Standard ESG disclosures and reporting will make ESG ratings less relevant
There has been a strong move toward globally harmonizing standard ESG disclosures and reporting requirements. The goal is that such disclosures and reporting provide measurable, comparable and verifiable data for investors to consider. While reporting frameworks consider materiality in determining whether a sector industry or company must report, the reporting does not assess whether overall a company is ESG good or bad. In absence of global standard data and reporting frameworks, companies have filled the void with ESG ratings, similar to credit ratings. The problem with these ratings is that they are opaque. Different providers have disparate methodologies, resulting in different ratings. The ratings companies have multiple layers of data, unverified data and in some cases data voids. Finally, investors cannot assess the assumptions and judgements underpinning the ratings.
The UK Financial Conduct Authority (FCA) and the International Organization of Securities Commissions (IOSCO) have launched consultations on whether ESG ratings providers should have greater global regulatory oversight through standard ESG disclosures and reporting. One of IOSCO’s underpinning points is that “…there is little clarity and alignment on definitions, including on what ratings or data products intend to measure….” From the FCA’s perspective, a globally consistent regulatory approach would be better than a country-by-country set of standards, particularly given the reach of the ratings firms. IOSCO appears to agree. The expectation is that there will be greater scrutiny with more disclosure harmonization.
An alternative to ESG ratings
While some may find third party ESG ratings valuable, others may want the ability to emphasize or de-emphasize particular factors. Individuals may not agree that all or any of the ESG goals are valid. As I noted in a previous blog not every investor has the same views about the underlying issues nor do they place the same weight on the different disclosures. Increasingly, investors want their views to influence their investments and decisions taken on their behalf. For example, hunters may be environmentalists.
With global convergence on how to categorize data, what to disclose and when to disclose; investors can establish their own views on what they believe is important in assessing a company. To translate values to an investment policy, advisors should not only elicit what the investor believes, but also how strongly. Such an approach more precisely aligns a portfolio to the investor’s values. As has been noted throughout the press, fractional share trading allows such customization at small asset sizes. Capturing the investor’s values and mapping to the portfolio is a critical and necessary first step. While there may currently be head winds to mass adoption and some regulatory concerns, the expected generational wealth transfer is likely to accelerate change.