Considering the urgency of the global climate crisis, there is, understandably, a premium on investments that promise emissions reductions or other positive social and corporate governance outcomes on top of conventional financial returns. These environmental, social, and corporate governance (ESG) investments and ESG funds are major players on international markets. Financial services firm Morningstar found that global sustainable mutual fund assets reached $3.9 trillion at the end of the third quarter this year.
It's not surprising that people want to "do well while doing good." The whole model falls apart, however, if ESG funds cannot point to verifiable yields for the climate, as is the case with an estimated 55 percent of climate-focused ESG equity funds.
Without accurate, comprehensive data on companies' ESG performance, investors are flying blind. Markets, and the planet, are the big losers in a dynamic plaguing the ESG world.
ESG funds that cannot show results face problems, of course. Growing evidence suggests such institutional investors can expect trouble in global capital markets.
Yet the climate--the priority for many ESG investors--suffers the most. Even companies we assume have smaller carbon footprints can, in a full-fledged accounting of the company's environmental impact, turn out to be responsible for inordinate emissions. Their inclusion in an ESG fund, then, is unwarranted, but investors have difficulty in measuring and reporting comprehensive impact.
This is especially true of organizations' Scope 3 emissions, or the greenhouse gases emitted by assets and operations outside their direct control, which can be as much as 5.5 times greater than the organization's direct emissions.
Accounting for upstream and downstream carbon emissions is, of course, more difficult than just estimating the emissions a company avoided through a building energy-efficiency retrofit or purchasing renewable power. The accounting difficulty, coupled with the fact that the final results will not look as good, could explain why only one-third of the net-zero emissions by 2050 commitments made by the world's 2,000 largest listed companies include Scope 3.
This is a tremendously difficult problem that even companies with substantial financial, technological, and human capital resources struggle to navigate. And big tech companies, a favorite of ESG funds on account of the relatively low carbon intensity of their operations, are no exception.
In many cases, firms of this breed possess the resources and manpower needed to develop, implement, manage, and ultimately disclose the progress of climate-related components of their ESG programs, as long as they concern direct, or "owned," emissions. Accounting of their full value chain, on the other hand, leaves much to be desired, with research from the Technical University of Munich suggesting these firms underreport their annual upstream and downstream carbon emissions by some 202 megatons and 189 megatons, respectively.
By way of example, consider the hypothetical case of a large tech company with a diverse suite of B2B and B2C products and services. Let's imagine the company commits to net-zero carbon emissions by 2050, and that this company has a strong track record of ESG and climate-related disclosures that generally shows investors progress toward that end.
Yet it is not hard to see how real-world activities could dramatically disrupt emissions models and consequently undermine emissions estimates. Say our tech company's model depends on getting products rapidly to consumers. Today's shipping bottlenecks would be unacceptable, and the company may well charter its own vessels rather than hope for the cargo ship backlog to ease.
Will the company's models of its emissions footprint, or of the lifecycle emissions footprint of any given product, take this change into account? Given existing ESG standards, the answer is probably no. Certainly, ESG investors lack adequate data to verify whether companies they invest in are taking such large changes into account.
There is no shortage of real-world examples of how real-world emissions accounting can get very complicated. Some utilities get well-deserved plaudits for strong ESG reporting going back nearly two decades and for rapidly decarbonizing their energy resource mix; yet how do we account for the climate impact of wildfires sparked by their equipment?
This is to say nothing of when a company faces competing reporting standards; investors and government entities like the Environmental Protection Agency may well require different disclosures, creating embarrassment (or worse) for a company when its disclosures to investors and to the government do not align.
These complications, and the fact that an estimated 9 percent of companies accurately quantify their emissions, make the 86 percent of institutional investors who don't trust companies' ESG data seem prescient. Without investment-grade ESG data, climate-focused investors cannot make informed decisions and reward climate-beneficial behavior, let alone reduce their own value chain emissions. If climate-focused ESG investors do not demand comprehensive, auditable data, they open the door for more widespread and camouflaged greenwashing.
Still, companies themselves have the capability, and the responsibility, to fix the root causes of the "flying blind" conundrum.
The first root cause is the inaccuracy and inconsistency of methods that organizations use to measure their contributions to climate change. The second cause is the insufficient extent to which organizations accurately and uniformly measure their exposure to the financial risks of climate change. Relatedly, the final cause is the inconsistency of methods organizations use to inform risk mitigation efforts and verify and disclose the effectiveness of any interventions.
But it won't be this way forever. Governments have a role to play, and jurisdictions the world over are beginning to implement more uniform standards. That was top of mind at COP26, where a day of talks dedicated to sustainable finance culminated in the formation of the International Sustainability Standards Board (ISSB), which establishes a "baseline" of minimum reporting on climate-related risks.
Still, the world is on a collision course with disaster. Some estimates are that global warming may exceed 3°C by century's end--well above Paris Agreement goals. Companies and investors alike must get their ESG data houses in order, so trillions of ESG dollars can flow to where they are the most effective. They have a responsibility to act before governments do.
Indeed, that is the entire premise of ESG investing.