The bright spots in a complicated ESG framework

Is ESG a distraction from climate change? That was the subject of a panel discussion at the recent New York Times Climate Forward conference. Environmental social and corporate governance (ESG) is a risk management tool to cater to long-term risks that organizations are likely to face in the future. It is a fast-growing sector of finance, and, according to Bloomberg Intelligence, global ESG assets are likely to surpass $41 trillion in 2022 and $50 trillion by 2025.

More and more investors are incorporating these ESG metrics with financial measures to evaluate the risks outside of the financial accounting framework. ESG variables span a broad range of topics that are typically not included in the financial analysis but have financial relevance. Accordingly, the inclusion of ESG has become essential in every corporate strategy from a risk mitigation and opportunity optimization standpoint.

Proponents and supporters accept that the current framework for ESG is complex and imperfect, compounded by a lack of standard references. Its critics deem it a ‘marketing decoy’ or a ‘neo-liberal fantasy' that gamifies corporate social responsibility.

There are over 600 ESG reporting standards. Some companies use their own custom frameworks and select their own parameters and standards created by the industries themselves without any regulatory oversight. Furthermore, companies are compared against their peers in their own industry, which explains why some oil giants are included, but companies such as Tesla are excluded from the list. Different standards create inefficiencies and undermine their integrity and utility.

Despite its imperfections, ESG is here to stay. There are calls for the sector to be regulated and enforced through a strong government policy. In March 2022, the US SEC announced its plans to formulate “a comprehensive ESG disclosure framework," which is likely to lead to enhanced disclosures and greater transparency.” Until a unified regulatory framework is in place, however, ESG is an additive that has the potential to not only improve climate action but might also address other social and governance issues, such as diversity and inclusion, fair treatment of workers, transparency and reporting standards of organizations. The idea being that investors can use their investments to drive climate action and tackle other important social issues, thus incentivising companies to take action on climate and other important social issues. Even its critics are of the view that ESG has the potential to play a pivotal role and it is increasingly being adopted as part of organizational strategy, even where it is not a requirement.

Private equity firms are adopting ESG strategies for their funds and portfolio companies too; 72% of the large private equity firms with an annual revenue of between $50 million to $1 billion, have incorporated ESG strategies. Environmental concerns are just part of the reason for such adoption. Other drivers include anticipated regulation, reputational risks, improved corporate governance, social concerns, talent attraction, branding, and increased transparency.

In this fragmented framework, how can well-intentioned investors look beyond the greenwashing and assess whether the ESG promises are real or a distraction? What indicators should be used to evaluate a firm’s ESG commitments and performance? Are there any metrics that are more important than others? Here, we identify some bright spots where the problem is tackled in a manner that allows ESG tools to make practical and equitable contributions, by highlighting the organizations that are achieving their stated goals and those that have fallen short in their grandiose claims and promises.

Sovereign bonds, such as Chile, and corporate bonds, such as Enel and Suzano, are good examples of such ESG bonds where the issuer’s failure to meet an objective, quantifiable standard will result in a penalty on the issuer. If Suzano, for example, is not on track to meet its goal by 2025 of reducing its greenhouse gas (GHG) emissions by 15% by 2030, “there will be a one-time coupon step-up of 25 basis points.” Similarly, Enel’s revolving credit facility is directly linked to a reduction in its greenhouse emissions.

In sovereign bonds, more countries are being urged to follow Chile’s example. With $31 billion in sales, the Government of Chile is Latin America's largest issuer of ESG bonds, and it is looking to further strengthen its environmental credentials. It recently formulated its first Sustainability-Linked Bond Framework, laying the groundwork for the issuance of sustainability-linked sovereign bonds in Chile.

It plans to use the proceeds from these bonds to curb GHG emissions and promote the diversification of the country’s energy portfolio. Unlike green bonds and other bonds with a sustainability label, these instruments are not related to specific projects or expenses, but the coupons of the bond are linked to certain KPIs and the achievement of its objectives. These require it to reduce its GHG emissions and increase the share of renewable energy in its portfolio. Failure to meet these targets on emissions reduction and renewable energy generation will result in Chile paying a set penalty to investors.

Linking an ESG bond with quantifiable and verifiable goals and imposing a penalty for the issuer’s failure to meet those targets ensures discipline on the issuer's end and provides an antidote to greenwashing. Simultaneously, investors can identify the ‘good apples’ from the bad. ESG-linked investments and asset managers cannot be expected to solve climate change and other social issues, but, hopefully, this will create a shift where more and more investors will demand a penalty on the issuer if it fails to meet the said goals at the end of the bond's maturity. Investors can also eschew ESG bonds that are ring-fenced, set too soft a target or do not promise tangible, verifiable metrics, such as a reduction in GHG or growth of renewables.

The use of explicit ESG goals in corporate and sovereign bonds, rather than notional, intangible goals, should allow investors to understand what to expect, and institute a discipline check as well. This will allow them to channel their concerns in the right direction and truly make an impact through their investment portfolios.