Better Data Is Letting Companies and Investors See Trillions in Climate Risk – Yale Insights

Better Data Is Letting Companies and Investors See Trillions in Climate Risk Yale InsightsBetter Data Is Letting Companies and Investors See Trillions in Climate Risk Yale InsightsRead More

Q: How do you define ESG?

ESG refers to environmental, social, and governance performance attributes. ESG became a buzzword and a concept in and of itself in the last 5 to 10 years as investors started to see data that suggested that external environmental and social trends were creating financial impact on companies.

There has been an explosion of funds labeled as ESG. They are not all created equal in terms of the level and integration of ESG information. Regulators have noticed. The EU has already passed a first draft of a regulation directing fund managers to meet certain criteria in order to label themselves as ESG. They’re explicitly trying to cut out the greenwashing. The U.S. may well follow suit soon.

There are a number of investment strategies that use ESG information. The most common one by far is what we call an ESG-integrated strategy. This is an investor looking to equal or beat market returns and they believe to do that they need to understand the environmental, social, and governance risks facing companies. They see ESG as an additional financial fundamental needed to predict companies’ performance.

There are other ways that you can use ESG. Impact investors are drawing on the same pools of information to do slightly different things. They will accept a slightly lower than market rate return in order to prioritize doing something to help save the world a little bit. Some ESG strategies divest completely from certain sectors or only invest in other sectors.

I see numbers that show a third or more of all global assets under management starting to integrate ESG factors into their decision-making. That rings true to me because I take a broad view of it. If you take a narrower view, the numbers get smaller. It comes down to what you count as ESG investing.

In terms of impact on companies and capital flows, the biggest group is the investor that sees ESG information as financially material.

Q: Why does ESG matter?

ESG is a framework for looking at huge megatrends that are creating risks that companies are exposed to. Climate change comes with severe weather, rising seas, droughts, wildfires. It’s driving the transition to clean energy. Climate-related regulations are here or on the horizon. There are trillions and trillions of dollars of risk. There are also trillions of dollars of opportunity.

Scientists are telling us there is about $22 trillion in exposure to climate change risks over the next 10 years. In the Americas, we’re looking at half a trillion dollars of agricultural productivity lost every year as a result of biodiversity degradation. Those are huge dollar-value risks.

If all these things come to play–climate change, biodiversity impacts, inequality–the general drag on the economy is going to be between 5% and 20% of global output. That wipes out all economic growth at a macro level. That is catastrophic to economic markets in general, but individual companies will suffer more or less.

ESG matters because it’s a way to understand the risks associated with these megatrends, and it’s a way to understand what companies are doing to respond. Is a company going to be paying or making money as a result of these enormous megatrends? Investors want to know if companies are ignoring it or prepared for it. What are their management governance controls–training, auditing, data collection, continuous improvement process, operational performance metrics–that can mitigate the damages from external risks? Are companies moving to take advantage of opportunities? Are they positioned for the renewable energy transition?

Q: Is ESG our biggest bet on a market-driven solution to climate change?

Yes. Governments set our direction through policies and regulations. That’s the steering wheel. A government says, “We need a market-based system to curtail carbon emissions.” Once the mechanisms are set up, then the market steps on the accelerator and says, “Here comes the capital to do that.” Because the flow of capital to address climate change is predominantly around ESG analysis and factors, ESG is the engine right now.

Q: When did ESG become a thing?

ESG is an evolution of corporate social responsibility (CSR) and corporate sustainability ideas that have been around for 30-plus years, drawing on elements of compliance and philanthropy– the idea is that corporations should be responsible citizens.

With CSR and sustainability, companies need to be responsible for the impacts that they create on the environment and society. The arrow flowed outwards from the company to society. With ESG, the arrow flows in. What are the financial risks associated with impacts from environmental and social trends flowing into the company?

One caveat here is that some environmental, social, and governance risks are inherently about perception. Greenwashing can create financial performance through a reputational boost, but it also creates a huge downside risk if you get caught.

Sustainability and ESG are two sides of a coin, so it’s not too surprising the concepts do get blended in practice. The distinction I’d make is that ESG is focused on the financially material aspects of environmental, social, governance on the business, whereas sustainability is implied to have a broader lens on those aspects that might not be financially material to the company but are still the right, good, and responsible things to do.

Q: What sorts of costs do you see with an ESG lens?

There are three buckets: direct, indirect, and intangible. For direct, there are obvious ones. In regulated markets where there’s a price on carbon, companies pay per ton of carbon produced. Another example is climate change creating more difficult operating conditions. A company might have to put resources into adapting processes, building seawalls, or even moving their operations.

Human capital can become an indirect cost. If you’re in an area where the education system isn’t robust or there isn’t a social safety net that allows people to pursue advanced degrees as opposed to having to go straight to the workforce, that costs companies money, because they can’t get the best people or they have to pay more for the equivalent people.

Finally, there’s the intangible. Historically, about 80% of the stock price of publicly traded companies was the book value, while 20% was intangible. That has completely flipped today. Now in the S&P 500 almost 80% of stock price is intangible value.

Intangible value is so tied up with brand and reputation that any action by a company that reduces its social and environmental capital can reflect back with an outsized impact on their stock price: i.e., people look at a company’s ESG choices and say, “Oh, you’re not a responsible company. I’m not going to purchase from you,” or, “I’m going to say bad things about you on social media,” or, “I’m not going to work for you because I consider you to be evil.”

The challenge for an investor, with any given company, is, which of these aspects should I be most concerned about? How is that cost, that damage, or that opportunity going to come into the company? And how do I assess whether they’ll be able to mitigate or manage those risks?

Q: Is that why we’ve seen an explosion in ESG data?

Over the last five years we’ve seen a hockey-stick-like rise in ESG data. Investors have been pushing for better and better data, specifically to understand the mechanism by which the risk is going to materialize within the company and whether the company has the means to mitigate the risk.

When we started seeing empirical studies showing that companies with stronger performance across a broad swath of ESG tended to do better financially, that led to a narrative of, we don’t know exactly what in ESG is driving this, but we know in aggregate it is.

Many companies were already putting out voluntary sustainability reports, typically following the Global Reporting Initiative or similar standards. In addition, we’ve been seeing more disclosure in the financial reports around climate change, severe weather, inequality, etc., as companies realize these are important fiduciary issues.

Data analytics firms scrape both company-reported data and huge outside datasets to try to understand companies’ exposures. Everything becomes a source of information. An analytics firm measures the length of the shadows cast by the floating lids on 20,000 oil tanks around the world to understand oil inventory. Investors want data on how many assets a company has in tornado alley. Do they have sufficient insurance coverage? Do they have backup generation and a business resilience plan?

All of this has led to two things. First it has exponentially increased the transparency on companies in ESG. And second there’s this push to figure out what exactly we are looking for.

Q: Do we know what we’re looking for?

The level of nuance in the data lets investors track down correlations between financial materiality and ESG aspects. The holy grail is the causal relationship. Investors want to know, “Companies that do this are going to perform better financially.” They’re trying to find the “this.”

Here’s an example of the learning curve we’ve seen. Pacific Gas and Electric (PG&E) has famously strong sustainability reporting. Yet it declared bankruptcy as an indirect result of climate change. The company was held liable for wildfires caused by line sparking, which were exacerbated by climate-driven drought conditions.

PG&E’s sustainability reporting focused on their incredible greenhouse gas reduction targets. They didn’t highlight how climate change could impact the company itself and how they were responding.

As companies and investors get better at this, they learn to report how climate change is being internalized by the company. PG&E’s assets are predominantly in drought and water-stressed regions of the United States. Fire danger was key, so what investors would have liked to have known what the plan was for preventing sparking of transmission lines.

We’re at a point now where, through these huge datasets, we can try to figure out the externalized risks and whether companies are responding. Those internalization pathways are not always obvious, but that’s where we are.

Q: The E of ESG gets a lot of focus. Why is there less on S and G?

E has better data. We know the impacts of climate change. We’re understanding the impacts of biodiversity. Those are huge megatrends; we understand how much money is at risk.

The S is much more difficult to measure. It’s hard to point to an individual company and say, “Do they have the S right or not?” Some social aspects–inequality; diversity, equity, and inclusion; and human capital management–are becoming clearer in terms of the scale of the potential impact and what data is needed to track within a company. But there’s a whole lot of S that is much more difficult to assess.

The reason we don’t talk about the G much is that governance was a big deal in financial markets long before the ESG acronym came into place.

Q: Is there a role for government?

The role of government is huge and important in sustainability and ESG.

We still need to protect people’s health. We still need to protect species whose extinction won’t have financial repercussions for companies. Areas where markets aren’t providing clear guidance, yet they’re important to society–that’s where governments are supposed to function.

Q: Where do things stand with regulators?

The SEC hasn’t established any regulations yet, but they’ve reopened the books on the definitions and best practices of ESG disclosure and materiality. There was also a red flag warning by the SEC about fund managers advertising climate benefits without having the evidence to back that up. In regulator terms, they’re moving pretty quickly

The EU has begun to enact regulations, so the SEC now has a template that they can use. I think that we’ll probably see some sort of guidance around climate change come out of the SEC in 2022. After that we may get guidance around ESG disclosures more broadly.

Q: Based on your research, what does this whole thing look like from within companies?

We looked at ESG information flows within organizations, focused in particular on climate risk. We found that cross-functional committees are incredibly important. Drawing in operations, finance, marketing and communications, investor relations, general counsel, and so on lets companies develop different perspectives on ESG data and integrate it into enterprise risk management.

One of the big shifts from corporate sustainability of yesteryear to today’s ESG is the increasing role of the general counsel. The legal implications of calling an ESG issue financially material are much more significant than saying it’s important to a lot of our stakeholders. And it’s not just the disclosure side; general counsels are, in some cases, very concerned about the potential liability associated with making claims in ESG. Even if the claims can be supported, the worry is it opens companies to liability that would be outside of marketing speech.

Q: What are you imagining in terms of a positive approach to standardizing and regulating this reporting?

[The Yale School of the Environment’s] Dan Esty and I have proposed a theory of change on the policy side. We envision a three-tiered structure of disclosure that we think will be effective at meeting the expectations of most institutional investors and large asset managers, helping to ease the burden on companies and also creating more capital flow to sustainable investments.

At the core of this policy proposal would be a small set of ESG indicators that are clearly financially material to the vast majority of the economy. Think financial risk from climate change, biodiversity and ecosystems loss, socioeconomic inequality, and maybe social safety nets.

With this small set, it makes sense to have a regulation that says, “We’re all going to report on it in the same way, and this is how we’re going to do it.” That would serve investors, the constituents of that government, and those who can use the information flow it generates to understand issues and frame national policy.

A second tier of indicators are sector specific. In those cases, we would not propose a regulation. Instead, we see the companies in the sectors, together with academics, policy experts, and civil society representatives, hammering out best practices in reporting. If the handbook is in front of you, it’s easier to start disclosing, so most companies would, especially when investor interest creates a market lever to incentivize disclosure.

And the third tier is, for lack of a better term, the great unwashed of ESG metrics. It’s that huge pool of reputation information, social media, geospatial data, and everything else some investors tap into to try to find advantage.

We envision that as purely voluntary. Companies can disclose it if they want to try to influence the narrative, or they can keep their mouth shut and let investors and civil society try to figure it out themselves.