Can the Blockchain Solve ESG Data Problems? — Part 1
Environmental, Social and Governance (ESG) Criteria is having a moment. When I first joined the responsible investing field eight years ago, ESG Criteria was considered more like a treehugger’s mantra, something that only faith-based or “socially responsible” investors took seriously.
But times have changed. Investors are demanding and consuming ESG information like never before. They want to integrate ESG data to manage short and long-term investment risks. Last year, the world’s largest investor, BlackRock CEO Larry Fink raised the bar by calling on corporate CEOs for their companies to have a social purpose and to be mindful of the impact of their business on society. Moving forward, he said, BlackRock will be keeping a closer eye on how companies behave.
Indeed, the time has arrived for ESG to transform the way corporate America behaves and financial America invests. After all, more and more investors want it because they think ESG is important. However, the world of ESG data is full of complexities and there are significant roadblocks to collecting, maintaining and using such data.
Here are some of the problems I’ve seen in my eight years in the biz.
Problem # 1: Data Quality
In an October 1st letter to the Securities and Exchange Commission (SEC), a group of asset managers and asset owners requested the Commission to “develop a comprehensive framework requiring issuers to disclose identified ESG aspects of each public-reporting company’s operations”.
Investors want the SEC to take the lead in developing a standard for disclosure because as studies have pointed out, many of the current voluntary ESG reporting “is of limited practical use” or the quality and the completeness of the reporting are “not high”. The investors also noted problems with comparability of available data.
“These conclusions are an indication of the weaknesses of voluntary disclosure: without a regulatory mandate, the information being produced is often incomplete, lacks consistency, and is not comparable between companies.”
In short, the data is there, but they are of limited utility to investors.
Problem # 2: The Burden of Reporting
To their credit, an increasing number of companies are responding to investors’ demand for ESG reporting, but the burden of reporting is immense. Producing an annual Corporate Social Responsibility (CSR) report, responding to requests from third-party ESG rating agencies and analysts, fulfilling commitments to third-party data aggregators require dedicated personnel. Year after year, CSR officers collect data from multiple internal sources (from their real estate managers and procurement to investor relations and legal) and process them into reports that are consumed by research agencies and investment houses. This annual process is complex and cumbersome.
Problem # 3: The Burden of Data Collection
How ESG data travel from a company to the desk of a financial analyst or a portfolio manager in an investment house is not straightforward. ESG data and research providers act as intermediaries between company and investment house by collecting and aggregating ESG metrics. ESG rating agencies add an extra layer by analyzing the data using their proprietary methodologies and producing ratings or assessments of a company’s ESG performance. These assessments end up on the desk of investment analysts who need to figure out how to integrate them to investment models.
ESG data and research providers and rating agencies spend a lot of resources collecting and analyzing data. It’s particularly manpower intensive. Someday, artificial intelligence may be able to capture relevant ESG data and conduct simple assessments. But it’s not there yet and more investment is needed for machines to be as intelligent as the average ESG analyst.
Problem # 4: The Specter of Greenwashing
Because of the voluntary nature of ESG reporting, companies tend to report on metrics that make them look good. And why not? They’re spending money on these reports after all. Many CSR reports exhibit feel-good stories that create a positive image of the company. As a consequence, companies continue to face allegations of greenwashing.
Another issue is the lack of third-party verification of ESG data. Unlike financial reporting, ESG reporting is not audited in full by an independent auditor. Some aspects, like carbon-related disclosure, may be verified by a specialized organization, but for the most part, the public just has to take the company’s word that it is a good corporate citizen.
If a company, for example, reports that it has improved employee capacity building by increasing the number of training sessions, there is limited opportunity to verify the impact of such sessions on an employee’s skills. If another company reports that it has improved its health and safety program in its manufacturing plants or in its Tier 1 supplier companies, it is actually difficult to independently verify the existence of a program, much less its effectiveness. We just have to trust that the company is telling us the truth.
Problem # 5: Inconsistency of Reporting
For ESG data to be useful in financial analysis, data reporting must be consistent year after year. Consistency provides insights on trends over time. But if companies change the type of data being reported, investors won’t be able to see trends and patterns.
Before transitioning to a product management role, I was an ESG analyst, covering a number of high profile blue-chip companies in North America. One company I covered reported in the early part of the decade a breakdown of taxes paid in countries where it operated. But after a couple of years, the company stopped doing so. If an investor were to determine if the company has not been avoiding taxes, the inconsistency of reporting of tax payments would have disrupted the investor’s ability to establish a pattern of behavior on tax payments, forcing the investor to expend additional resources on due diligence.
Problem # 6: The Fragility of Digital Assets
Related to the example I provided above is the problem of maintaining ESG reports. ESG reports are maintained by the companies themselves and companies can choose to keep them accessible to the public, or pull them out of circulation. If a company decides to purge ESG reports from public circulation, recovery of these documents would be close to impossible. Or a company could also scrub its ESG reports of negative information, and no one would know it. Think: the Environmental Protection Agency censoring “climate change” in federal websites.
In Part 2 of this blog post, I will explore blockchain and distributed ledger technologies (DLTs) options to help solve these problems. Stay tuned.
