Mind the carbon gap

“There are as many frameworks as there are disclosures” is a common phrase at ESG Book. It’s not without reason; the number of climate-related regulations and frameworks that companies and investors are expected to adhere to seems to grow by the day. Greenhouse gas (GHG) emissions data is essential for financial market participants to understand corporate alignment to various climate pathways, stress-test climate scenarios to identify transition risks and opportunities, and to engage with and hold companies accountable on their progress to meet their net zero targets.

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Always check the label

Using ESG Book’s recently launched Fund ratings which are applied to over 4,000 ETFs and more than 32,000 mutual funds, we explore how marketing claims and the labelling of funds can be inconsistent with the actual data behind a fund’s investments. For this analysis, two groups of funds were selected. The first group contains any fund with ‘ESG’ in its name, and the second any fund with ‘climate’ within its name. These two groups contained 420 and 95 funds respectively, all of which have at least 68% market value coverage from ESG Book data.

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Uncharted waters

Water is a crucial part of Earth’s climate system and, as a result, is intrinsically linked to climate change. While water is a victim of climate change, the way we manage and use water can contribute to it. Climate change affects the availability, quality and quantity of water required to meet basic human needs and threatens our human right to access clean water and sanitation. Water-related risks are becoming more immediate and significant, potentially adversely affecting all water users across the globe¹. On the other hand, energy use and greenhouse gas emissions in water supply, treatment and desalination can be significant contributors to global warming.

Water is input to almost all production activities. While specific sectors have unique KPIs, dependency on water is universal. In this landscape, water-resilient investments will be vital, and water data will be necessary for decision-making. Water is an important area for impact investors because water delivers a positive, clear, measurable impact – the trade-off between the benefits and sustainability of water is unambiguous². Water extraction, consumption and discharge are all closely interlinked, and good practice will have a positive chain effect.

Despite its importance, water reporting lags behind carbon reporting with information deficit and disclosure insufficiency. Many companies are still new and ineffective in water management and reporting³. The proprietary ESG Book dataset shows that even the most frequently disclosed metric for water (Quantitative Water Data Disclosure) has a coverage of only 54.91% in 2020, lower than the 65.11% coverage for Scope 3 GHG emissions (Figure 1). Moreover, the carbon reporting paradigm may not apply to water reporting due to water’s multifaceted, unidirectional, and localised nature. Unlike carbon, which can transport and accumulate worldwide, water issues are confined to certain times and geographical areas.

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What’s your fund’s ESG strategy?

The U.S. Securities and Exchange Commission (SEC) has proposed changes to the ‘Investment Company Act,’ an umbrella fund labeling regulation that requires 80% of holdings to be invested in accordance with the fund’s suggested investment focus. Funds that deem themselves ‘ESG,’ ‘sustainable’ or ‘green’ would be required, under the ‘modernized’ regulation, to identify securities included in the 80% basket. The proposed rule seeks to enhance data comparability and help investors differentiate between investment strategies. Given the investment industry’s demand for quantitative data, the S.E.C. has also introduced a standardized methodology for reporting emissions metrics. The fund labeling rule will be opened for comment and subject to further amendments. If finalized, it would be enforced at the start of the upcoming fiscal year FY 2023. In its proposal, the S.E.C. notes the rapid expansion of the sustainable investment universe – a 25 times increase from $639 billion to $17.1 trillion. The regulator is presently undertaking multiple measures to protect investors from misleading or exaggerated ESG claims, including the recent climate disclosure rule. The S.E.C. is, however, facing backlash for extending its powers. Several republican treasurers are punishing big banks including Wells Fargo, JP Morgan, and Goldman Sachs for fossil fuel divestment and preventing them from obtaining government contracts. The governing landscape is undergoing a paradigm shift in the U.S. and progressive rulemaking is being blocked beyond the treasury in republican-led state legislatures.

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One Draft at a Time

In an increasingly complex reporting landscape, firms are faced with an overabundance of frameworks and standards against which they can report their sustainability credentials. As stakeholders progressively highlight the need for consistent and comparable data1, standard-setting bodies are taking note. Public consultations for the International Sustainability Standards Board (ISSB) General Sustainability and Climate exposure drafts (IFRS S1 and S2), and the European Financial Advisory Group (EFRAG) Draft European Sustainability Reporting Standards (ESRS) were both live in Q2, 2022. The introduction of two draft standards with a potentially wide reach signals a trend towards the standardization of ESG reporting across jurisdictions.

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Fifty shades of green

Europe’s landmark anti-greenwashing rulebook for the investment industry, the Sustainable Finance Disclosure Regulation (SFDR) has triggered a growing number of investment funds to self-classify as either Article 6, Article 8, or Article 9. Since its implementation in March 2021, every financial market participant operating in the EU must disclose the extent to which their entity and investment products are aligned with the SFDR sustainable investment objectives (Article 6, 8 or 9 funds).

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Heating Up: the SEC Rules on Climate Disclosure

“What gets measured gets managed.” This quote by Peter Drucker also applies the other way around. Failing to measure corporate climate exposure and impact results in a lack of management, or even mismanagement in the face of climate risks and opportunities. Among the wide range of ESG topics that might be relevant information to investors, emissions can be seen as the ‘clearest’ data point to measure. Hence, it is emissions disclosure we must focus on to optimize our investment for positive (financial) impact, according to The Economist. Indeed, the recent Inflation Reduction Act in the US indicates a new momentum for the US pushing ahead on addressing climate change, with subsequent transition risks for companies.

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ESG has the ‘S’ Factor

Amidst all the media focus on climate and environmental concerns, it is easy to overlook another important facet in sustainability – the ‘S’ of ESG. Unlike the Environmental dimension, social impacts are often subjective, and identifying what to measure is a key first step in quantifying a firm’s social impact on the community in which they operate. While social indicators such as diversity ratios, presence of human and labour rights policies, and workplace accident rates have been used by ESG data providers to quantify a company’s social impact, many other possible indicators of a company’s impact on the community still pass by under our radar due to a lack of awareness or understanding about how they can impact society.

One such unknown aspect that can greatly impact society is design. The design of a physical or virtual object or space is traditionally viewed as simply the aesthetic inclination of the designer. However, the design of objects and spaces defines how we interact and engage with our daily lives. At its heart, design is as much a social tool as it is an aesthetic one, where design choices that does not account for disabilities for instance is discriminatory and can be a source of lawsuits. More importantly beyond legal risks, we must be conscious about how we design our society to not only ensure that everyone in our community can participate equally, with comfort and dignity, but also to guide individuals towards more sustainable decisions for themselves and for society.

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Machine Learning Models Don’t Work

*Without Good Design.

Machine learning (ML) is a branch of artificial intelligence that uses data and algorithms to imitate human behaviour (Brown, 2021). It is used in a variety of financial applications such as fraud detection, automatic trading, robo-advisors, loan underwriting, and targeted advertising. Machine learning revolutionizes how we invest, trade, advertise, and do business more broadly.

Machine learning also transforms how we conduct research and generate business insights. It offers unprecedented opportunities to use big data to identify patterns and extend our understanding of mechanisms. For example, creditors increasingly use ESG information to assess default risks. Currently, this assessment is predominantly of qualitative nature meaning that the analyst screens available material and incorporates the resulting impression into their assessment. Research involving machine learning could allow us to systematize the interrelations and generate tangible and actionable insights, including quantitative prediction of credit default probability.

A key question that arises upon this new opportunity is how to integrate machine learning in research design. Is it an add-on? Or a replacement? Or does using machine learning in research require a completely new way of designing studies altogether? This article discusses different ways to integrate machine learning into research design and their implication for knowledge generation and product creation. We use ESG and credit default as an illustrative case study. Specifically, we demonstrate the applicability of an ML-driven research design approach to determine the inter-relationships between ESG factors and credit default probability.

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Beyond The Acronym

Investors are eager to incorporate environmental, social, and governance – ESG – considerations in their investment strategies, even outside of what is explicitly framed as “sustainable investing”. In this blog, we explain how sustainability standards and frameworks are contributing to this trend; how they are ensuring a clearer rationale on sustainability in finance, and finally, where reporting guidance is headed towards.

The rise of sustainable investments has led to the burgeoning growth of sustainability standards, and frameworks for disclosure of investor critical ESG information. Among other things, Standards and Frameworks are helping companies and investors measure and disclose sustainability-related performance and make well-informed decisions while factoring in different emerging risks. In addition, they allow comparability over time, across sectors/industries, and in between peers or potentially with any company(s) operating anywhere in the world.

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