Turning chaos into clarity

Video produced in collaboration with Bloomberg.

By Patrick Bryden, Head of ESG Research, Global Banking and Markets, Scotiabank

With pressing Environmental, Social and Governance (ESG) issues top-of-mind among business leaders and investors, there is significant momentum to integrate the often chaotic, non-financial factors into corporate reporting, to heal the planet and bolster bottom lines. But can standard-setters and market regulators turn the data chaos into clarity with a sort of ‘Theory of Everything,’ and what can companies do today, to navigate this dynamic landscape?

ESG chaos and its challenges crystalized

While sustainable investing has steadily trended upward in recent years, as CEOs, world leaders and asset managers acknowledged the real risks of global warming and resource depletion, ESG momentum has really spiked in the last 18 months.

After a brief pause at the onset of the global pandemic, as everyone got their bearings after being acquainted with systemic risk firsthand, in an instant, COVID-19 shone the spotlight on the previously opaque ‘social’ factors – the ‘S’ in the ESG movement – and revealed the vast social, racial and gender issues that affect the most vulnerable people and threaten busines resilience.

Suddenly, decision-makers in world summits, boardrooms and trading floors gained clarity about the real importance of ‘S,’ sometimes after shocking social media postings revealed real-time events that were previously unseen. Overnight, companies pledged to help confront these issues. And, business leaders are embracing research that connects an organization’s financial performance to its track record on wide-ranging ESG issues, not only in sustainability and stewardship but also in societal considerations, from workforce diversity to human rights to community health and safety. Companies and investors recognize that there is the potential to outperform, if they genuinely tackle ESG issues rather than simply go through the motions of ‘box ticking’ to appease activists.

While this sounds like significant progress, the unfolding challenge is the matter of quantifying the often-murky factors, by collecting, verifying and analyzing a universe of proof points that could help identify companies that do good, and deliver better returns. In this increasingly data-centric world, many companies are providing better disclosure of relevant data such as employee diversity, salary, turnover, training, and so on. This means, as analysts, we are becoming more experienced with leveraging new, forward-looking data that can help predict future outperformers.

At the same time, this fountain of new data can create its own chaos, by introducing an overwhelming array of information sources and conflicting interpretations. Companies must decide which metrics best explain their business, and investors must evaluate this new disclosure to make optimal investment decisions.

The case for harmonization and unification

In response to the vast quantity of emerging ESG datapoints, the world’s ESG standard-setting bodies, ratings agencies and regulators raced to individually draft standards and frameworks to better count, validate and compare the emerging ESG disclosures.

Recognizing that this dizzying array of reporting guidelines only added to the chaos, last year the World Economic Forum and the Big 4 accounting firms called for harmonization of the diverse methodologies, and the five leading sustainability standards-setting bodies began working toward the same goal. Most recently, two of the five members completed a merger to create the Value Reporting Foundation (VRF), to help amalgamate their extensive bodies of work. The IFRS, the international accounting standards outside of US GAAP, has also begun working rigorously on a more coordinated approach to ESG reporting. And, national and regional governments are attuned to these activities, to respond with suitable regulation and supervision.

While the harmonization process holds real promise to combine non-financial and financial metrics to achieve the long-promised goal of triple bottom line reporting, will it result in absolute clarity for companies and market participants?

We do not wish to pretend that ESG is akin to splitting the atom, as much of it is social science rather than hard science. We do believe though that the pursuit of a theory of everything in physics through the synthesis of different forces and theories into one unified theory as an overarching task, is an apt metaphor for what we see at play in the maturation process of ESG within finance today. We believe financial and non-financial information are likely to be unified, with accounting as integrated reporting potentially the ultimate vector of finance and stakeholder capitalism. We further believe the reconciliation of the general and the specific is the other major global challenge in ESG today in order for ESG analysis to be fully grasped, in the same way that physicists seek to reconcile the two competing theories of how the universe works at both a very large (general relativity) and very small (quantum mechanics) scale.

We believe there is a role for fundamental investment research and advisory personnel to play, through the integration of ESG issues at the sector specialist level to better inform investment research and management processes, as well as companies and stakeholders, with respect to the modern-day pursuit of opportunities and assessment of risks. At Scotiabank Global Banking and Markets, our ESG Analytical Framework is built upon top-down universal metrics, while our ESG integration efforts continue to evolve bottom-up sector-specific and company specific information and insights to help better inform the capital market capabilities of our organization.

Be authentic, be all in

With so much still in motion before the dust settles on ESG reporting, what steps can companies take today to craft sustainability frameworks that pass muster under current stakeholder scrutiny? This is a question our team frequently fields from clients who are eager to act, but are unsure of the best steps to take in a shifting landscape.  

My simple answer is that “authenticity matters,” and that one should pursue ESG objectives that logically and naturally align with their organizational culture and business realities. Rather than try to completely revamp the organization to satisfy the markets – and tick a bunch of boxes that notionally meet expectations – it’s better to build on their organization’s true strengths. Hand-in-hand with this, the challenge should be embraced, as we believe the underlying trends of ESG are secular in nature and not about to go away any time soon.

To find the right path, a company must evaluate which items are materially relevant to its business performance and stakeholder needs and which are not. Finding true and effective alignment between purpose and profits will serve investors more efficiently and effectively than vast, all-encompassing reporting and vague commitments. Ultimately, a thoughtful strategy to address a company’s most significant risk-and-return factors will transmit the message that this is a well-run company from all perspectives.

Then, a company should build a clear narrative that explains its data, outlines its actions, and reports on progress toward its vision for sustainability, stewardship, and stakeholders. Such numbers and narrative, and consistent behaviour at all levels of the organization, will help the company earn trust with the markets, regardless of evolving ESG reporting standards.

We expect to see today’s ESG chaos turn into clarity and orderliness for stakeholders, with the caveat that emergent standards must dynamically accommodate diverse market participants and the growing body of knowledge on sustainability practices. Companies that make their mantra, “Be authentic and be all in” will in our view be able to best navigate the ESG landscape now and into the future.

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