seeking standardisation

This is where financial institutions are seeking universal standards for reporting ESG performance and measuring the impact of investment, lending and credit.

Different asset managers will have their own strategies and methods of gathering information and data to provide their own ‘in-house’ view about ESG performance and sustainability and use this to support their own investment strategies.

Standardisation however can provide the transparency and immutability of data relating to ESG impact to inform decisions across all financial services, and there will therefore be demand for data solutions that can provide this.

“We have a plethora of reporting standards initiative idiosyncrasies whereby each institution adopts what works best for them and you don’t have comparability across institutions and you don’t have bodies that everybody’s aligning to,” says Daniel Hanna, global head of sustainable finance at Standard Chartered. 

“There’s the TCFD (Task Force on Climaterelated Financial Disclosures) to some extent, and there’s EU sustainable finance reporting directives, but they’re only being adopted piecemeal. We don’t see a Bangladeshi company reporting under the EU standards, for example.”

Multiple reporting frameworks are cumbersome and resource-intensive and are also putting smaller firms at a disadvantage and stopping them from providing a sustainable investment proposition to their clients.

Standardisation can therefore address the pain points of retail investors or smaller companies without the resources to manage differing standards and data sets.

“Small and mid-sized investors and asset managers may not have the scale to properly resource integration of the disparate datasets, either raw or thirdparty,” says Winnett-Seelig.

“This can create asymmetric markets which will simply slow widespread integration of ESG in investment decisions.”

Is it achievable?

Despite the consensus that a universal standard should be sought, comparable with international reporting standards for financial statements, there remains the question to what extent it is achievable.

“We have achieved a high level of standardisation in financial reporting, with specialised accounting principles for some sectors, so there is no reason why we couldn’t achieve a similar level of standardisation for sustainability reporting, particularly because these ESG factors can be financially material to a company,” Winnett-Seelig says.

“The question is one of will and time frame. Already, we now have climate data sets and tools that we didn’t have five years ago, and they will continue to improve.”

One of the main impediments is that current ESG reporting is as subjective as it is based on empirical fact, meaning financial institutions must offer clients a range of different ESG scoring solutions to cater for different priorities and other political, economic or social views.

“You can look at a number of very large cap companies across different industries and you’ll find polarised opinions across different ESG ratings providers,” says Chris Johnson, senior product manager of market data at HSBC.

A prime example of this is the electric car industry. An electric vehicle will help to reduce emissions and pollution while being driven, but will still have a substantial carbon footprint before it has been driven, due to the emissions caused by the production of the battery. There is also the potential unscrupulous labour practices involved in the mining of the battery’s materials in some of the world’s poorest countries to be considered.

“Some ESG ratings may be looking at how a company operates - the materials that they use, the workforce practices, how they’re governed and so on and that’s their priority,” Johnson says.

“Others will just look at the postproduction impact of low emissions and the transformation of the car industry. So, some will say the company’s a top performer; others will say it’s actually a poor performer.”

This helps to explain why there is very little in the way of standardised ESG data, given the seemingly infinite number of variables that must be accounted for.

“There are different ways of interpreting sustainability issues,” Frances Barney CFA, head of global risk solutions, BNY Mellon, says.

“So, you could provide an accurate number that reflects a disclosure from a corporate issuer. But does that directly translate to investment’s impact on global warming?”

Any ESG reporting relies on a number of assumptions being made that there will be debate over from one institution to the next.

Some will look at wind farms, for example, and judge them to be sustainably sound investments thanks to the carbon emissions that will be ‘saved’ thanks to electricity not being generated by burning coal or gas.

Another institution however will focus on the amount of coal used in the production of a wind turbine or the amount of land or sea area that the farms take up and the effects this has on biodiversity. Nothing is straightforward when it comes to measuring impact on the planet.

“Accurate reporting is possible, but are you accurately predicting the specific outcome that an investment will have? That’s debatable,” Barney sums up.

Engaging in values

“There could be a standardised taxonomy and framework but I don’t think a single set of single, standard reports is achievable because regulatory frameworks are so different and different institutions and investors have different interests,” Barney says.

Standardisation could be achieved in a context of communication and understanding specific objectives and implications, so that investors are able to report on the issues that they most care about.

Therefore, financial institutions may choose to approach ESG from a values perspective and use it as a means of engaging with and challenging a company over its environmental, social and corporate governance performance.

Where a company is rated poorly, they should seek to understand why that is and what their transition to improve and engage with them in doing so.

“On the one hand, you can decide to exclude any investments that don’t meet the mark in a particular area of importance,” Johnson says.

“On the other, you can stay engaged with a company and work with them, vote at their meetings and so on, to encourage them to come up with targets to improve.”

Financial institutions are by and large favouring the latter. Therefore, rather than focusing on the absolute standardisation of ESG-related data to assess the impact of a company or a portfolio in the here and now, they will require tools and metrics that can measure progress and how transition is being managed going forward.

Finextra Research's latest report, 'The Future of ESGTech 2020', explores the challenges and opportunities in finding value in the data web of sustainable finance, with insight from an array of financial institutions includinig HSBC, Citi and BNY Mellon. Click here for more information