Tackling ESG for the Future
This week is Climate Week, so we thought it was a good time to look at what’s going on in environmental, social and governance (ESG) investing.
ESG investing is finally starting to gain traction in the U.S. But ESG data doesn’t naturally flow out of company accounting statements, so building an ESG-focused portfolio requires a whole new set of disclosures by companies.
Regulators in Europe and the U.S. have proposed standards to help standardize ESG disclosures for investors, which could help with ESG portfolio construction. But it’s also a lot of work, and companies are concerned that the costs of these new rules significantly outweigh the benefits.
Expanding on our first analysis of ESG, today we look at these competing dynamics with:
- Data on ESG fund flows
- A summary of some regulatory initiatives to provide investors with consistent ESG data
- An overview of the concerns of companies, including the costs of providing additional disclosures
ESG flows have picked up
This topic is increasingly important, especially because eVestment data shows ESG investor inflows in the U.S. have recently increased. Cumulative U.S. inflows since 2018 were $60 billion in Q2 2022, more than doubling the three prior years combined (Chart 1, dark blue bars).
Still, ESG investing activity in the U.S. remains well behind Europe, which saw $160 billion in inflows over the same period (light blue bars).
For the world as a whole, data suggests cumulative ESG funds inflows have eclipsed $250 billion since 2018, more than doubling in the last six quarters.
Chart 1: ESG inflows are growing in all regions of the world
If the debate about index funds is right, over time, strong flows into ESG could boost “good” company prices, thereby reducing costs of capital and investment competitiveness for those firms.
However, estimates of total assets invested in ESG vary greatly. For example, some report that the value of global sustainable funds was $35 trillion in 2020, while eVestment (which we referenced above) puts total ESG AUM at about $1.2 trillion, and a recent Morningstar report puts it at $2.5 trillion. It all depends on how you define an ESG investment.
Many new proposals to help pick ESG stocks
One of the reasons the assets vary greatly is a lack of consistent data, and that’s because currently, there are no consistent global standards defining what makes a mutual fund or ETF an “ESG” fund, and companies must navigate several voluntary ESG reporting frameworks.
A variety of proposals have been made internationally to set ESG standards, including:
- TCFD (Taskforce on Climate-related Financial Disclosures) developed recommendations to assist companies with the disclosure of climate-related metrics, targets, and transition plans.
- ISSB (International Sustainability Standards Board) recently released its first two proposed standards based on the TCFD recommendations. The first sets out general sustainability disclosures, while the second specifies climate-related disclosures.
- European Financial Reporting Advisory Group (EFRAG) has issued draft European sustainability reporting standards to standardize ESG reporting in the EU.
- IOSCO (International Organization of Securities Commissions) has adopted a 2022 work plan to develop sustainable finance by increasing transparency and mitigating greenwashing.
But there are also changes afoot in the U.S. In fact, the SEC has three separate rule proposals currently under consideration that impact companies and funds, including:
Company reporting of climate metrics: Companies would need to include climate-related information in their SEC reports, such as their Form 10-K. This includes:
- Climate-related risks to their business from things like office and factory locations. For instance, if they could be impacted by rising sea levels, increased fires or water shortages.
- Green House Gas (GHG) emissions from their own direct (Scope 1) and indirect (Scope 2) emissions, as well as those of their suppliers and customers (Scope 3) if they are material or part of an emissions reduction target.
Fund disclosures: Additional fund disclosures by ETFs, mutual funds and investment advisors to describe ESG factors in their stock selection methodology. It classifies three new categories of “ESG” funds:
- Integration funds: Use ESG factors as one input in their stock selection process.
- ESG-focused funds: Use ESG factors as a significant factor in stock selection. These funds could apply a screen to include ESG or exclude non-ESG stocks. They could also actively meet with issuers to encourage “good” ESG behavior.
- Impact funds: Aim to achieve a specific ESG-related impact, like financing clean water or sustainable logging.
Fund names: Tightening the rules in the Investment Company Act of 1940 (Rule 35d-1) around the naming of funds:
- 80% investment: This will require funds to invest at least 80% of their assets with the investment focus the fund’s name suggests, including funds with ESG-related names.
- Misleading names: Prohibit a fund from including ESG in its name if ESG factors are not the main consideration (which will affect “integration funds”) or if the fund makes anti-ESG investments within the other 20% of the portfolio.
Importantly, most of the SEC’s new rules focus mostly on improving “E” disclosures, although the rules proposed by the SEC are modeled in part on the TCFD’s recommendations.
Nasdaq issued comment letters in response to the SEC’s company climate reporting proposal and fund disclosures/names proposals expressing concerns that the proposals would impose additional complexity, costs and burdens on issuers, suppliers, and ultimately, investors.
What do companies think?
Index providers and portfolio managers are seeking more standardized ESG data and disclosures, while the data collection and calculation will mostly fall on companies. Although as investors' returns are based on the profits of companies, the additional costs and burdens will ultimately be borne by investors.
A recent survey suggests only a third of companies are already largely aligned with the recommendations in TCFD, and 36% were either not aligned or not familiar with the TCFD recommendations.
That’s partly because companies report relatively low demand for these types of disclosures – with 68% of respondents saying their investors “seldom or never” urge them to disclose more information regarding climate change. Only 5% say their investors “regularly” urge them to disclose more climate change-related information.
Chart 2: The majority of companies are still not experts in international reporting standards
Many companies also question the cost-benefit of all these new disclosures, especially when some of the reporting will require evaluation and attestation by experts.
The survey shows that 73% of respondents believe U.S. sustainability reporting compliance costs will be higher than the SEC estimates, which the SEC believes will be around $500,000 per year. In fact, 41% of respondents expect their ongoing costs to exceed $1 million, more than double the SEC’s estimates.
Chart 3: Companies estimate costs will be much higher than the SEC estimates
Adding to the complexity and costs of reporting is compiling Scope 3 (value chain) data. Our survey found that 99% of companies affected say not all of their suppliers provide reliable information regarding Scope 3 emissions. Other data suggests that 93% of small-cap companies (less than a $700 million market cap) do not report emissions.
That makes compliance with this proposed requirement extremely challenging, if not impossible, for the vast majority of companies.
Chart 4: Very little data is currently available to compile Scope 3 emissions
While issuers are concerned about the costs of compiling data related to climate disclosures, they are still communicating their ESG strategies. Next week, Nasdaq Corporate Platforms will be publishing its third-quarter ESG report, which will highlight how issuers are discussing their ESG strategies on earnings calls. Based upon the findings from the second-quarter report, companies across all sectors are increasingly discussing ESG during their earnings calls, even if they are not formally disclosing certain metrics or following specific frameworks.
Getting ESG right is tricky
In the past year, we have seen droughts around the world and a record hot summer in many regions, some of the things many climate experts said would happen. But ESG disclosures are still evolving among companies, with smaller companies just getting started.
If better disclosure could attract more investors, it may make a difference to companies' costs of capital. If companies focus more on sustainability because of that, they might also be better positioned to profit, or avoid losses, from climate change – creating longer-term returns for investors buying into ESG.
But from an economic perspective, most of the positive externalities (like a cooler climate) accrue to everyone (even non-investors), while in the short term, the costs of compiling data and changing behavior fall mostly on companies.
Getting ESG reporting right might be important, but it seems it isn’t going to be cheap or easy.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Phil Mackintosh
Nasdaq
Phil Mackintosh is Chief Economist and a Senior Vice President at Nasdaq. His team is responsible for a variety of projects and initiatives in the U.S. and Europe to improve market structure, encourage capital formation and enhance trading efficiency.
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