Demand for “ethical” investments not matched by quality information (yet)

type
Article
author
By Guy Beatson GM Governance Leadership Centre IoD
date
18 Aug 2022
read time
6 min to read
People walking over coloured grid pavement photo from above

Key messages- The Financial Markets Authority’s (FMA’s) latest review highlights how hard it is for investors to understand and assess Environmental Social Governance (ESG) disclosures as these concepts are often poorly articulated by companies.- A focus group of individual investors suggests their approach is to “set and forget” and after making initial investigation before making investments, pay only limited attention after that. - ESG information and reporting is “immature” according to the FMA.- The issue with ESG information and reporting is not a new problem and it is not confined to non-financial reporting. Similar issues have arisen with financial reporting, including with changes in accounting standards.- Reporting requirements and standards have been strengthened following company collapses and crises (e.g. Enron. Lehman Brothers, Satyam and New Zealand finance company collapses). As ESG metrics, measurement methodologies and reporting evolve and mature, along with issues that arise, they will likely be strengthened and improved.

What has the FMA said about ESG information about investments?

Investors are undertaking relatively limited analysis of managed funds that offer financial returns while purporting to take account of environmental, social and governance (ESG) considerations, according to the FMA.

Within that limited analysis, the FMA finds that formal disclosures from those managed funds may not currently be useful for investors.

Investor focus group research undertaken for the FMA, suggests:

  • “Ethical investment” is the term by which most people define what is now called “ESG” by those in the governance community.
  • People are motivated to consider ethical investment at different level of engagement – from wanting better Return on Investment (ROI), to impact investing.
  • There are a range of challenges for those seeking to make “ethical” investments, including:
    • People don’t feel equipped to search for these types of investment opportunities
    • There is limited awareness of the help services available and there is suspicion of that help.
    • Big providers aren’t seen to offer that much information and support.
    • The sector uses language and ways of talking about this type of investing that is “jargon heavy”
    • The final decision to invest is seen to require a leap of faith.

Against this background, the FMA found deficiencies in the information the Integrated Financial Products Funds provide investors and the way the information is presented. They suggest that this makes it difficult or even impossible for an investor to fully understand the nature of the investment they are making.  Contributing to this were:

How do these findings line up with international analysis?

ESG Information is a central theme in the FMA’s findings, particularly the nature of it, the way performance is specified and measured and the provision of it.

While it appears that demand for ESG or “ethical” investment is growing the quality and availability of data to inform those investment decisions and monitor performance is lagging.

International analysis suggest that two principal issues sit behind the gaps the FMA and others internationally identify:

  1. ESG investment outcomes and measurement focus: There are two ways of thinking about outcomes and measurement:
    1. Measuring the impact that a company (or other organisation) has on the welfare of its stakeholders, such as employees, suppliers, customers, local community and the environment. Companies improving wider outcomes or at least reducing harmful impacts accompanied by long-term financial benefits is mostly the focus for individual investors.
    2. Measuring the impact on a company (or other organisation) of societal and environmental factors, and particularly the financial impact (and risk). This is most often the focus for ESG rating providers who provide the approach and data on which individual investors rely.
  2. Evolving and different methodologies, and data availability: A critique of ESG ratings that can be applied more generally is that the methodologies continue to evolve. There is also no agreed or standardised methodology. There are also issues with data availability and there are concerns that where there are data gaps, these are addressed through statistical techniques that are not wholly reliable.

Much of the current situation with ESG domestically and internationally reflects the maturity of the thinking about ESG, including the outcomes it is intended to deliver in the short‑ and the longer term.

As an example, the Australian Prudential Regulation Authority (APRA)’s Climate risk self-assessment survey reiterated some of the findings from the FMA and the ESG rating papers:

  • Institutions have begun embedding climate risk into element of the risk management framework and strategy planning
  • Metrics and targets is an area for improvement, particularly using more advanced quantitative risk metrics
  • The focus for institutions in the early stages of developing their climate risk management practices is on qualitative measurement.
  • Institutions should continue to evolve their climate risk practices. [emphasis added]

Overall, the current situation with ESG investment, outcomes and performance measurement is best summed up in the FMA observation that “we believe [a] lack of maturity risks exacerbating investor disengagement and a ‘race to the bottom’, where minimal effort is applied to achieving non-financial objectives and the distinction [between funds] eventually disappears.”

How does this differ from financial reporting?

Surprisingly, despite financial reporting having a much longer history than ESG, similar issues highlighted by the FMA on ESG-related documentation, also arise with financial reporting.

Indeed, in 2014 the FMA suggested the following steps for improvement in financial reporting:

While these areas of focus were highlighted in  2014, the FMA’s 2020 review of financial reporting, noted that companies still needed to make improvements with:

  • Preparation of technical papers to support financial accounting and reporting judgements
  • Clarity, conciseness and effectiveness of disclosures of accounting estimates in financial statements and application of new accounting standards
  • Documentation of accounting judgements in Board and audit committee minutes

And it isn’t as if there haven’t been major issues more broadly which financial reporting did not address, pick up (through auditing) or even contributed to.  For example, collapses and crises over time (e.g. Enron, Lehman Brothers, Satyam, Carillion and New Zealand finance company collapses)

These issues have arisen despite well-developed and long-standing accounting and financial reporting standards applied by accounting professionals, backed by a range of assurance systems.

Following these issues and others like them there was a response that strengthened accounting and auditing standards, as well as regulatory and legislative change.

Why does this matter for directors and boards?

ESG metrics, measurement methodologies and reporting will continue to evolve and be strengthened.

We are seeing this already with climate-related disclosures in New Zealand and internationally based on the foundation established by the Taskforce on Climate-related Financial Disclosures (TCFD).  Sustainability reporting is heading in the same direction, including through the development of sustainability standards internationally (eg through the International Sustainability Standards Board and remit of the New Zealand External Reporting Board (XRB) to issue non-binding standards

Climate-related disclosures will see major companies and financial institutions taking a first step towards more standardised reporting with the release of the exposure drafts of the Climate Standards in August 2022 by the XRB.

This is in the face of increasing demand from various types of investors:

  • institutions – for example the development of a Stewardship Code for Aotearoa by Toitū Tahua | Centre for Sustainable Finance and the New Zealand Super Fund’s approach to responsible investment (which also provides responsible investing resources to the Accident Compensation Corporation and the Government Superannuation Fund Authority)
  • small investors - for example through Sharesies as illustrated in their blog investing ethically: it’s up to you.

The bottom line is that while there are clearly issues with different perceptions of what ESG means, measurement and methodology differences and dispersed information, directors and boards need to be alive to increased standardisation for this information, initially with climate-related disclosures for major companies and financial institutions.  The scope of this seems likely to extend to other aspects of ESG over time and may extend to a wider range of entities.  We’ll keep directors up to date to help directors and boards be prepared for these before they are put in place. 

References

Financial Markets Authority (2022), Integrated financial products: Review of managed fund documentation  

Financial Markets Authority (2022), Ethical Investment Journey Research.

Financial Markets Authority (2022) by fiftyfive5: Ethical Investment Journey Research

Larcker, D., Pomoroski, L, Tayan, B. And Watts, E. (2022) ESG Ratings: A compass without direction, Stanford Closer Look Series, p. 2.

Australian Prudential Regulation Authority (2022) Climate risk self‑assessment survey

Outlined in Financial Markets Authority (2018), Improving Financial Statements, p 2

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