ESG: The case for convergence

The most recent instalment of the UN Climate Change Conference, or COP27, which concluded in Egypt over the weekend, elicited mixed emotions. On one hand, participants announced a loss and damage fund to support countries most vulnerable to climate change. On the other, they failed to agree on a commitment to accelerate cuts to greenhouse gas emissions and phase out fossil fuels.

“The world still needs a giant leap on climate ambition,” said UN Secretary-General António Guterres. He added that the pledge to keep global temperature within 1.5 degrees of preindustrial levels, which some countries had sought to abolish, is “the red line we must not cross.”

On the margins of these headline debates, there was some succour for Asian private equity investors, among others. The International Sustainability Standards Board (ISSB) – which is seeking to do for sustainability reporting what international accounting standards did for financial reporting – unveiled measures aimed at facilitating disclosure for companies in developing and emerging economies.

The partnership framework for capacity building has three main pillars: tailored jurisdictional engagement; structured partnerships that leverage specialist expertise to enable the implementation of standards; and initiatives that translate ISSB ambition into tangible action. It is about supporting standards adoption and giving emerging economies a voice in the standards-setting process.

“It involves taking what looks like Mount Everest to some companies because they haven’t started at all in their disclosure journey and providing different tools, materials, and resources to help them along the way,” Katie Schmitz Eulitt, director of investor relationships and senior market co-leader for Asia Pacific at the IFRS Foundation, told the AVCJ ESG Forum.

The development taps into broader themes around convergence. There is a general expectation that, through ISSB, the IFRS Foundation will ultimately achieve its goal to create a global baseline for sustainability-related financial disclosures. Meanwhile, the Task Force for Climate-related Financial Disclosures (TCFD) appears to be emerging as the preferred framework for environmental disclosure.

Donald Chan, a managing director for Asia Pacific at CDP, which runs a disclosure system focused on environmental impacts, noted that disclosure is a journey with different starting points. It’s not unusual for companies to fill out only half of CDP’s questionnaire in year one and receive a C-grade. As data quality improves in year two, they ascend to B-grade and perhaps from there to A-grade.

“Disclosure is a practice: practising what to disclose, what is material, and dealing with a market that is changing,” Chan told the forum. “Always think of it as a process – you will eventually get there – but companies need to prepare themselves now, because TCFD is being implemented and mandatory regulations are being implemented very quickly.”

Consolidation effort

CDP is playing a role in convergence. The non-profit used COP27 as a platform to announce that ISSB’s climate-related disclosure standard would be incorporated into its global disclosure platform, which covers 18,700 companies worth half of global market capitalisation.

This is one of numerous alignments and mergers that industry participants hope will result in the alphabet soup of reporting standards and frameworks being strained into a more unified approach. The lack of a standardised and recognised measurement system is often flagged as the single biggest threat to effective disclosure on environment, social, and governance (ESG) metrics.

CDP was there at the beginning as secretariat to the Climate Disclosure Standards Board (CDSB) in 2007. The International Integrated Reporting Committee (IIRC) was introduced a few years later, supported by the Global Reporting Initiative (GRI) and International Accounting Standards Board (IASB), and the Sustainability Accounting Standards Board (SASB) emerged around the same time.

IIRC and SASB combined in mid-2021 to form the Value Reporting Foundation (VRF) and then ISSB was launched at COP26 that November. The IFRS Foundation simultaneously announced plans to consolidate VRF and CDSB with ISSB.

ISSB has published two exposure drafts: a set of general requirements that ask companies to disclose all their material sustainability-related risks and opportunities to investors; and a climate disclosure standard that focuses on transition risk and other climate-related risks.

SASB is the reference point for the general requirements, with companies encouraged to study the organisation’s materiality map, which identifies likely risks and opportunities for 11 different sectors and 77 underlying industries. The climate standard is built upon recommendations made by TCFD and incorporates industry-based disclosure requirements derived from SASB.

Companies operating in the same industry share common risks and opportunities. According to Eulitt, on average, the five dimensions of sustainability defined by SASB – environment, social capital, human capital, business model and innovation, and leadership and governance – can be addressed for a single industry through six disclosure topics and 13 metrics.

This is regarded as a starting point, not a ceiling. However, when asked what investors could do to elicit compliance from private companies they do not control and where founders might struggle to see the direct benefits for their business, Eulitt’s response was simple: start small.

“If it’s not relevant to have your portfolio company report on a million things, there will be a handful that intersect with its core business and the management or mismanagement of them can directly affect value creation or risk its destruction,” she said.

“If you are in emerging markets and facing more risks and unknowns, ESG factors can be risk multipliers or risk mitigators. You want to have your head wrapped around these things as much as possible. Industry-based standards can be incredibly helpful for companies that have limited resources as well as for generalist funds that don’t necessarily have industry expertise.”

A broad church

ISSB’s offering is intended to be accessible and interoperable. That applies to jurisdictions that focus solely on the notion of financial materiality and those that take a broader view, and to companies using an array of reporting frameworks.

The Singapore Exchange (SGX) asked member companies to choose the reporting framework that best suits their needs. Nearly 90% use GRI as a guideline. Digging deeper, SGX found that only 2% also used a dedicated climate framework despite about half identifying climate as a material factor impacting business. Last year, all companies were told to report against the TCFD framework.

“ISSB has an opportunity to create a global baseline for reporting that addresses investor concerns about consistency of disclosure,” said Michael Tang, head of listing policy and product admission in SGX’s regulatory unit. “But there is still a role of GRI and other reporting frameworks that provide more thematic or additional information that certain investors might require.”

He contrasted the prescriptive approach taken by ISSB, which concentrates on financial materiality and information that affects the enterprise value of the company, with GRI’s multi-stakeholder focus that considers all impacts of a company on the external environment.

There remain concerns within the private equity industry about being pushed towards a single standard. Kazushige Kobayashi, a Tokyo-based managing director at MCP Asset Management, said that a one-size-fits-all-approach would be difficult to implement in Japan given the gulf in company size and data quality, while mandatory ESG reporting could be detrimental to smaller businesses.

Jo Saleeba, Australia-based head of sustainability at real assets specialist New Forests, added that there is a risk of “over-burdening the whole investment ecosystem with reporting to the point where we spend so much time on the reporting that we aren’t using data to enhance investment decision making or the market is not using data.”

Echoing the view that there will continue to be multiple reporting frameworks to serve different purposes, Saleeba believes standardisation of data should be the priority. Technology can be leveraged to ensure conformity, accuracy, and robustness of collection, and then stakeholders can use it as they see fit. Reporting effectively becomes the front end of the system.

“The critical point is that you get underlying metrics consistent and comparable. GHG [greenhouse gas] protocols, gender diversity, health and safety, biodiversity – there need to be clear metrics that everyone is using. They can be standardised, and LPs can consolidate their reporting needs across different GPs,” she told the forum.

Quality counts

SGX has introduced its own front end into which companies can upload data and supporting evidence relevant to their situation. It maps to different reporting standards, so investors can study information in a systematic manner. The supporting evidence is supposed to help assurance providers get comfortable with data when conducting external validation.

Still, the challenge is ensuring the raw data fed into these systems is reliable. Chan of CDP observed there is a heavy reliance on secondary or proxy data, which has limited use. He said that investors increasingly want primary data delivered in an organised manner because it “gets rid of the greenwashing” amid criticisms of rating methods and criteria used by consulting firms and agencies.

Earlier in November, the US government – the world’s largest procurement entity – issued a proposal requiring major federal suppliers to publicly disclose GHG emissions and climate-related financial risk and to set science-based reduction targets. TCFD, CDP’s reporting system, and the Science Based Targets Initiative (SBTi) criteria were all referenced as likely guidance tools.

It came eight months after the US Securities & Exchange Commission (SEC) announced plans for mandatory climate reporting largely based on TCFD. Alongside existing regimes in Europe, including the Sustainable Finance Disclosure Regime (SFDR), and a ramp-up in reporting requirements for listed companies in parts of Asia, there is a sense that – on climate, at least – regulators are on the move.

Jie Gong, a partner at Pantheon, told the forum that climate discussions with GPs have increased in terms of frequency and technicality, a development she links to the rise of TCFD. Engagement has progressed from the qualitative level, where managers are asked to identify risk areas and draw up strategies, to quantitative measurement of scope-one and scope-two emissions.

“As SFDR has kicked into high gear in Europe, it’s become a compliance issue and legal departments are getting involved in that exercise,” Gong said. “In Asia, we have a tailwind behind our backs. This has already come to Europe, the UK is going to have a similar thing, the SEC has gotten a lot more focused on it – and it’s going to come to Asia as well. Be prepared.”

Another takeaway from COP27, identified by Steven Okun, a senior advisor to the GPCA and founder of APAC Advisors, a consultancy that specialises in ESG, sustainability and stakeholder engagement, is greater recognition of the social issues that accompany environmental action.

“Businesses and investors are going to be expected to know those trade-offs and mitigate them,” he said. “If you are doing renewables or something with a focus on the environment, know the harm you are causing in terms of jobs or raising prices during the energy transition. You might have to mitigate that through some type of offset programme that is totally unrelated to your business.”

Beyond climate

It tallies with the strategic direction of ISSB, which started out focusing on climate but will look beyond that in 2023. A request for information on potential consultation items is set to be issued.

“I encourage people to think of standards as a living, breathing document. We never say they are finished. We refer to SASB standards as codified standards, but they will always be evolving, and it is critical for us to get market feedback on how we make the standards interoperable with others around the world,” said Eulitt. “Standards are only as good as the feedback that informs them.”

Further, she advised against the pursuit of strategies that prioritise E at the expense of S and G. First, such agendas run contrary to the interests of LPs. Pension plans want private markets exposure to generate returns that meet long-term liabilities, but they also recognise that members don’t want to retire in a world beset by problems like income inequality as well as environmental damage.

Second, ESG represents a set of intertwined risks that can be hard to prise apart. Eulitt cited the hypothetical example of an electric vehicle manufacturer that addresses environmental issues very well, yet it remains on a disaster course because people aren’t being managed effectively and employee engagement scores – a critical factor in knowledge economies – are at rock-bottom.

LPs speaking at the forum made similar observations in terms of GP selection. When working with smaller or younger managers, there isn’t necessarily a requirement that an ESG policy and implementation framework is already in place, but they expect to discuss a timeline. Some LPs get actively involved during that journey, mobilising their own resources and networks.

Suzanne Tavill, a partner and global head of responsible investment at StepStone, noted that the SASB materiality framework is a good starting point for private equity firms looking to establish due diligence processes for specific assets. This can have a flywheel effect as GPs build up domain expertise in the sectors where they are most active.

“We are looking to see that material risks have been comprehensively mitigated. When you choose to ignore just one of those risks, that will be the risk that comes back to bite you,” Tavill said. “You need multiple workstreams, but private equity is no stranger to that.”

Navjeewan Khosla, a principal at Novo Holdings, which manages the wealth of Denmark’s Novo Nordisk Foundation, added that his firm often helps managers frame ESG policy and then holds monthly meetings with teams where they review progress towards tangible milestones. He sees value in any small step towards compliance – provided this happens in a balanced way.

“A lot of funds have a very myopic view on ESG,” Khosla said. “They pride themselves in focusing on ESG, but they are only focusing on one part of E, S and G, and ignoring the other two.”

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