What do COVID and ESG have in common?

Systemic change at speed shows the emperor has no clothes

What do COVID and ESG have in common? On the face of it, very little. One is a global pandemic; the other, an investment style.

Dig a little deeper, however, and you find similarities beyond the fact they were each christened with an acronym.

COVID takes ESG viral

First, and most frequently cited: both are catalytic forces that prompted a new way of thinking about how businesses operate within communities and environments.

It’s no surprise that COVID made sustainable investing go viral. The pandemic and its socio-economic fallout brought the principles of environmental conservation, social protection and good business governance into sharper focus.

In particular, the disruption laid bare the systemic problems inherent in our short-term, overleveraged global economic framework. As hospitals buckled and businesses went broke, systems resilience--particularly healthcare, enterprise and financial system resilience--became paramount from both a social and fiscal perspective.

Systems resilience is now seen as so integral, in fact, that the World Economic Forum last month suggested we add an R to ESG, while UBS suggests systems resilience will outstrip all other investor issues on the back of the pandemic.

Change like that only happens when we’re forced to face flaws in the system. Which leads us to the second thread bringing together COVID and ESG.

COVID : markets :: ESG : data

Just as COVID revealed flaws in the economic status quo, so too has ESG revealed major fissures in the financial data market underpinning it.

Escalating at nearly the same speed as the pandemic went global, appetite for ESG exploded between 2019 and 2020. Tailwinds soon met headwinds, however, in the form of bad data and lazy capital allocations.

High off ESG’s perceived unparalleled performance and inflows (some $51bn of net new money in 2020) versus a stagnating market, breathless investors and journalists at first overlooked what was happening under the surface.

This year, however, supposed sustainable funds have been subject to greater scrutiny, in light of the fact so-called ESG funds almost mirror their (much cheaper) non-ESG counterparts. Our own data holds that up. Greenwashing is rife.

To a degree, it’s not hard to understand why. The current state of ESG research and ratings is a mess. There is little consensus between the incumbent ESG ratings agencies; coverage is sparse and dwindles in line with market cap; methodologies are unclear and informed by fallible human opinion; and company disclosures are notoriously unreliable. When the ratings agencies enter the advisory market--which, the FT reports, is already happening--it will get even messier.

As EY recently observed: there’s a profound disconnect between the data asset managers need and what’s available to them. ESG investors are underserved.

Not all data?

There’s an irony here. Nobody would have started looking critically at the flaws in ESG ratings and research were it not for the speed at which they were being built into fund analysis: funds whose underlying assets were themselves ballooning.

The buck doesn’t stop with ratings agencies. In essence, ESG data is simply extra-financial data: all the qualitative stuff that can’t be bottled into a P&L statement but which does matter, thanks to 21st-century events such as climate change and COVID.

Seeing the extent to which the ESG fund market is a house of cards has prompted us to think more critically about extra-financial data and the way it’s gathered. Inconsistencies in aren’t just annoying: when they underpin this much money, they can prop up valuations and, if left unchecked, create market bubbles.

Take the way words have been used by investors to uncover qualitative information about companies--and then by those same companies to influence investor activity. We recently published an article about buzzword bingo, one of the ways companies outmaneuver investors. UBS analysts revealed to the FT that carbon and associated keywords tripled over the last three years--no doubt an appeal to the massive flows into carbon-conscious companies whose valuations have shot up.

Qualitative information, quantitative data

Just because extra-financial information isn’t as easily distilled into a metric, it doesn’t mean it can’t be scientific. Making it so is of paramount importance. Burgeoning flows into ESG are an existential threat, as subsequent scrutiny reveals the building blocks supporting the system might as well be made of card.

Just as for financial information, extra-financial information must be concrete enough to support the system it claims to represent. Consistency and reliability are guiding principles for financial data. If environmental and social issues are to sit comfortably in financial markets, their data must follow the same principles.

That’s really what unites COVID and ESG: inadvertent evidence that, in a changing world, systems reliability matters above all else.

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