Responsible investment is on the rise but does the ESG emperor have any clothes?

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25-Nov-19

Aidan Davy of the International Council on Mining and Minerals says investors demand transparency from companies, but are opaque about how they use ESG information, raising questions of whether they are having an impact.

This story first appeared in Ethical Corporation on 25 November 2019.

The rise in responsible investment is seemingly inexorable. The Principles for Responsible Investment (PRI) now boasts over 2,300 signatories, representing close to a dizzying $90trn in assets under management. To put that number in context, responsible investment criteria apply to investments worth four times the GDP of the US. But beneath the headline numbers, important questions remain over the extent to which this is a driver of responsible behaviour by investee companies.

First, are processes for ESG integration too opaque? Investors rarely disclose specific details about their internal processes for integrating ESG factors into investment decision-making, and the relative weight assigned to ESG factors is completely opaque. A double standard applies to disclosures. Investors express frustration with mining companies’ inability to provide readily comparable data on an asset-by-asset basis to facilitate the investment decision-making process.

However, they are typically coy about how they use the information – their descriptions of how they integrate ESG factors vary from science to art to alchemy. So mining companies are likely to be subject to increasing demands for ESG data and details of how they factor ESG issues into their allocation of capital, but can’t expect reciprocity from investors in terms of disclosure of their investment processes.

Second, is investors’ obsessive focus on data healthy? The opacity around how investors use data might matter less if companies were not under increasing pressure to provide information directly to investors – or to the research/ratings agencies. The latter play an important role, especially where investors have limited capacity to undertake their own ESG research. However, this can result in large numbers of contradictory data requests to companies. The rating agencies also typically place a lot of emphasis on controversies, irrespective of a company’s ability to manage these.

But does all this data offer real insight? Investors will tell you that aggregate data – eg through GRI reports – has limited value (with the possible exceptions of carbon and safety). But how insightful is asset-level data for many important sustainability issues? It is very possible for a company to disclose asset-specific data on issues as diverse as water, biodiversity, or human rights, without providing any confidence to investors that such issues are well-managed. For many ESG issues, shouldn’t we be far more concerned about quality of management at the asset level rather than data?

Third, is the current risk focus of investors far too narrow? I would argue that ESG factors are still primarily regarded through a risk lens – a lens that encourages tunnel vision and often ignores “peripheral” concerns. Investors expect a company to be able to clearly articulate its ESG risks, how these risks connect to core business, and to outline strategies to mitigate risks. But where ESG risks don’t have a direct and tangible connection to enterprise value, for the most part investors aren’t interested. I would argue that responsible companies should understand and address a range of environmental and social concerns that may not impact on enterprise value, other than through the blunt instrument of reputational impact.

Similarly, investors have shown very little interest in positive impact. Neither ESG research agencies nor investors give much, if any, credit to companies that create positive social value through their investments. Investors may regard the creation of social value (which can include environmental protection) as a useful risk-mitigation strategy. For example, if a community believes that it has received value from a local mine, they are less likely to disrupt its operations. But little if any credit is given to positive social or environmental value creation.

Finally, does the ESG emperor have any clothes? In the Hans Christian Andersen fairy tale, a pair of canny weavers persuade the emperor that they have woven cloth of such delicacy that only the discerning and clever can appreciate it. Is there an analogy here with the integration of ESG into investment decision-making? And does the answer to the first three questions matter – the opacity on the part of investors, the focus on quantitative data as opposed to quality of management, and narrow focus on risk? I would argue that it does, as it remains unclear to me whether ESG has a meaningful impact when it comes to the allocation of investment dollars. I believe there is an extraordinary prize to be won if investment decision-making can be made more transparent, and more responsible.

While the growth in responsible investment implies dramatic progress over the past decade, I believe we need much greater line of sight on how ESG issues are integrated into investment decision-making if this is to become a driver of responsible behaviour on the part of companies. I also believe the investment community needs to pay much more attention to the quality of management of ESG issues rather than data disclosures that are often of dubious value, and move beyond a narrow focus on risks with a direct and tangible connection to enterprise value. Lastly, they also need to find a way to give credit for social value-creation.

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Aidan Davy is Chief Operating Officer of the International Council on Mining and Minerals.