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Transparency in ESG investing: Full disclosure

7 Dec 2020

Regulators are increasingly targeting asset owners in a bid to raise corporate transparency standards, but how effective are pension schemes at collecting sustainability data from their portfolio companies?

Sustainable investing has a problem. Institutional investors setting policies that forbid them from backing excessive greenhouse gas emitters, companies lacking diversity in their leadership team or those with children working in their supply chain is as easy as uploading a statement to a website.

Proving that your capital is being invested within the boundaries of such policies is a lot harder. Corporate strategies may be evolving from pleasing shareholders to also keeping employees, consumers and local communities happy, but one issue will not change: investors will always want to measure the performance of their portfolio. The growing focus on the non-financial aspects of corporate life is where the problem lies with sustainable-led investing.

There are very few regulations forcing corporates to release information on how they are protecting the planet or building a better society, but this is changing. Some investors did not see the scandal coming at fashion house Boohoo this year and were happy to hold the stock. But an investigation by the Sunday Times found severe shortfalls of health and safety practices in factories making clothes for the retailer while workers were being paid well below the living wage.

When the scandal broke, investors lost money and Boohoo had to mount a huge PR campaign. To avoid a repeat, regulators are increasingly making pension schemes responsible for ensuring that the corporates they invest in are performing sustainably.

Earlier this year, The Pensions Regulator outlined that it expects trustees to explain how they are protecting their members’ retirement funds from climate risk. This requires data, so it is a case of hand it over or you will not see our money.

“The whole thrust of the regulations around sustainability and climate at the moment centres on transparency and disclosure,” says Tim Manuel, head of responsible investment in the UK for Aon. “That is one of the fundamental pillars of almost every piece of legislation that is coming out at the moment.

“The changing tactics of regulators has been to target asset owners rather than necessarily target companies. It is imposing that requirement on the people at the top of the decision making pyramid.”

“As pension funds need to disclose information, they put pressure on the people who serve them, like asset managers and investment consultants, to help find the answers. “Ultimately, for pension schemes to disclose, they need that data disclosed by the companies that they are investing in,” he adds. “Currently, the level of disclosure from companies is inadequate.”

Greenhouse gas emissions is the only factor where it is mandatory to report. It is also easy to calculate, making Scope 1 [emissions a company generates] and Scope 2 [emissions from energy bought by a company] more easily measurable and definable. Scope 3 emissions, which are harmful gases released by sources not owned or controlled by the company, are more difficult to assess and so only a small number of companies attempt to.

“Even then you find a range of approaches and methodologies among such a small sample, so trying to aggregate in a sensible way is a challenge if you are trying to look at something from a portfolio perspective,” Manuel says. “Greenhouse gas emissions are probably the best piece in terms of disclosure, but there are so many other dimensions of sustainability that investors want to know about in terms of the companies they put their money into.”

This includes waste management, where, Manuel says, details on recycling are “sparsely” reported. How much of the world’s scarce resources are used by companies is another area of interest as is how well employees are treated. “If you scour a company’s sustainability reports you might find a mention of some of these factors, but it is manual job to get this data, so it is hard to compare and contrast within a portfolio,” he adds.

Wish list

There are factors that are relevant to almost all sectors, such as climate change risk, workforce diversity and good governance. But with ESG being such a broad church, the importance of individual ESG metrics varies from industry to industry. In mining, for example, water and energy usage, health and safety and local community interaction are key concerns. In financial services, data security will be paramount, as is making sure that people are not sold unsuitable products.

“There is no one-size-fits-all approach to ESG,” says Gabriel Wilson-Otto, head of stewardship, Asia Pacific, at BNP Paribas Asset Management. “If we look across different sectors, you have to be specific to get the required impact.”

He praises the disclosure standards in the UK and Europe but adds that improvements are needed across the board. “Even in mature areas, such as emissions, if you look at the data, we do not have reported actual numbers for a large percentage of companies,” Wilson-Otto says.

“For a lot of companies, where the data is available there is still an estimate of its performance, it is not an actual reported number.” Fred Isleib, director of ESG research and integration at Manulife Investment Management, would like companies to be more open about the social aspects of their operations, but he understands why some are reluctant to do so. “They do not want to put a target on their back,” he says. “They are not interested in providing information that could create a competitive disadvantage for them.”

Remuneration is one area that could cause a standoff between corporates and their investors. Disclosing a pay gap among senior staff, for instance, could be used to lure key personnel away from the business, but, on the other hand, investors need to know what is happening internally at the companies they are considering investing in. “We need to understand how they are developing, retaining and recruiting key personnel,” Isleib adds.

UK companies with more than 250 staff members are mandated to report any gender pay gap, but it is a different proposition when investing in international companies, making comparisons difficult. One of the reasons why Isleib wants greater openness on corporates’ social aspects, such as diversity, is that it is a potential signifier of future performance. “When I talk to companies, I want to make sure they are fishing from the whole pond, not just part of it,” he adds.

“Ultimately, that will drive better success in the long term for that organisation.” For Manuel, the answer is to make ESG reporting an annual occurrence. “What you want is for this information to be included in a company’s financial accounts. They have a standardised format and methodologies for creating the output and they are also audited, whereas sustainability reports are not.” To get to that stage it needs to be mandated, Manuel says.

This could be through legislation, through the accounting standards setters insisting on it or through a requirement for listing on stock exchanges. “Some geographies and jurisdictions are looking at how that can be done,” he adds.

Areas that remain challenging for Wilson-Otto involves supply chains. “There are issues where quantitative data on performance is not available,” he says. “We find this with supply chains and some of the scandals globally highlight how difficult it is getting pure transparency on company supply chains.”

Changing behaviours

So, what is needed to improve disclosure standards? “Regulation is not the answer,” Isleib says. “What has to happen is that companies need to recognise the value in providing disclosure. “Instead of looking at it from a negative standpoint, look at it from a positive,” he adds. “If you are trying to recruit younger people into your organisation, they can see the publicly available information which could mean that company is seen as being progressive.”

For Manuel, it is interesting to see the behavioural changes that have resulted from existing mandatory disclosure requirements. Pension funds have to put their policies on their website and they have to disclose in an annual statement how they have delivered on those policies.

“They are not just saying what they are going to do, they have to follow up and demonstrate what they have done,” Manuel says. “What I have seen when working with trustees, is that it changes the way they approach these issues knowing what they are saying what they will do and what they do will be played out in the public arena. They can be judged more easily, they can be compared with their peers more easily, they can be called out more easily or they could be celebrated more easily.

“For me, the transparency and disclosure piece is the critical element for the whole drive for pushing the sustainability agenda,” Manuel says. Data on a company’s operations is crucial in ESG, where engagement and improving a company from within is a big part of the strategy.

A lack of disclosure makes this a challenge. “It can be harder to benchmark, harder to map progress and harder engage with the objective of driving change because you do not know where the base line is,” Wilson-Otto says.

“It is easy for a company to say that they have improved if they have not given you any data to evaluate that improvement. “Regulation is one element that may improve the availability of data, but it may not improve engagement with the data,” he adds.

“What we want to avoid is a compliance mindset with regards to dealing with ESG data. As investors we are looking for strategic engagement with the underlying issue, which can help mitigate some of those risks. Regulation could be a great way of directing attention and providing data, but it has to be focused on quantitative of data.”

He welcomes the Task Force on Climate-related Financial Disclosures, which includes governance and oversight in data recording, so more of a discussion of why the data is material to the company and how it is factored into their risk and strategic decisions. But it is not just about regulation. “Influence from investors and stakeholders can play an important part here,” Wilson-Otto says.

“One of the key problems that we find is that companies are saying there is no point recording all this data because not many people ask for it and it is another complex burden that they have to bear. Increasingly, as investors and stakeholder demand the data it will start influencing the ESG rating and will lead more to an internal argument and internal justification.

“Education is required,” he adds. “ESG risk is not just about disclosure and compliance, it is a strategic exercise. We want issuers to see that a lot of the ESG analysis and corporate transparency is not only a regulatory requirement but as a way of better assessing the risk that they will be exposed to in the future.

This should be very much part of the strategic everyday operations for the business. “That mindset shift is happening, but it still needs more capacity building globally,” he adds. Could the new European Mandatory Disclosure Regime help create capacity? It proposes disclosures across all entities within the financial system, including pension funds, investment funds and financial services firms. “It is the whole of system regulation that is needed to make sure that disclosure in one part of the system helps support disclosure from elsewhere,” Manuel says.

For Wilson-Otto, this is a step in the right direction. “It is difficult for an asset manager to report meaningfully on the composition of the portfolio if they do not have granular detail from the portfolio companies on their performance, so it ends up being estimates built on estimates, which can be indicative but may not be precise.

As the data environment improves, the framework that is being put in place now will be increasingly neutral and will provide a real insight into the comparative performance and structure of funds and underlying issuers.”

An independent view

One area where pension schemes can source the data they need is from independent providers. Yet these companies have different approaches to collecting and interpreting the data, which means the outputs vary. “Some commentators say that is a problem, but I don’t think it is,” Manuel says. “It means that it is important to understand the methodology they have taken in their approach. You cannot take the output at face value you need to consider it within the methodology that they have used to create that output.

“The range of providers gives people a choice to find a methodology that aligns with what they themselves have tried to achieve in using that data. “Do I think the world would be a better place if every ESG data provider gave the same output? No, I do not,” Manuel says.

Manulife Investment Management assesses independent ESG data from several sources, which helps the firm to mitigate against bias risk. “I try to differentiate between what is truly a weakness, an area in need of improvement or a lack of disclosure or perception of risk. We need to distinguish between that,” Isleib says.

BNP Paribas AM relies on a combination of third-party data providers for the raw underlying data on the companies it covers. The asset manager has its own people looking at ESG issues in each sector allowing them to enhance that data. It looks at the raw underlying data on the performance of a company rather than their views and assessment of an issue.

“We do find bias typically to do with company size, region and sector. We try to minimise in the construction of our ESG scoring framework any bias associated with those factors,” Wilson Otto says. If investors do not get the information they need, they can apply pressure through raising their hand to vote against manage at the AGM. This is a last resort and could be taken as a sign that engagement is failing.

It is in a corporate’s best interest to practice high standards of transparency. Just as ask the experienced professional trustee Alan Pickering, who has chaired industry bodies and produced a government-sponsored report on the pensions industry. During a panel discussion portfolio institutional hosted on emerging market debt in October, he explained why. “The better governed countries and corporates are the more accessible they are to institutional investors,” he said. So, the greater the level of transparency, the greater potential for attracting capital if needed. Perhaps the change in approach by regulators may prove successful over the long term.

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