Why ESG reporting needs to balance ‘purpose with profit’ for real impact

The flow of capital towards ESG (environmental, social and governance) oriented funds has rapidly moved from a trickle to a deluge.

In the third quarter of 2021 global sustainable funds hit a record high of $3.9 trillion, more than doubling in less than 12 months. This trend reflects growing interest from private equity (PE) firms and some of their biggest investors in renewable energy and energy transition companies like battery makers, and to a lesser extent, emerging sectors like sustainable agriculture and recyclable/circular production.

Increasingly, ESG investing is seen as a lever for delivering value in a volatile world. With fuel prices rising to new heights, energy-efficient businesses, which are less dependent on raw materials, are likely to have a far more reliable cost base. Similarly, companies that can demonstrate sustainable supply chains and good human rights records are less vulnerable to environmental shocks or reputational damage.

Where once, investors looked at ESG as merely a risk factor, PE dealmakers are now approaching the whole transaction life cycle from an ESG perspective, building ESG into due diligence, and eyeing the potential value on exit.

However, fund managers face a shortage of genuine ESG investments. Much of the current crop of ESG/sustainable funds are, arguably, standard trackers minus fossil fuel-heavy companies. True impact investments – which aim to have a positive effect on people and the planet – are thin on the ground, with few options for investing in “brown” businesses transitioning to “green”. Indeed, the business case for impact investments has yet to be clearly established.

Specialist ESG thematic investment funds are growing in popularity – albeit from a small base – targeting areas like renewable energy, waste, water management, nutrition, health, biodiversity and climate, amongst others. But investors remain unclear over what constitutes a sustainable company: some businesses have low carbon emissions but poor people practices, and vice versa, while others have gaps in ESG reporting.

As investors and asset managers seek concrete metrics to present to their investment committees, a major stumbling block for investors and asset managers is the lack of uniformity in ESG reporting. There are a host of reporting standards, both nationally and internationally, some mandatory, many voluntary, which hinder meaningful comparisons. Different rating providers may, therefore, give varying pictures of the same company.

And with companies moving at different speeds in adopting ESG reporting, it can be hard to distinguish between those companies that genuinely embrace sustainability and those that are merely greenwashing.

In the latter case, the reports and statements may present a business as highly sustainable, but dig a little deeper and one will find a general lack of commitment and action towards actually making this happen. If called out, this could be highly detrimental to a company’s brand equity and consumer confidence.

Many companies are still at a low point on a steep ESG reporting learning curve. With every dollar invested by financial institutions impacting the real economy, it’s essential to understand a range of ESG consequences of these investments. Scope 3 emissions – indirect emissions that occur in the value chain – are notoriously hard to calculate, including a range of measurements like purchased goods and services, leased assets, business travel, waste disposal, and logistics. Capturing such data from a host of suppliers and third parties has proved a big challenge.

Meanwhile, those financial services companies investing in high-emitting businesses must also show these organizations’ efforts to reduce carbon footprint and provide offsets.

Regulators are making progress, with the EU leading the way in regulating corporate sustainability reporting. Its Non-Financial Reporting Directive (NFRD) and Sustainable Finance Disclosure Regulation (SFDR) require respectively disclosure of non-financial information and evidence that ESG risks are integrated into investment decision-making.

In March 2021 the US Securities and Exchange Commission (SEC) announced that US companies must now report on climate risks facing their businesses, and their plans to address those risks, along with metrics on climate footprint.

However, even in a perfect world of standardized, global reporting, investors will likely need access to new types of data that go well beyond regulatory requirements, not just on environmental performance, but also for social impacts like diversity, gender and racial equality. Until such information is readily available, capital markets will likely struggle to fully gauge ESG performance and related value.

Mandatory reporting may improve internal awareness of ESG issues, and help investors, but it doesn’t necessarily oblige companies to change their business practices. Similarly, much of the financial services regulatory action is less about saving the planet and more about managing climate risk.

If companies are serious about meeting net-zero targets and producing a more equitable society, then metrics are just a starting point. In many nations, the commitment of businesses to their shareholders is enshrined in law, placing profits ahead of purpose. This has to change, with companies re-evaluating why they exist and legitimizing wider stakeholder interests in strategic decision-making. Until this happens, investors may only really be interested in ESG so long as it drives traditional notions of value.

Things will not change overnight, but there needs to be a genuine shift towards stakeholder capitalism, where companies prioritize zero emissions, human rights, fair pay, equality and diversity, as well as the circular economy, cutting waste and pollution, and encourage recycling and biodiversity.

PE funds and other investors have been getting excited about resilient, ESG-oriented businesses; now they, and wider stakeholders, must demand that business is not about “profit with purpose” but rather about “purpose with profit”.