What Is ESG?
ESG stands for Environmental Social and Governance.
As it relates to the Business Sector (outside the Investment Markets) ESG is non-prescriptive, non-exclusionary and based upon solid principles of:
That a business process is benign in terms of its affect upon the environment.
That the business activities of a company or individual practitioner implement strategies which assure not only that business’ employees are treated fairly, but that the business contributes to the wider benefit of the community as a whole.
In terms of smaller businesses, who are not a listed company, good governance relates to how the business is managed from a financial and operational oversight perspective.
The basis of ESG includes aspects of sustainability as defined in the 1987 Bruntland Report; which clearly forms the basis for all subsequent iterations of “sustainability initiatives’, including socially responsible investment (SRI), corporate social responsibility (CSR), green, eco, environmentally friendly, et al. These activities are based upon emotional judgments and subjective criteria, i.e. they are prescriptive and exclusionary and all based upon the personal viewpoint of self appointed SRI and CSR Practitioners.
‘For if we have to rely upon the ‘standards’ of SRI and CSR, then we have no standards at all.’
Whereas sustainably based ESG is based upon third party verification of fact. This includes quantatively based metrics and most importantly sustainably based ESG, which measures the ESG risk related affects of an entire business process and not what product is produced ( i.e. process not product). Therefore sustainably based ESG is non-prescriptive and non-exclusionary in terms of final product, it is entirely focused upon actual risk and not a variety of emotionally driven, unverifiable viewpoints.
The role of SRI, CSR, etc. is at best a second stage analytical process which must firstly be based upon the established risk metrics of sustainably based ESG, however of late in an attempt at legitimacy the CSR/SRI Industry often describes its business as being the same thing as ESG, it is not. As Paul Hawken describes, view article. HERE
Socially Responsible Investing (SRI) & Corporate Social Responsibility (CSR)
“No standards, no definitions, and no regulations. Anyone can join; anyone can start a Socially Responsible Association or a Corporate Socially Responsible Association, where members set the rules and standards without recourse to any verifiable facts.”
The practice of verifiable ESG must therefore be clearly defined as an Industry based upon verifiable fact, commonly agreed risk metrics and an enforceable common standard, this is the basis for the Probus SME ESG Standard.
There is strong and ever growing evidence that ESG factors, when integrated into a company’s future planning and decision making, provides long term performance benefits. ESG is based upon sustainable principles and has become the benchmark of well managed lower risk companies.
Within the Small and Medium Enterprise sector ESG is particularly relevant as it often reflects the existing culture of small enterprise which previously was not codified and was often an adjunct to the business and not thought of as being an important business process within itself.
ESG As An Investment Tool
The emergence of ESG as an investment tool needs to be clearly distinguished from the field of Socially Responsible Investment (SRI) and other similar terminology.
The fundamental distinguishing feature between these two approaches is motivation. Whereas SRI is essentially motivated by ethical imperatives and aims to actively shape the market, ESG integration is motivated by economic imperatives and is a risk-analytics tool aimed at capturing the effects of environment, social and corporate governance considerations on the risk-adjusted return of portfolios. In this regard, ESG integration is arguably a more tangible and effective method of addressing such issues given conventional investment practice, which relies heavily on quantitative measures and standardised benchmarks.
Please download full article here HERE
ESG & Investment Risk Analytics
Clearly any and all claims made without the ability to verify those claims seriously questions the credibility of that information. Sustainably based, verified and quantified ESG risk metrics based upon accepted financial market rating principles take precedence over qualitative based data. As much as the CSR, SRI, Green and Eco practitioners claim that these acronyms represent ESG, they provably, do not. However having established a credible agnostic risk metric, these acronyms may be used to filter resultant data and thus provide a basis for “conscience” investing. According to long term Financial Academic study, (Please see the Probus ESG Protocol Preamble) implementing “conscience” investing principles prior to the establishment of a credible risk metric is to seriously increase portfolio risk.
In the seven year research programme undertaken by Probus specialists in conjunction with some world leading Financial Academics and leading players within globa l investment markets, a credible multi functional, quantitively based ESG risk metric has been developed (data sheets and full information available).
The Tool may be programmed to assess and risk rate a variety of environmentally related small and large scale projects such as Dam and Hydro Projects, REDD Projects and in fact any type of environmentally based project that has accreditation and certification of ISO based hybrid standards involved.
In Financial and Investment Markets, the tool operates as a standalone risk rating methodology. It will devise Indices’, rate entire investment portfolios plus much more. A key competency of Sigma is that it is predictive and able to be reverse engineered to provide risk averse construction of projects and investment strategies.
In pre-deployment phase this unique tool gained significant acceptance as testimonies show:
“This is the best concept I have seen in the market.”
Shell Pension Fund
“Maybe I should run my whole portfolio using this concept.”
Marine Stewardship Council
“This is the Holy Grail of sustainability.”
“Index performs better than almost all conventional indices.”
“Extensive study of the Sigma Methodology has showed a positive correlation with share price performance.”
Environmental Risk Management (Financial Sector)
Recent complex relationships between industry and, in particular, environmental NGOs have led many corporations to recognise the weakness of relying upon traditional environmental based consultancy services alone. Whilst these people are knowledgeable in respect to the everyday environmental world, they often are not trained to recognise the wider personal (directors liability) and corporate Climate Change risks faced by listed and non listed corporations. This includes, particularly, the long term financial and legal implications of policies and procedures which are non compliant with ever more national and international legislation and best practice agreements.
Probus Sigma has pioneered environmental and non-financial risk analysis, and can meet and surpass the most robust client and regulatory requirements via recognised expertise in a range of legislative, fiscal and ESG compliance aspects. These include: mergers, acquisitions, disposals and Climate Change risk analysis.
Underpinning the Probus risk management methodology is Sigma©, our proprietary quantitive ESG risk assessment and management tool. This is an objective and globally replicable tool which allows us to assess corporate risk concerning the parent company, any number of subsidiaries and on through the entire supply chain, harnessing the opportunities arising from improved ESG practices.
If you would like more information please consult our information downloads section.
Probus Global ESG Protocol
The pending launch of the Probus global ESG Protocol for Investment Managers is the result of seven years research into defining non financial risk and ESG correlation with risk, value and share price.
Based upon proprietary Sigma technology the Protocol is scalable and based entirely upon quantative data. The Probus Protocol is not based upon SRI or CSR, practices but rather a Global common ESG Standard which not only provides non financial risk analysis capabilities but the necessary ESG Compliance in 161 Countries.
The Sigma driven Protocol can be implemented across several aspects of environmentally based investment (in addition to standard project risk analysis) and it may also be used proactively to produce risk models linked to performance.
If you would like more information please consult our information downloads section.
Integrated ESG Lowers Cost of Corporate Borrowing
Integrated ESG in the Credit Markets
Much of the focus of Socially Responsible Investment (SRI) methodologies is to try and demonstrate high environmental and social performance amongst listed companies with the aim of imbuing a perception of good corporate citizenship and thereby attracting investment.
Quantitively based, third party audited ESG metrics are based upon accepted mainstream financial risk identification and they are specifically designed to integrate with financial risk calculus, thus producing individual risk calculations for each aspect of ESG risk: Financial, Environmental, Social and Governance, (F-ESG).
The quantitive, third party audited basis of F-ESG enables lenders to assess real risks especially within industries operating in high risk sectors such as mining. Firms with environmental concerns have a significantly higher cost of borrowing and in some cases Pension Funds will avoid lending to this sector entirely. The proven link between the management of ESG Issues within high risk industries and lower cost debt financing and higher credit ratings is well proven. SRI screening has achieved some measure of improvement related to disclosure of environmental and social concerns but being based upon self-disclosure and qualitative information the results are not reliable and therefore cannot be implemented by lenders as evidence of proactive ESG Management.
With an ever-increasing impact, environmental and social performance have become a measure of lending risk that was immeasurable previously. This statement is based on research that has proved that SRI based ESG ratings were and still are devoid of the vital elements that can provide necessary assurance and yet lenders who have sought and still seek proof of good corporate citizenship have used these as previous benchmarks, despite their ability to only provide a limited indication of risk – hence “measuring the immeasurable”. New technologies have overcome the SRI shortcomings and now produce accurate and predictive ESG metrics.
Findings related to corporate ESG management
Recently substantial research has been carried out regarding corporate ESG management and corporate borrowing, all these research papers confirmed a direct link to proactive ESG management and the cost of borrowing. The main findings are that:
1. Environmental performance is linked to significant differences in credit risk
2. Results robust and considered extendable to bank loans
3. There are implications for credit screening and risk management
The main causes of risk
The same research also revealed a number of findings related to the causes of risk in relation to environmental performance and its impact on companies. The main areas of risk were found to be:
1. Risk of litigation
2. Clean-up costs, fines, damages, legal costs etc.
3. Reputational risk
4. Sales shocks, transaction costs (media, customers, suppliers, etc.)
5. Access to financing, liquidity constraints (i.e. investors)
6. Regulatory risk
7. Increased legal risks due to tightened monitoring
8. Increased compliance-requirements and subsequent costs
9. Tax increases
Proactive environmental engagement
What has become definitively clear is that a reduced risk exposure, the awareness of which is aided by ESG metrics and management, can lead to improved cash flows and lower borrowing costs. Furthermore there is proactive environmental engagement, which delivers demonstrable economic and social performances thus going deeper than just creating a perception of good corporate citizenship.
To learn more about the new ESG metrics and technologies please consult our downloads section.
The Birth of a Real ESG Metric Benchmark
Increasingly major European Fund Managers, Sovereign Funds and Hedge Funds are calling for a solution to the ever growing problems of the lack of credible common metrics associated with Socially Responsible Investment, (SRI) and it’s sibling Corporate Social Responsibility (CSR). The lack of commonly agreed definitions and a global standard which would facilitate some kind of credibility for these currently pseudo metrics continues to restrain Environmental Investment and therefore is substantially affecting the fight against Climate Change.
SRI Rules, Norms & Standards
The economist Milton Friedman once said that the sole duty of corporations was to make profit and to abide by the rules. But what are the rules when it comes to SRI?
According to Dexia Asset Management, Global Standards would benefit the further expansion of the Socially Responsible Investment (SRI) space. Cécile de Lasteyrie, head of SRI development at Dexia AM, said “Investors talk about SRI a lot, but it is complicated for them to do. They need to understand how and what to invest in, which is why transparency is key to the development of SRI, and to aid transparency and full disclosure in the space, it would help to have standards. Currently, only local standards exist – there are no global initiatives.” France and the Netherlands are keen implementers of SRI, according to de Lasteyrie. Demand for SRI is also growing in Germany and Italy, but she sees less interest in the space in Spain. Responsible Investment (RI) makes up roughly one-quarter of Dexia AM’s €79.3 Billion assets under management.
According to The French based company Novethics they are the, “Leading expert of the French SRI market” Novethic’s SRI studies focus on an issue raised by a specific asset class or the integration of ESG criteria into new financial sectors. As the only source of analytical and statistical information on the French SRI market, Novethic provides the information that investors need to make informed decisions on their ESG investments, and guides SRI fund managers in enhancing their transparency and management processes. (Source Material)
Many ESG Research Facilities and Financial Academia beg to differ with Novethics, and indeed Dexia, whereas they agree that within the SRI Industry, transparency would make a major difference to credibility, (or lack of it) and that a global Common Standard would add greatly to the usefulness and value of the SRI Ratings, many feel that Dexia has missed an important, maybe crucial fact, there actually is a long term initiative to develop common global ESG Standards, (not an SRI standard-Please see ‘ESG as an Investment Tool’) and in fact a major part of this initiative is French based. The claims made by Novethic are perhaps more worrying, their claim of being “the only source of statistical information on the French SRI market” ignores Dexia, and more importantly, the new quantitively based ESG Metrics developed by French Financial Academia based in Sophia-Antipolis where several thousand International companies carry out their Financial Research. These leading Economics Professors who have already built similar neural based predictive risk tools for The IMF and World Bank are also in partnership with the world’s leading experts in environmental and social investment benchmarks, not only have they developed a global standard (reciprocity in 162 Countries) but have developed a high quality, reliable, global, quantitively based ESG risk analysis tool based upon this Standard.
Financial Academia, legal experts and others, have sought to clear up the, CSR/SRI, ESG, sustainability conflation once and for all time, according to their research, it should be understood that SRI & CSR are a part of ESG, only to be considered once an overall ESG risk analysis has been performed. The reason why this is a fact is fairly simple. The founding Fathers of modern sustainability, (the Greeks invented it) whose work and ethos was captured in the famous Bruntland Report of 1987, spoke about not mortgaging the future to fulfill our needs now. It also mentions how sustainability may be measured, it does not mention SRI/CSR or any other theoretical emotionally driven (sometimes politically driven) “standard” for sustainability, but what it does describe is a process of measuring and managing the process of manufacturing a product or a service, nowhere does it mention that the actual product should be measured by some magical means as to it’s desirability, political acceptability or consumer marketing value. Increasingly Governments are questioning the influence that unelected Practitioners of SRI methodologies have over who is worthy of receiving investment and who is not worthy. Recently Senator Scott Ryan of the Australian Government has been asking serious questions regarding why unelected special interest groups are able to influence Sovereign Funds investment policies based upon nothing more than a set of pseudo metrics which are derived not from verified quantitive metrics but rather from politically motivated unsubstantiated pseudo SRI metrics. Sustainability should be third party verified and agnostic.
What does this mean in today’s SRI/CSR environment? Since the SRI Industry discovered that very few corporations knew anything about sustainability definitions and even less about standards, from that perception, a massive global pseudo metrics Industry has arisen, operating in an entirely unregulated market and mirroring the sub-prime model, Fired by the same circularity and in some cases by the same special interests, where each firm awards another ever higher honours and awards, often based upon the theory of “Trust me, I am a big company.” In an Industry that has no reason to exist above hi-jacking the consumer’s interest in environmental and social issues allied to the Investment Industry needing something that plays to the consumer.
This has spawned an unregulated global Multi $ Billion SRI Industry which:
1. Is based entirely upon historic self-reported information with little or no verification
2. 41 International Protocols and Agreements, (not standards) themselves based on voluntary self-reporting.
3. Has never identified any real value drivers within their multifarious non-common methodologies which are themselvesnon-transparent
4. Have developed policies and procedures leading to yet more lack of definition.
5. Have hi-jacked the term Sustainability which clearly and provably is not SRI based.
6. Survives by writing their own methodologies and then having another entity verify that process thus providing “proof”that their self-generated methodologies are legitimate.
7. Has serious potential legal ramifications for corporations (Please see: Corporate Legal Liabilities Associated with SRI Methodologies).
Are the 41 International Codes of Practice, Conventions, Protocols and agreements upon which many corporations base their ESG Credentials themselves the source of the SRI problem?
All the major SRI Ratings Agencies award substantial positive awards to companies that are signed to many of these conventions and Agreements. Being a signatory to The Global Reporting Initiative (GRI) is classed as automatically being a highly rated SRI compliant, Socially Responsible Corporate Citizen. The GRI is lauded as a “benchmark of transparent sustainable corporate behaviour”; The GRI is the basis for many SRI Practitioners rating of a company. However, in reality is it in fact a benchmark? (Please see here for a brief description: Confidential Report)
There are serious issues with SRI based ESG compliance in various countries, this is due to the fact that most legislation refers to sustainability which is provably linked to ESG, however, SRI is not ESG and therefore is as provably not compliant. Lack of comparability between the various SRI/ESG Indexes and methodologies, produce a total lack of ESG risk rating ability amongst the globally important SME sector, and fails to comply with WTO regulations. (Please see: Where is SRI Heading?)
Increasing Concerns Regarding the Political Aspects of SRI
In a recent statement regarding Australian Sovereign funds mandated to include SRI screening, Senator Scott Ryan said: “Dictating which investments the Future Fund can make is a dangerous precedent” he went on to say that:
‘Social licence to operate’ is a term used by those who advocate conditions on investment in certain industries as they try to use capital markets to pursue “political objectives” and “The Greens also do not trust the sta at the Future Fund whose job it is to ensure that investments adhere to best practice.” Far from ignoring ethics, Future Fund ocers recently told a Senate committee investigating the Greens’ proposals that they already impose a three-stage test before investing. They ask, is the investment legal? Does it adhere to Australia’s treaty obligations? And do the economic activities of the company being invested in contravene Australia’s treaty or convention obligations?
For the Greens though, this is still not enough. They want the finance minister to dictate to the Future Fund board exactly which investments it must avoid, and they want the Future Fund to relegate the rate of return to taxpayers down the list of investment priorities in order to achieve their own political objectives. This is not an isolated denouncement of the unelected dictating to Governments where and who to invest with, since SRI & CSR have no basis in quantifiable fact it enables special interests (the Green lobby and some political supporters) to dictate global investment policies based upon absolutely no verified evidence at all.
In September 2012 The UK Sustainable Investment and Finance Association (UKSIF) and Green Party MP Caroline Lucas have called on the Parliamentary Contributory Pension Fund (PCPF) to commit to the UK Stewardship Code.
But the PCPF has not made a public commitment to the Code since its publication in July 2010. UKSIF and Lucas have written to the chairman of the board of trustees of the PCPF Brian Donohoe, requesting a meeting to make the case for the fund’s signature.
Lucas said: “Most people would be appalled if they thought their pensions were being invested in corporations with, for example, poor records on human rights or environmental protection. By signing the MP pension fund up to the UK Stewardship Code, Parliament can demonstrate its commitment to sustainability and transparency, and really lead by example in responsible investment. There are currently approximately 250 signatories to the Stewardship Code, including public service pension schemes such as the London Pensions Fund Authority, the Environment Agency Active Pension Fund and the Pension Protection Fund.”
Does the UK Financial Stewardship Code based on the principles of The Global Reporting Initiative (GRI) simply continue to facilitate SRI Reporting Greenwash?
(Please see: GRI/Asset4 Report)
A recent review of the UK Financial Stewardship Code carried out by a senior standards expert highlighted a number of serious concerns; these were summarized by the reviewer as follows:
In July 2010 the Financial Reporting Council (FRC) published its UK Stewardship Code3 the stated aim for which is “…to enhance the quality of engagement between institutional investors and companies to help improve long-term returns to shareholders…” It provides this through a series of seven related principles that are stated within the document and are to be used for guidance. So the UK Stewardship Code is a series of subjective guidelines collated to outline a proposed “…proper practice…” for financial institutions; what it does not do is set out a series of objective requirements against which institutions have to comply. There would seem to be no stated requirement that institutional shareholders follow this code, and for the ones that have adopted this code there is no objective measure against which they can compare individual companies or their own practices.
According to the documents preface, the code provides institutions “…good practice on engagement with investee companies to which the FRC believes institutional investors should aspire…” it does not indicate how the FRC have determined these practices and (lack of transparency) should an organisation decide to use this code then it is the organisations own responsibility to decide to both adopt the code and ensure that they “…comply with the terms of the mandate, as agreed…” Organisations are expected to provide a statement on their website as their compliance with the code; however, there is no compulsion to comply with all seven principles of the code such that where compliance does not occur then the institution involved is expected to state why this is not so. Once they have stated on their website that they have adopted this code the name of the organisation is then added to the FRC’s list of institutions that have adopted the code. There would appear to be no assessment stage in this process.
Throughout the Stewardship document, institutional investors are informed of activities and documents that they SHOULD have/do; nowhere in this document is there an activity/document that the institution SHALL have/do. This is a careful usage of words that allows the applying body to omit requirements from the Code without risking non-compliance. Each principle is provided with a series of guidance notes aimed to help the institution comply with the relevant principle; as it suggests “guidance” is a suggestion and not an instruction as such will be very dicult to assess for compliance. The Code appears to be a code of practice that organisations may/may not adopt in part or in full, and that they police themselves; the Code suggests that an individual be named as contact point for providing information to interested parties but do not require that person be responsible for ensuring compliance – no such person is mentioned in the document. Similarly, no mention is made at any point throughout the document suggesting there is an objective third party assessment to ensure companies work according to the practices set out in the practice against which they may state they comply, in fact it is the responsibility of individual institutions to “… disclose on their website how they have applied the Code…” Apart from requesting that investors notify the FRC when it has published a statement of compliance there would seem to be no other requirement before the FRC adds the investors name to their list of Code-compliant institutions on their website.
Highlighting the problems with each of the seven Principles just the first two indicate the carefully constructed lack of accountability:
Institutional investors should publicly disclose their policy on how they will discharge their stewardship responsibilities.”
Whilst nowhere in this document does it state that an investing organisation should have a policy on how it discharges its stewardship responsibilities the Code now states that the organisation should publicly disclose such a policy. There are no requirements listed in this section as to how the institutional investor will monitor the investee companies; instead it indicates that the investor should determine its own set of rules on how it accomplishes this and suggests that the organisation engage in “…active dialogue…” with the board(s) of each investee company. In other words, the Code suggests that monitoring of investee companies is to be undertaken through a subjective process of talking with the people who are responsible for running that same company!
“Institutional investors should have a robust policy on managing conflicts of interest in relation to stewardship and this policy should be publicly disclosed.”
Once again, the Code provides guidance that the investor should have a policy on managing conflicts of interest. This is vague terminology, it does not impose a requirement that the investor have a procedure on how to identify and manage such conflicts to include detail such as person(s) responsible, means of monitoring such an issue etc.
Clearly and demonstrably the UK Financial Stewardship code is in no way a meaningful and robust code of practice, it very much provides and illustrates the same basis of SRI methodologies, “have a group of interested parties write a self-serving code of Practice which appears to be a substantive document, this to assuage the consumer”, however ensure in that Code that no real effect or substantive rules, therefore while it may appear that an entity signing up to the UK Financial Stewardship Code are held to account, the opposite is true, it merely provides a licence to carry on as before.
The above example is merely the continuance of the “business as usual” reaction to the consumer call for change and respect for environmental conservation and better social conditions, the call for improved governance, (ESG) was heard loudly after the collapse of the International Banking Industry but the Investment Industry invented its own solutions. Earlier calls for transparency and accountability especially amongst the larger NGOs resulted in the construction of 41 Major, International Protocols, Codes of Practice and Agreements, (PRI, GRI, Equator Principles, etc.) it all sounds very good and impressive, however anyone not familiar with standards would not realise that, in fact these voluntary agreements reflect exactly the same flaws as does the UK Financial Stewardship Code.
Not one of these Codes and Agreements contain any binding agreements for corporations to abide by a set of rules, all rely upon self-reporting, all take over one year before being disclosed and all contain similar wording to the UK Financial Stewardship Code, no audit, no proof of claim, no redress for mis-reporting, however, signature to one or several of these Codes is judged by the SRI Industry to be a “key indicator” of ESG compliance, this is the start of the myth of SRI Metrics.
For even the most junior of ISO Auditors, the simple check of any Standard, Code of Practice, Agreement or Protocol to establish credibility is to look at two words, should & shall. Simply place the document into Word and complete a word search for these two simple words and see the results. ‘Should’ means that there is guidance but no real strength of requirement and ‘shall’ indicates that there is a requirement to comply. Sadly, all 41 International Protocols, Agreements and Codes, are mainly based upon the word, “should” just as is the UK Financial Stewardship Code. Therefore as we strip the Greenwash we see that SRI is based upon self-serving, self-reported, non-auditable information, which is then dressed up similarly to The Emperor’s New Clothes, (only those who profit from it see the value) and presented as ESG, which it is not.
Clearly, what is required by Shareholders, Investment Managers, the NGOs, United Nations and many others, is a credible, reliable and agnostic/neutral Metric that defines sustainability and ESG. The other requirement is for a Global ESG Standard, once again, this Standard must be neutral, highly credible and entirely based upon ISO methodologies and best practice which guarantee non-conflict of interest ownership, preferably it would become an actual Internationally agreed ISO Standard.
While it is impossible to easily remove the worst excesses of SRI methodologies and indeed the companies that promote SRI as the solution and not merely an emotional filter, it would allow a benchmark from which SRI Practitioners may then construct exclusionary filters as required by their Clients, a neutral benchmark provides such a platform. Since it is unlikely that a common agreement on transparency and methodologies amongst SRI and CSR Practitioners could be achieved easily, the implementation of a Benchmark would enable all the Global Ratings Agencies to compete on performance for their particular brand of exclusionary filters.
Sustainability & ESG
Measuring the impacts (not the end product) of manufacturing and production processes which depending upon good management leads to sustainability both in corporate, environmental and social aspects and has a significant impact upon the finances of corporations, and therefore their sustainability, and long term financial performance. Methodologies that measure corporate sustainability risk are designed to be agnostic and do not ever call for, political, emotional or conscience led methodologies, let alone be actually driven by such subjective actions.(SRI exclusionary policies may be implemented after actual ESG risks are established) The globally agreed ISO standards for each and every requirement of corporately managing Environmental, Social and Governance risk are already in place and fully compliant, tried and tested, in fact most companies already have these in place. Methodologies for aggregating and quantitively measuring these risk benchmarks have already been developed over some years. And have now been formulated into an algorithm which has power to:
1. Pinpoint the real value drivers in any given company
2. Deliver highly accurate performance comparisons across countries, Industry sectors and in fact differing Industries to a common standard
3. Deliver highly accurate ESG analysis of non-listed companies
4. Is predictive and not historic
5. Has acceptance in 162 countries
6. Is entirely agnostic
7. Is entirely transparent
8. In live test gained substantial acclaim from some large Pension funds & NGOs
9. Allows application of non quantitive SRI/CSR methodologies after establishing the real risk factors thus facilitating conscience investment with much lower risk
10. Has a substantially lower cost base than SRI/CSR methodologies
11. Entirely solves Fiduciary Duty compliance
12. Substantially reduces corporate legal liabilities
The fact that the development of this algorithm has been achieved by two separate entities, both highly specialized within the ESG world, who came together after some eight years of independent research, has provided the necessary skills to solve previously unsolvable questions, which makes the solution even more credible. The resultant algorithm is based upon eight years of empirical experience by the people who build and have built most of the Environmental and Social benchmark Private Standards in use today, standards which seamlessly facilitate over $3 Trillion in annual trade. Perhaps it may make sense that if close examination of this Industry is required, the logical people to approach are those who helped build the standards by which all E&S investment is made, these are people with track record and who actually have long term qualifications within the Environmental and Social Investment sector.
Likewise, the calculations involved with establishing real ESG Metrics call for another skill altogether, due to the fact that Environmental & Social issues often do contain necessary elements of subjectivity which could skew the final results if not accounted for, this calls for Financial Academia to apply yet another algorithm which aggregates these subjective areas and delivers quantitive results, this technology is based upon Neural Finance techniques which again have been well proven in a range of investment situations and are established methodologies in entities such as, The World Bank and the IMF. The neural Technologies implemented within this algorithm are the work of Cfar-m, which is a complex algorithm, produced by two French based leading university Professors of Economics who designed similar technologies for the World Bank and the IMF. Therefore we have two powerful algorithms based upon quantitive data which produce the necessary agnostic risk analysis for ESG.
According to Dexia, the risk analysis of ESG should be performed as a separate function to financial aspects, Financial Academia disagrees, this is only wise if the ESG risk analysis is based upon unverified and subjective SRI methodologies which do not follow or have any relativity to standard financial risk analysis, this being of course their qualitatively based SRI methodologies, however, when applying ESG risk analysis which mirrors exactly the same methodologies of established financial analysis, the results enable the Investment manager to not only gain an accurate measure of ESG risk but he then has ability to integrate each differing factor of environmental, social and governance risk within one matrix, therefore the list of possibilities are substantial and may be tailored exactly to requirements, all within a credible matrix produced very quickly within his own oce. Quantitive ESG Metrics are not concerned with SRI, CSR, Green, Eco environmental or social aspects, ESG, is about mainstream sustainable financial performance. It includes ESG factors merely because these factors have become important in the investment matrix, sometimes for compliance reasons sometimes for marketing reasons but often because investors demand to know how their money is being invested and who or what is behind these decisions.
Who are the people behind the move to agnostic and quantitive ESG Metrics?
SRI analytics are only available in relation to listed companies no system exists to benefit the vital European SME Sector
The European SME Sector
While the SME Sector in Europe employs 60% of the workforce and produces 40% of Europe’s GDP, SRI based ESG Ratings Agencies completely ignore the whole sector. Because SRI Ratings rely upon self generated information, mainly from Media, Annual Reports and similar sources, (i.e. it relies upon regulation to gain information without being regulated itself) it ignores the very sector that has the most chance of really driving sustainability and recovery, the smaller, entrepreneurial, more tactile and often more environmentally and socially attuned SME Sector.
This cynical and complete disregard for the companies that account for 40% of the entire European GDP and 60% of the entire European workforce and their Families who are investors and consumers themselves and who’s Savings and Pensions provide the money to Pension Funds who then ignore the entire SME Sector, is questionable. An obvious question to ask is “since a great proportion of the money held in Pension Funds belongs to some 60% of the entire European business owners and their employees, why is it that these entities do not invest back with the owners of the money?” This is easily answered, most Investment Funds and Pension Funds are mandated to only invest in Listed Companies, and therefore some 60% of all the EU companies unwillingly invest in larger listed companies while being excluded themselves.
The French Context
According to recent studies by MA Consulting
In Europe Approximately 90% of all businesses employ fewer than ten employees and almost 60% of employed people work for a small or medium-sized business. In addition, the SME sector contributes approximately 40 per cent of Europe’s GDP and is the catalyst for innovative products and services.
Across Europe the SME Sector is suering from a substantial Equity Gap. Funding for small and medium enterprise is at an all time crisis point, this situation severely damages enterprise and innovation and will very much affect future economic growth and employment.
Whereas banks and Investment Managers talk about “sustainable development” of the SME Sector this is made impossible to achieve due to the “top down” imposition of SRI based “sustainability”.
In fact one of the largest barriers to gaining funding for the SME Sector is the unnecessary confusion caused by SRI and CSR, because:
1. There are no common standards within SRI based “sustainability” by which to assess risk and therefore facilitate loans to the SME Sector
2. The current SRI ratings and rankings apply purely to listed companies, this is because in most EU countries the SME Sector does not issue an Annual Report, therefore under current SRI methodologies the SME Sector cannot be rated in terms of ESG Risk
3. The current SRI Industry focusses entirely upon listed companies, that is where the large fees are generated and the circularity of fee generation exists
4. With thousands of differing definitions of SRI & CSR, no lending Institution is able to adequately assess lending risk within the SME Sector, therefore the current SRI rating methodologies starve the SME Sector of investment.
5. Whereas there are several initiatives concerning the SME Sector and ESG compliance both mandatory and voluntary all of these are once again based upon un verified SRI methodologies involving fee paying over a substantial amount of time, therefore once again, are more about Greewash than fact and more about revenue generation for the owner of the “standard” than actually contributing to the sustainability of the SME Client.
The French SME Sector suers from additional dis-incentives not suered by its EU counterparts, this problem centers around succession planning and taxation, often it is better for a successful business owner to shut down a business rather than dispose of it by way of sale to a new owner. Therefore France is facing a major loss of not only entrepreneurship
but the additional loss of employment in one of the country’s vital providers of employment. This situation when added to the loss of small businesses through lack of funding and finance in general will become catastrophic in the near future.
While Dexia boasts of having some € 79.3 Billion under investment management with 25% under SRI filtering which equates to some € 19.8 Billion, (we estimate that there are similar sums amongst the total of French Investment Houses that could account for over € 300 billion) none of this investment is available to the cash starved SME Sector, why? Because as non-listed companies this sector cannot be ESG risk analysed, via existing SRI based methodologies. In other words, while Dexia and several other large investment houses implement SRI based ESG risk analysis methodologies which can only be applied to listed companies, the vast potential to energize the SME sector with it’s high level of innovators and entrepreneurs is excluded simply because these investment houses apply self-serving short term fee generating methodologies which have nothing in common with identifying real long term (sustainable) value within companies which could substantially benefit both the SME Sector, employment and Investors, a real “win-win” above short term fee generation.
As has been previously noted in this article, the major benefit of sustainably based ESG metrics lies within it’s Agnostic nature, while these technologies are able to predictively analyze financial and ESG risk in one action it is also able to provide quantitive information which can drive investment towards the SME Sector. This has been entirely ignored by the
large SRI ratings operations. Governmental financial support for the SME Sector is mainly channeled through the existing bank mechanisms that have been at the heart of the SME Equity Gap and originally caused the problem, this appears self-defeating. Talk of founding “Green Banks” and similar Institutions to facilitate SME funding have come to nothing due to the major established financial interests demanding a share of this money and a continuance of the failed SME funding policies that saw ever more money going into “the system” and not reaching it’s intended target, the SME Sector…
If just one percent of the money invested under SRI in France alone were dedicated to seed funding financial support for the SME Sector in France the initial funding would total € 3 Billion, perhaps the French Government might mandate this into action?
Where Is the Return for an SME Investment Fund?
Investment Funds specifically set up to fund SMEs have a history of a high rate of failure, This is for many reasons, but inability to define risk and opportunity is one of the key problems. Actually, there is potential of greater reward for Investors amongst middle range SMEs, beyond Start Up and achieving revenues, in the case of “Transition” SMEs. These “Transition” SMEs are entities with a proven long term track record and therefore potentially a valuable investment opportunity. The key to unlocking value for investors lies within the aggregation of risk; this is where neural technologies can play a major role. These proven technologies are already widely implemented across much of the Financial World and have the capability to provide incisive risk analysis across all the important aspects of investment namely: Financial Environmental Social Governance (FESG). FESG matched with real quantitive data then enables Financial Academia to base calculations upon empirical evidence and quantitive metrics for all four key aspects of risk. In terms of energising ESG compliant investment, Fund Managers are often constrained by Regulatory-Fiduciary Duty requirements and of course some aspects of ability to invest in non-listed companies.
Unlike SRI risk analysis which is based upon historic un-verified data and therefore cannot in Fiduciary Duty be termed as predictive which therefore denies the Investment Manager Regulatory compliance, the new neural technology based methodologies are predictive and regulatory compliant.
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Mainstream ESG Equity Allocations
The application of ESG data into the investment process should be identifying value and financial risk considerations within the same portfolio.
To achieve this, Investment Managers must face two challenges: firstly to identify the value drivers within ESG, secondly to identify opportunities to achieve this, managers must have reliable and up to date quantitive ESG information. There are now several global data sources for SRI available to investors, including Thomson Reuters, MSCI and Bloomberg in the US, that provide detailed and timely information on SRI characteristics. Since companies are not required to publish ESG data but instead operate on a voluntary disclosure basis, usually under one of the global 41 Voluntary Codes of Practice, collecting SRI data on a global basis requires a substantial sta to disseminate the information. However, it should be noted that, Bloomberg, Reuters and MSCI, are fed their data mainly by the SRI Ratings Agencies, who gain it from the various reports and analysis which are in turn taken from the voluntarily disclosed data. Therefore due to the nature of self-disclosure, very little of this data has been verified or could be verified.
To duplicate this level of research and collation, is not practical unless the Asset Manager is a significant sized entity, therefore the smaller and midsized Asset Manager are reliant upon the Larger SRI Ratings Agencies, and here is the first problem. For Active Managers with risk and return targets set against mainstream benchmarks, the most important components are scope of research and timeliness in a fast moving market. The scope and accuracy of research allows for a wider selection of stocks which gives greater opportunities to find good investments, while timeliness provides opportunity.
Accurate ESG Data Is Vital to Investment Performance
By measuring ESG and not SRI, the timeliness component allows managers to make decisions on the current valuation of stocks to decide on buys and sells. Quantitively based ESG metrics not based upon un-verified self-reported data but based upon Generally Accepted Accounting Principles and Financial Due Diligence are predictive and extremely current.
The nature of SRI is completely different from the usual data implemented by investors, SRI Data is (as opposed to ESG data) mostly static, since it relies upon the publishing of corporate annual reports and the voluntary disclosure under many Codes of Practice, therefore the data is at least 12 months old before being distributed and in some cases up to 18 months old before being analysed.
This makes it extremely dicult for Managers to capture value and actively manage their ESG risks, it also makes it impossible to predict risk which brings with it aspects of Fiduciary Duty, the reader may at this point be puzzled as to the mix of terminologies, SRI research methodologies measuring ESG risk? ESG risk analytical metrics are the only reliable metrics with which to measure ESG risk. It is a given that analysts seeking ESG value identification implement a vastly different set of metrics and methodologies than those implemented under SRI in seeking ESG value drivers.
Exposure to SRI Based Analytics
Perhaps one of the most important decisions that an asset owner must make is, how much exposure to SRI themes is prudent and sucient? Whereas the calculations and question change substantially if we ask the same question and use the term ESG, because most SRI based calculations are based upon the requirements of PRI, GRI or some other notional benchmark of Socially Responsible Investment (SRI). This methodology then continues the flaws and problems of basing serious investment calculations upon unverified data at least a year old, it also relies entirely upon negative and positive screening of which there are hundreds of differing ways to define that screening process, therefore even trying to cross reference for best in class is impossible without knowing the basis of the screening process.
By integrating quantitive, verified ESG metrics into the investment matrix alongside and on par with the same calculation methodologies as established, accepted financial risk methodologies, the picture changes dramatically (Please see An Introduction to FESG). Fully integrated ESG risk technology and performance now facilitates direct comparison with mainstream Indices to a point where it, in some cases, not only consistently outperforms mainstream Indices but makes up a substantial benchmark of measuring risk and performance.
While previous SRI based portfolios maintained their identity by comparison with similar SRI Indexes, risk and return has been determined by standard large cap benchmarks. Integrated ESG provides significant informational advantage, the timeliness and depth of material information of a potential target investment exploits information not widely available and not available at all for the SRI based Index constructor, Integrated ESG information provides active managers with a substantial advantage, it represents an information premium.
ESG is a measure of corporate management quality, based upon metrics derived from established International Standards which require robust third party verification of reported facts, these benchmark standards cover, sustainability issues, social norms, legislative requirements, regulatory requirements, shareholder activism, and more. Unlike SRI based analytics ESG analytics provide a direct correlation to share value and the identification of the value drivers. When integrated with financial data ESG provides additional insights into a company and contributes to making better investment selections.
Given the impossibility of integrating current SRI analytics into fundamental valuations, the advent of ESG quantitive metrics facilitate the valuing of stocks across several dimensions, value, earnings potential, sustainable growth factors, fully integrated with Environmental, Social and Governance (ESG) factors at source. A key component of the new ESG risks analytics is that the system actually breaks down each of the ESG constituent risk factors and assigns an individual factor. Finding Alpha implementing ESG integrated risk analytics has now become a reality.