Sustainability is no longer a naive afterthought or a “hippie” utopian pipe dream. It is now becoming top of mind for many businesses and investors. The shift from dream to hard reality is probably down to a few factors, one being the most obvious and that there is a demand for cleaner industries and technologies because the climate on this planet is starting to heat up and resources are starting to dwindle.
Secondly, public support for sustainable practices and products has gained massive traction over the last decade. Combine this with the exponential rate of technological innovation, your sustainable dreams for the future are now a plausible reality and a necessary one.
But also as the cumulation of the above factors converge, they have created the conditions that are prime for opportunity. Basically, there's money to be had investing in and developing sustainable industries and technologies currently, rather than it being a financial hindrance. And this is exactly where ESG reporting comes in, providing a guiding hand in screening investments.
“There’s a misconception out there that you need to be willing to give up returns in order to invest responsibly but a growing body of research shows that ESG actually helps mitigate risk,” – Smith of The Haverford Trust Company.
Knowing which sustainable horse to place your bet on will become increasingly important as ESG based investments are set to reach 1 trillion USD by 2030 and in the Q1 2021, ESG funds raked in over 21 billion USD.
This ‘green’ transformation is leading investors and investment firms, namely private equity firms, to sniff out new and greener markets. This is bringing a new scope on how Private Equity firms (PE) and general partners (GPs) view potential companies, putting the lens of ESG reporting to screen future investments.
What is esg reporting and scoring
Well, to start off ESG reporting looks at the environmental, social, and corporate governance criteria that is used to scrutinize various companies. These reports and analysis are being used to screen businesses and provide investors insights that need to be considered for long-term stakeholders. Here’s the breakdown of the three criteria:
Encompasses the impact a company has on the conservation and protection of the natural world. Think everything from climate change to waste management.
Refers to the impact the company has on employees and on society in general. Is the business ethical in how they treat their labor force? Does the company have a negative impact on the community it is situated in?
Is the way in which the board and management conduct themselves and navigate their business. For instance, corruption and bribery would have a business score low in governance.
ESG metrics and rating agencies
ESG reporting and criteria was first tailored together in 2006 by the UN’s Principles for Responsible Investment (PRI) report with the hopes to further the development of responsible and sustainable investments.
Currently, the criteria have become increasingly commonplace in financial reporting for private equity investing, however, there is still no completely standardized ESG reporting metrics scale. This does not stop the growing number of ESG rating agencies that calculate scores based on a 1-100 point scale. Some of the most well-known firms in this regard are MSCI, Refinitiv, JUST Capital, Bloomberg and, S&P Dow Jones Indices.
And where there’s smoke there’s fire, as ESG compliance and reporting is becoming ever-more commonplace. Case in point being that in the beginning of Q3 2020 90% of companies on the S&P 500 have published ESG reports.
Important criteria for private equity investing
What has laid the foundational success for Private Equity firms historically has been the ability to spot where future value will be generated. You can see this occurring now, as many firms are shifting their focus onto ESG reporting, using these criteria as a snapshot of investment opportunity and value generation that sustainable-based business will potentially bring down the line.
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ESG reporting seems to be a reflection of the changing attitudes of stakeholders across companies. A study conducted in 2020 by Capgemini found that 79% of consumers are shifting their purchasing preferences towards sustainable alternatives.
This is coupled by 61% of employees of various companies feeling that sustainable practices should be mandatory for companies. And as a result 88% of limited partners (LP) use ESG performance indicators when making investment decisions.
It is hard to speculate who is driving the shift in sustainable attitudes, either policy and law makers are influenced by the public or vice versa; a near chicken or the egg conundrum. However, it is most likely a little bit of both, as with most things in life are not dealt with in absolutes.
The fact of the matter remains that attitudes are shifting across the board, and policy makers and regulatory bodies are putting more regulation regarding environmental, social, and corporate governance issues. Case in point being the EU Taxonomy for Sustainable Finance and the government in the UK mandating the Task Force on Climate-related Financial Disclosures (TCFD).
Private companies are being held to a higher sustainable standard and will be in the near future, as well as further down the line. Compliance to regulation will be necessary and business practices will have to eventually fall in line. This Makes ESG reporting a well-fitted sieve for GPs and private equity firms to help filter through the companies who will come out on top.
ESG reporting also offers an alternative screening for risk management as compared to other more traditional considerations, such as leverage risk. Of course, ESG metrics shouldn’t be the only focus point you should consider, but it should be a part of your screening tool box nonetheless. However, in many PE firms’ eyes, a company that addresses environmental, social, and governance issues over the long haul is a safer bet and less of a risk.
Part of the reason why ESG reporting is carrying such clout is because businesses who are aligning themselves along the criteria are creating a cohesiveness throughout their organizational structure and improving stakeholder confidence across the board. In turn, this is helping companies with their brand positioning, operational efficiency, long-term value creation, and market differentiation.
When considering ESG investing, some issues arise with the framework. One being that the ESG rating agencies have no standardized or uniform measurement criteria. Each firm uses their measurement parameters and methods to score various companies and their ESG standards.
Of course, some methods may overlap and are similar to other agencies, but none use a blanket uniform measurement or method across the ESG board. There are currently a wide range of frameworks used for ESG reporting and scoring, some of the most popular are Global Reporting Initiative, Sustainable Accounting Standards Board and Task Force for Climate related Financial Disclosures.
Of course these organizations are using their own criteria and of course some of these criteria they use to measure must overlap with other organizations. But let’s say that you’re a PE firm looking to invest in a company based upon ESG metrics, then you might start to question how reliable the data is that is listed in the reporting method.
“Without one standardised framework for reporting standards, we will continue to see firms mixing and matching various guidelines, hindering long-term process in the area. We’re still seeing high-profile cases of failed IPOs and increased divestment attributed to poor credentials in all areas of ESG.” – Andrew Probert, Managing Director of the Sustainability Accounting Advisory Services at Duff & Phelps
Also, relying on companies to self-report and provide data that they gathered themselves can potentially be misleading. The issue revolves around how accurately those data points reflect what the company is actually doing regarding ESG policy.
It's in the company’s best interest to report that they are more than ESG compliant. This could potentially see ‘greenwashing’ take root and become ever-more common and problematic. As it stands now without a standardized method to score, the best tool PE firms have to combat these issues is due diligence. As it would be key in order to extract the most reliable data.
Just a trend?
What has been witnessed in recent years is a steady incline of ESG reporting standards. In 2021, what was reported by an annual survey conducted by Investech, found that 62% of GPs have decided to pass on investing in a company due to ESG considerations.
Other various demographic and geographic factors have been reported as influencing investment decisions regarding an ESG policy. The report found women are more likely to avoid investment founded on ESG grounds, and Continental Europe is 10% more likely to base an investment decision through ESG criteria.
It would appear that ESG reporting as a screening method for PE investing is on the rise, especially when you consider that 83% of investors below partner level at a firm report not investing in a company based on ESG principles.
However, this hardly displaces the fact that PE firms still invest in companies that do not put ESG standards first. For example:
“But it is in the environmental field that a good chunk of the private equity industry is playing its most obviously reactionary role. When oil majors are looking to sell off stranded production assets, private equity are among the readiest bidders.” – Patrick Jenkins, Deputy Editor at the Financial Times
And this probably won’t change until ESG returns begin to outweigh every other investment under the sun. Even though the tide may have not completely shifted towards complete focus onto the ethical, sustainable, and the responsible, the flow is moving towards this scope.
It appears that ESG reporting holds a massive potential when it comes to sustainability, because what has traditionally held sustainable advancement and innovation back is the financial incentive for businesses to innovate and implement new business practices and standards.
Now that the proverbial carrot is being dangled, the incentive to ‘go green’ has never been more attractive to business owners and this is in part propelled by PE investment pushing ESG policy and screening on prospective investment opportunities, but on the other hand also propelled by stakeholder interests and attitudes shifting across the board towards sustainable behaviors.
The metrics being applied to analyze prospective investments and acquisitions, is a major tool for PE firms and GPs to use in order to assess the long-term value creation of a particular company. This is also backed by the fact that in the U.S. private equity ESG fund returns were 4.3% higher than traditional funds in 2020, and the buck doesn’t appear to stop there.
But also on the other hand, ESG metrics and criteria can be used as a structural way for businesses to align and position themselves in order to prepare for regulatory and societal shifts towards sustainable practices in the near future.
However, doubts on the reliability of scoring still remain, and rightly so. The lack of a standardized means of measuring companies is an issue and it can damage the longevity of ESG reporting. This is backed by a study that found 45% of valuation experts think the lack of standardization is the biggest issue facing ESG.
The rise in GPs applying ESG reporting standards to their evaluation process combined with a lack of standardization could potentially see more and more companies ‘greenwashing’ their self reported data, making it harder for PE firms and GPs to peel back the layers and view the factual and overall standards of a company. However, this still remains a hypothetical, but is still one foreseeable outcome of the situation.
ESG reporting may not be perfect, and it is still a tool that needs a bit of honing in order to realize its full potential. If certain hurdles can be overcome then an ESG policy can be the foundational basis for businesses and PE firms to ensure the value creation and retention down the line.
Any tool that can be used to screen potential investment opportunities for the future are priceless. Being able as an investor to stay one step ahead and on top of the latest and greatest is the main ingredient to finding success.
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