Environmental, Social, and Governance (ESG) were first coined in 2005, but its concept goes back further. It wasn’t until the 2006 United Nations (UN) Principles for Responsible Investment (PRI) Report, consisting of “Who Cares Wins” and the Freshfield Report, that ESG issues were first mentioned. This was the first time ESG criteria had to be incorporated within the financial evaluation of companies. At this point, only sixty-three investment companies (representing USD 6.5 trillion in assets under management, AUM), comprised of asset managers, asset owners, and service providers, had signed up. By June 2019, this figure had grown to two thousand four hundred and fifty companies representing over USD 80 trillion in AUM.
In recent years, the World Economic Forum (WEF) and the International Business Council (IBC), alongside the Big Four accounting firms (Deloitte, PwC, KPMG, and EY), are accelerating the transformation of ESG. This is by creating a standardised measure of twenty-two specific metrics for companies to report their results. The challenge has been to make an identical and transparent framework for reporting financial and non-financial ESG metrics.
To try and address this issue, the Davos Manifesto 2020: The Universal Purpose of a Company in the Fourth Industrial Revolution was published. The Davos Manifesto highlighted twenty-two quantitative metrics consisting of both information already being reported on and data that can be easily obtained. Phase two goes one step further in introducing a set of 34 metrics, although these metrics are less established. These metrics align with the UN’s 2030 Agenda for sustainable development. The metrics are centered around four key areas, planet (led by PwC), governance (led by Deloitte), prosperity (led by EY), and people (conducted by KPMG).
With ESG becoming more critical to companies, so has the emergence of frameworks for supporting ESG. The foremost widely used frameworks are Global Reporting Initiative (GRI), Carbon Disclosure Project (CDP), Sustainability Accounting Standards Board (SASB), Taskforce on Climate-related Financial Disclosures (TCFD), and Workforce Disclosure Initiative (WDI).
The GRI was established in 1997 to create a framework for companies to indicate their responsible business practices. GRI began specialising in ESG in 2009. Many governments, businesses, and investors use the GRI ESG framework to show their impact on global climate change, social well-being, governance, and human rights.
The CDP started in 2000 to create a world financial setup that protects against global climate change. The objective is to shift businesses to prioritise environmental reporting by transforming capital markets. In 2002, CDP established its environmental disclosure program. CDP is currently utilised by over 8,400 companies in over 800 cities worldwide.
The SASB began in 2011 to develop standards for financial fundamentals and sustainability. Currently, SASB focuses on financially material information that is more industry-specific.
With Michael Bloomberg as its chair, the TCFD started in December 2015 to give some thought to the climate within the global financial system. The TCFD provides companies with a framework to report their climate related-financial risks. As of February 2020, over 1,000 companies of USD 138.8 trillion AUM were using this framework. ShareAction created the WDI in the UK in 2016. Modelled on the CDP, the WDI collects data on supply chain workers and direct employees. As of 2019, the WDI had 118 companies using the framework.
In addition to ESG frameworks, Rating Agencies have begun to create their ratings for ESG factors. The foremost prevalent of these agencies are MSCI, RepRisk, Sustainalytics, and the newly created ISS. Since 2010, MSCI has been one of the most important providers of ESG ratings. MSCI rates ESG for over 6,000 companies and more than 400,000 fixed income and equity securities globally with a scale from AAA to CCC. Founded in 2008, Sustainalytics combines several sources: Scores from Germany, DSR from the Netherlands, and AIS from Spain. Sustainalytics ratings are on a scale of 0-100 and incorporate sector and industry-based comparisons. Currently, over 7,000 companies across 42 industries are rated.
Starting in 1998, RepRisk provided ratings for more than 140,000 public and private companies across 34 sectors. RepRisk’s rating scale ranges from AAA to D. The newest of the leading rating agencies is the Institutional Shareholder Services (ISS) Environmental and Social QualityScore, launched in February 2018. The ISS provides a rating scale of 1-10. As of 2018, the agency offers ratings for over 5,000 companies across 18 sectors.
A uniform framework to match companies’ ESG commitment without utilizing third-party rating agencies has long been a problem. The difficulty with rating agencies is that there is a lot of inconsistency regarding ESG ratings. As an example, MIT’s Aggregate Confusion Project, it had been found that between 5% and 10% of firms that were within the top 5% for one rating agency were within the bottom 20% for another. The US Securities and Exchange Commission (SEC) created its ESG disclosure framework to supply comparable and consistent data to deal with this issue.
ESG has come a long way since its inception and has become a hot topic recently. Asset managers are increasingly scrutinizing their ESG policies before investors choose to invest with them. As ESG regulation continues to increase, expect more focus in this area in the coming years.