Capital Flows, Data, Policy and Regulation

The developing art of measuring ESG performance

From IFRS’s newly launched International Sustainability Standards Board to CalPERS’s data convergence project, where are we in the complex and multifaceted challenge of quantifying companies’ environmental, social and governance performance? 


While there is an increasingly clear consensus around the importance of assessing environmental, social and governance (ESG) factors in the long-term value of assets, there is no such agreement about how to do it. At a time when many entities are publishing plans to drastically reduce carbon emissions, this becomes a question of not only assessing performance today, but how to measure whether improvements are being made. This helps judge the credibility of plans with targets decades in the future.

There is also the parallel problem of uneven disclosure — without reliable information from companies about carbon emissions, and other important ESG data points such as energy use or staff diversity, it is impossible to accurately judge their performance. But such disclosure remains largely piecemeal and can vary in quality considerably between companies, if they even publish any such data at all.

Adoption period

While it can be very easy to take a ‘glass half empty’ view of these issues, this is also an area that has developed significantly in recent years. Engagement is high across a range of stakeholders and there is a willingness to have serious discussions about how to move forward.

Remy Briand, global head of ESG and climate at indices and financial market data provider MSCI, believes that the world is now in a fast-moving “adoption” period for ESG performance measurement and disclosure. “Even just five years ago, many portfolio managers were not fully engaged on these issues, and many were still not convinced about the potential for them to have a financial impact,” he says. “We have now moved beyond that, and there is far greater acceptance of the long-term risks and opportunities associated with ESG. Managers are now interested in understanding the impact across their full portfolios.”

Regulatory progress

A host of regulatory developments and industry initiatives would also seem to bring the promise of major developments in the coming years. For instance, in 2017 the Task Force on Climate-related Financial Disclosures, a group convened by the Financial Stability Board, gave its recommendations for how organisations can develop and publish effective data about their climate-related risks and opportunities. Since then, according to the TCFD, 83 out of the world’s 100 largest companies now support or report in line with its recommendations, and more than 50 per cent of companies now disclose their climate-related risks and opportunities. A small number of national governments, such as the UK, have also committed to mandating adherence to its recommendations for companies in their country.

In November, the International Financial Reporting Standards Foundation, the global body for international standards and co-operation on accounting, announced the formation of a new International Sustainability Standards Board, to develop a set of universal sustainability disclosure standards. The body, which will build on the work of prior groups, such as the Sustainability Accounting Standards Board and the Climate Disclosure Standards Board, has already published prototype requirements.

There have also been developments at a more regional level — the EU in particular continues to be a leader on these issues with its European Green Deal, green taxonomy and sustainability-related disclosure regulations, the Sustainable Finance Disclosure Regulation and its envisaged Corporate Sustainability Reporting Directive. The EU approach is having wider influence, for instance with the UK currently considering the composition of its own green taxonomy. In the US, the Securities and Exchange Commission is widely expected to introduce new ESG disclosure requirements for listed companies, with its Climate and ESG Task Force already engaged in this area.

However, there is clearly still considerable progress to be made — for instance, climate and financial markets think tank, Carbon Tracker, recently published research highlighting that many of the world’s heaviest carbon-emitting companies did not include disclosure about climate risk in their 2020 financial statements. 

Best practice examples

As the regulatory environment develops, and as scrutiny from a range of stakeholders increases, standards of disclosure are likely to improve.

There are already some examples of companies taking a more innovative approach — such as those including direct and indirect carbon emissions, and the impact of such carbon — in the calculations of their performance. “We’re starting to see some examples of companies using carbon-adjusted earnings per share (EPS) figures,” highlights Keith Tuffley, global co-head of sustainability and corporate transitions at Citi. “These look at the notional price for their Scope 1 to 3 carbon emissions and then apply that to their EPS figure, to give investors an insight into what that figure would be if they were paying a carbon price. That’s interesting because often what investors are really interested in is EPS growth, and if a business is decarbonising then the growth in carbon-adjusted EPS should actually be at a higher rate than a non-adjusted EPS.”

Emily Rose Laochua, a managing director in Credit Suisse’s ESG financing group, believes that “most participants in this community would accept that there’s still a lot of harmonisation that needs to happen around ESG data”. However, “the sector has also already developed substantively. For instance, large-cap companies have the resources, people and skills to implement best-in-class ESG disclosure and strategies, and those best-in-class approaches feed into what the small and mid-caps are doing, even if they don’t have the same level of resources,” she says.

More data to process

It is, however, difficult to get away from the fact that even when companies are providing better ESG data, it is still relatively early days for being able to assess what ‘good’ looks like, both for an individual company and within a broader industry; how to rate performance over time; and, crucially, how its performance against ESG metrics will impact it financially. Although more data is becoming available all the time, there is far from a common understanding about how best to interpret it.

“The fact there is more — and more detailed — data available is an unqualified good thing,” says Eric Pedersen, head of responsible investment at Nordea Asset Management. However, “it does create challenges because, of course, the more information you have, the more there is to process,” he adds. “And I think that’s really at the heart of why this becomes difficult, because for a portfolio manager already looking at a range of financial indicators, also looking at ESG factors can be a heavy time-demand.”

Material impact

Materiality — the idea that the material impact of an ESG factor on a company’s value will vary depending on the nature of what it does — is also important here. For instance, metrics around water pollution are likely to be highly relevant for a chemical company, whereas for a clothing manufacturer data around the treatment of workers in its supply chain may be more significant. As such, the ratings process for each company needs to be relatively bespoke.

“The critical part of doing good ESG analysis is to do due diligence based on the material issues of the company,” says Wim Peeters, vice-president of business development at EcoVadis, a company that provides sustainability ratings for companies. “Each and every assessment starts with a question of ‘OK, what are we looking at, what’s the framework of elements that we want to assess?’. And, indeed, all these elements get a different weight, depending on that materiality. For example, if you assess a company that provides temporary labour, you probably wouldn’t be looking at animal welfare. However, if you were considering a pharmaceutical company then this would be relevant, in relation to animal testing.”

Evolving considerations

This is also far from a static set of considerations. Rating agencies and investors must constantly evolve their approach to reflect developing attitudes and market data around different areas. Pedersen highlights that beyond issues where there is already some understanding about how this may impact a company’s financial performance (such as carbon emissions), there are also emerging areas to bear in mind. “There are also what can be thought of as ‘guardrails’ in areas that aren’t, at the moment, easily quantifiable in terms of financial risk to a portfolio — such as human rights or biodiversity,” he says.

“We’re still in the infancy of putting value on these kinds of factors. And in those areas, it’s about taking a decision that although in the short term, individual companies may not be threatened by biodiversity loss, when you look across the bigger picture this issue clearly poses a threat, and being cognisant of that.”

Indeed, there is a recognition that even though the most material of issues must take precedence in ESG analysis, it is vital to have a wider view. For instance, Briand highlights that although an investor may, for instance, be most concerned about climate change, it is also prudent to understand, at a base level, an asset’s exposure against broader ESG considerations.

Private markets

These are also not only issues in relation to publicly listed companies. For private equity, ESG is also becoming an increasing priority at both the new investment stage and on an ongoing basis for portfolio companies. “Sustainability considerations are integrated into every investment decision across the platform and at every stage: at sourcing, due diligence, transformation and exit, with an increasing level of emphasis at the pre-investment stage,” says Sophie Walker, head of sustainability for private capital at EQT. “We use public benchmarks for these assessments, but we also apply our own bespoke analysis depending on a company’s sector and its peer group. That will be looking at the relative performance within that peer group and at its own trajectory in relation to ESG factors, as well as increasingly its ability to transform the market,” she says.

For a broader set of investors, this is also pertinent when considering whether to invest in an initial public offering — there is a clear interest in understanding a company’s ESG performance prior to its public listing.

Obtaining ESG data for private companies can be more challenging, given the absence of public reporting, and direct engagement may therefore be necessary. Increasingly, agencies such as MSCI and EcoVadis report that they are acting as intermediaries between private companies and investors. Where companies do not want information to be in the public domain, but understand investors will want some insight on it in order to access capital, such agencies can provide a valuable role in making assessments, without potentially sensitive data being revealed to the wider market.

Much like public markets investors, private equity is also grappling with challenges around the proliferation of ESG data and the lack of a standardised approach to it. One response that has already gained considerable support and buy-in across the industry has been the ESG Data Convergence Project led by CalPERS, the California Public Employees’ Retirement System, and the Carlyle Group, one of the world’s largest private equity investment firms. The project brings together a group of large limited partners (institutional investors that invest in private equity funds) and general partners (the firms managing the private equity funds) to advance a standardised set of ESG metrics and a mechanism for comparative reporting.

General partners will track and report on an initial six agreed metrics from their underlying portfolio companies; the data will be shared directly with invested limited partners and aggregated into an anonymised benchmark, beginning with the 2021 calendar year. The initial six metrics are: Scope 1 and 2 greenhouse gas emissions, renewable energy, board diversity, work-related injuries, net new hires and employee engagement.

Megan Starr, global head of impact at the Carlyle Group, says of the project: “This really started from a conversation we had with CalPERS, almost a year ago, where CalPERS was asking reasonable questions about why, when it looks across its underlying general partners, is it not possible to track even a single ESG data point across all of them; for instance, on greenhouse gas emissions or board diversity.”

She adds: “The challenge has been that because every organisation wants more and better ESG data, we have seen a profusion of new frameworks and reporting requirements created … this is not a problem with the frameworks themselves, as very capable people have spent a lot of time figuring out how to define all of these metrics. This is a critical mass problem.”

She explains that the first six data points are only a starting point — the group plans to build on the metrics over time to increase “the nuance, the scope and the rigour”.

Differentiating between narratives

Although understanding of how to measure ESG performance is clearly continuing to evolve across the spectrum, further developments are needed. This will be particularly crucial in the coming years as investors and the broader market must digest all the net-zero and broader ESG strategies being published by a range of companies.

At face value, many companies appear to be making similar commitments, such as to reduce carbon emissions or make improvements in other areas, like board-level diversity. Briand emphasises the importance of looking carefully at what is being proposed. “The headline news is often the same, but it is vital to look at the details. For instance, a firm may only be committing to be net zero on its Scope 1 and Scope 2 carbon emissions, and not Scope 3. Or, even worse, certain parts of the business, such as a particularly carbon-intensive area, are excluded from the plans.”

He also stresses the importance of considering companies’ relative track records on these issues; for instance, the decarbonisation plans of a firm that has had no prior success on this can perhaps be viewed with more scepticism than one that has. Monitoring whether companies actually hit these targets will also be essential.

There are also concerns from some market participants that investors may not be able to discern effectively enough between companies with credible transition plans, and those that are not to the same level. Laurent Bouvier, global head of ESG advisory at UBS, says: “For the vast majority of assets, I think it is possible to tell a compelling story about transition. Whether there is currently enough market discernment amongst transition stories is a question.”

Taking a long-term view

Bouvier also raises the important issue of whether markets are taking a considered enough approach to assets that are regarded negatively in the context of transition. He says: “I think we are getting to a point where in certain sectors you might struggle to obtain finance, and that, I think, is problematic. These are companies with employees, technologies and expertise, and that often are still fulfilling an important purpose in the current economy. I believe there is a social responsibility for the approach to these ‘stranded assets’ to be actively managed and where possible, strategically repositioned.”

There are concerns there could be perverse consequences if companies rapidly spin-off, divest or close down assets that could potentially taint their ESG credentials, without proper consideration of the long-term consequences. Kevin Smith, vice-president of investment banking at Goldman Sachs, speaking in a recent Refinitiv webinar about the emergence of ESG-linked shareholder activism, commented that this is an issue that investors and companies with carbon-heavy assets increasingly need to grapple with.

“There is a big question about whether it is a better option for folks to keep assets and manage them in a responsible way that aligns with overall societal objectives, versus selling them or putting them in the hands of maybe less responsible actors,” Smith said. “I think we’re going to see a lot of change in terms of how investors and broader stakeholders think about particular industries that are going through these transitions. Because it’s a very tricky dynamic in terms of what’s the best option, both for the company itself and also for the impact more broadly in society.”

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