Bundling E, S and G together ‘isn’t terribly helpful’

European ESG regulation is coming fast, with sweeping changes, and most of the regulation is centered around assessing risk. But trying to assess risk across areas of ESG and then combining them into one score doesn’t really assess a firm’s risk exposure in a helpful way, said panelists at a recent webinar held by Apex Group.

“The way that the regulations are driving this is that bundling [ESG initiatives together] in that way isn’t terribly helpful from a risk perspective,” said Alexander Rhodes, head of Mischon Purpose.

The classic public market example, Rhodes said, is Tesla – a company that received a glowing top-ESG stock nod from MSCI, while FTSE claimed it as its worst performing stock on ESG metrics.

“What do either of those things actually mean?” Rhodes said.

When providing scores to private market participants, ESG ratings firms focus on what’s material to a particular business and sector, and assess the material risks a firm faces from there.

But that approach, which ESG ratings firms employ, is antithetical to the nature of the scores they are providing.

“It’s a completely different approach from saying, ‘where’s your aggregate ESG rating?’, to saying ‘where are you in terms of ESG factors? What’s material to you? And are you on top of the most important things in that place?’,” Rhodes said.

Separating and prioritizing the ‘E’

As firms begin to prepare for added disclosures from the European regulatory regime, many of the individual disclosure requirements are focused on adding sector-specific disclosures.

The Task Force on Climate-Related Financial Disclosures, an organization whose goal is to “enable stakeholders to understand better the concentrations of carbon-related assets in the financial sector and the financial system’s exposures to climate-related risks,” is helping to ESG disclosures around climate-related issues. The TCFD is supported by many central banks and large financial institutions.

But just as ratings firms and markets more broadly begin to pick up on the difficulties of just focusing ESG initiatives around risk, some are beginning to recognize that some initiatives must be treated differently.

“We tend to treat climate as a separate category because we think that both companies and investors will have an ESG strategy and a climate strategy,” says Remy Briand, global head of ESG at MSCI.

The company is going even further within its environmental analysis to include “scenario stress-test carbon footprinting” for private market participants. “We’re now offering, essentially, the analytics required to create things like a TCFD report,” Briand says.

Treating environmental, social and governance initiatives as separate mandates as opposed to a standard box-ticking exercise could help firms weave ESG concerns into a company’s core business strategy.

“Up to now, it was mostly a discussion about risk and return,” Briand says. “But if you’re forced to have in your mandate, for example, carbon emission targets reduction… you have to take that into consideration at the same level as the traditional risk and return dimension.”