Balance and Flexibility Are Keys to Building ESG Confidence

Real Clear Markets

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Environmental, Social, and Governance – ESG – has been growing in prominence as its application becomes essential to investor decisions and for businesses throughout the world who work to adhere to an evolving array of ESG framework principles.  As more stakeholders engage, ESG is playing a decisive role as investments are evaluated and decisions are made which will ultimately affect the returns on those investments and, importantly, the costs and allocation of capital.

For multinational firms, especially those publicly held and whose ESGinvestment profiles and operations are already subject to growing review and verifications, the ability to identify meaningful and measurable frameworks is imperative. With ESG frameworks and practices at a relatively early stage of development, a look at three key regions across the globe highlights the ESG state-of-play and suggests why now is the right time to start building the processes and principles that will help balance the ESG and financial results and provide the flexibility that businesses and their investors need to achieve:

In the U.S., the Securities and Exchange Commission (SEC) under the leadership of former Chairman Jay Clayton, had considered existing securities laws and financial materiality standards as sufficient. However, driven by developing ESG trends and investor demand, recommendations within the SEC’s Investor Advisory Committee in May 2020, suggested the establishment of ESG disclosure requirements for publicly traded issuers and urged creation of a principles-based framework.  That work continues under new chair, Gary Gensler, with the SEC responding with the creation of a Climate and ESG Task Force and a timely request for public comment on climate change disclosures. New mandatory ESG disclosure proposals are anticipated in the fall of 2021, including rules targeting climate, human capital management, cybersecurity, and diversity.

In the European Union (EU), the ESG process has evolved with new rules for European financial products, advisers, and managers that came into force in March of this year through the Sustainable Finance Disclosure Regulation (SFDR). SDFR is designed to help financial institutions meet climate change goals by directing capital toward ESG and sustainable impact investing. This will affect an estimated $3 trillion of investment outside the EU, as affected firms consider what to measure, monitor, and report on ESG performance that will now be within the regional scope of the SFDR.

In the Asia Pacific region, a 2019 report by the Chartered Financial Analyst Institute: “ESG Integration in Asia Pacific: Markets, Practices, and Data,” suggests there are varying levels of ESG awareness and integration in Asia-Pac countries.  According to the report, portfolio managers are increasingly incorporating ESG factors in their investment processes. However, with ESG in its relative infancy, investors and analysts are calling for more guidance on, as the report states, exactly “how” they can “do ESG” and integrate ESG data into their analysis.

The capital investment potential covered in just these three regions is vast and growing. As policymakers and institutional participants implement ESG frameworks and metrics, they are finding that if ESG is to yield its anticipated benefits, the near term race to simply “do ESG” cannot be allowed to compromise the long term benefits that smart and well thought out ESG frameworks can help to achieve.

The key issue in “doing ESG” is, of course, materiality. That is, reporting should include metrics that help investors’ decision making. Environmental, social, and political pressures will continue to create confusing expectations, but they can also be a catalyst for constructive conversations and collaboration that can spur a balance of qualitative and quantitative metrics and favorably resolve differing interpretations of financial and legal materiality.

Further, reporting systems must be flexible and principles-based. Highly prescriptive requirements are likely to create significant difficulties when comparing metrics across business sectors and in different countries.

Understand that it will take time to develop effective and balanced frameworks that comprehend desired ESG and financial outcomes.  Knowing that, policymakers and regulators need to keep in mind that this work is critical to long-term investor and stakeholder confidence in ESG.  As such, it is now important to advance the forums that will encourage collaboration among all appropriate stakeholders to be flexible and to balance financial and ESG frameworks and metrics to ensure that the positive outcomes ESG is designed to achieve are fully realized.

Michael J. Roman Is a non-resident Senior Fellow at American Council for Capital Formation. He’s also President of CertainPoint Strategies L.L.C.