How will ESG performance shape your future?

Most investors are moving toward more rigorous ESG evaluation

As part of the recovery from the COVID-19 pandemic, capital markets are reflecting on the potent impact that environmental disruption can have. The failure to consider environmental and social risks adequately, due either to their perceived longer-term impacts or the reduced likelihood of occurrence, has left many wondering how well prepared capital markets are to such shocks. At the same time that society and regulators alike are looking to companies to play a leading role in rebuilding our global economies, investors are increasingly asking whether risks such as climate change will be adequately addressed.

The research shows that investors are stepping up the game when it comes to assessing the performance of companies using ESG or nonfinancial factors, with a major commitment from investors to move to more rigorous evaluation.

Today, 72% of investors surveyed say they conduct a structured, methodical evaluation of nonfinancial disclosures – a significant jump from the 32% who said they used a structured approach in 2018. However, while the research shows a directional shift in philosophy toward a structured approach, it is the quality of the structured approach that is critical.

Investors are embracing Task Force on Climate-related Financial Disclosures (TCFD) as part of evaluations

The research shows that investors in our survey are building their understanding of the ESG reporting universe. In particular, they are factoring in disclosures made as part of the TCFD framework into their investment decision-making.

The extensive use of TCFD disclosures reflects the challenges that investors could face in obtaining information about a company’s existing climate-related risks and opportunities from other sources, as well as the climate-related impact on a company. The TCFD recommendations provide companies with a comprehensive framework to report the impact of climate risks and opportunities systematically, making it easier for investors to analyze a company’s potential financial impact due to climate change.

Investors have a strong appetite for a formal approach to assessing intangible value

Investors can often be deprived of important information about a business’s potential to create long-term value because of a failure to establish whether intangible assets are driving organizational performance. However, access to greater insights into intangible assets can allow investors to look beyond book value.¹

The research shows significant investor appetite for a formal framework allowing companies to measure and communicate intangible value, so that investors can evaluate their long-term value-creation strategy.

Companies that want to provide investors with a comprehensive view of how they plan to create, measure and communicate long-term value should ensure a connection between financial and nonfinancial reporting. However, investors surveyed say that this connection is missing.

A growing disconnect threat

Investors are looking for companies to provide standardized and rigorous nonfinancial data to support their approach to ESG evaluation, and any expectation gap between companies and investors could come at a significant price. Companies could find it harder to access capital, with investors that are concerned about lack of risk insight responding by raising a company’s risk profile. Choosing not to engage on ESG, or weighting performance solely toward positive aspects, may lead to investors coming to their own conclusions. One of the biggest areas of disconnect is in how companies are disclosing ESG risks to their current business models. The research shows dissatisfaction with risk disclosures has risen across all areas since 2018.

Investors are focused on TCFD climate risk disclosures, but questioning insight into processes for managing risk

Environmental risk is a key issue for investors and, when asked about the most valuable way companies can report ESG information, the TCFD framework emerged on top. The TCFD recommendations are especially aimed at sectors that are identified as particularly vulnerable to climate change impacts. While implementation of the TCFD recommendations is largely voluntary, investor appetite for this information will likely drive further uptake of the recommendations in nonfinancial reporting.

However, despite the importance of this information to how investors evaluate companies, the 2019 EY Global Climate Risk Disclosure Barometer – which assesses company reporting – found that responsiveness to the recommendations differs significantly between countries and sectors.² There were question marks around the depth of the disclosures on climate risk exposure and resilience, and the 2019 EY Global Climate Risk Disclosure Barometer found room for improvement in both the coverage and quality of disclosures by companies.

This latest research also points to concerns around the information provided. Investors surveyed highlighted risk management as the area where they received the least-developed information. This may reflect the fact that, while some companies disclose that they have processes for identifying and managing climate risks in their overall organizational risk management system, this is described in general terms without a clear link between the climate-related and overall risk management.

ESG is fundamental to investment decision-making

The importance of strong alignment between companies and investors is reinforced by the central and decisive role that ESG information plays in investment decisions: 91% of investors surveyed say that nonfinancial performance has played a pivotal role in their investment decision-making over the past 12 months either “frequently” or “occasionally.” Furthermore, the proportion of investors that say this happens frequently has jumped to 43% from 34% in 2018 and 27% in 2016. This trend in using nonfinancial information to determine a businesses’ value is likely to continue in a post-pandemic world, as investors look not only at a businesses’ resiliency, but also at the alignment of their purpose to long-term value-creation.

The climate imperative: physical and transition risk are critical to asset allocation and selection

Investors are paying increasing attention to climate change because they want to understand what it means for companies and the potential for a systemic financial shock to the economy. In the EY Megatrends 2020 report, new technologies reveal that climate-driven geophysical change is happening much faster than first thought. This is creating additional pressure for business leaders to adapt more quickly to climate risk because of the potential for disruption to supply chains and damage to infrastructure.

TCFD disclosure information is seen as a critical way for investors to secure the information they need on a company’s existing climate-related risks. The TCFD disclosures characterize risks and opportunities along two dimensions: physical impacts and transition impacts. The research found that investors surveyed plan to devote considerable time and attention to evaluating physical risk (75%) and transition risk (73%) implications when they make asset allocation and selection decisions over the next two years.

Exclusionary and positive screening are used extensively

In September 2019, institutional investors responsible for more than US$4.6 trillion in investments formed the UN-convened Net-Zero Asset Owner Alliance. The aim was to use their financial influence to combat climate change, with the group committing to move their portfolios to net-zero GHG emissions by 2050.³ The research shows that this kind of sustainable investing, involving exclusionary and positive screening, is on the increase and often being used to inform investors’ decisions.

The extensive use of positive screening reflects its growing importance in sustainable investing. Investors are using positive screening of ESG risk factors to create a modern best-in-class investment approach that generates performance that is in line with – and often exceeds – market benchmarks.

ESG is critical to success in the post-COVID-19 new reality

The COVID-19 pandemic – rather than distracting us from the need to drive a sustainable future – reinforces that imperative. The transition to a decarbonized future is critical to the long-term resilience of companies, the economy and the planet as a whole. Strong ESG strategies and frameworks will likely be critical to recovery and thriving in the long-term future.

Investors will likely be keeping a close eye on how countries and organizations recover from the economic impacts of the pandemic. The national economies and companies that set an agenda for climate-resilient growth will likely be seen as an attractive prospect, both in terms of near-term opportunities, such as job creation, and their long-term ability to withstand systemic shocks.

For investors to understand a company’s resilience maturity, they need to have insight into the ESG risks that companies face and how they intend to manage them. Credible and trusted ESG disclosures are therefore essential. The research has found that there is significant appetite among investors to build trust in the credibility of ESG disclosures.

Building trust and credibility in climate-related disclosures

Environmental issues are front of mind for investors; however, environmental and climate change disclosures – and insights into companies’ approaches to managing the related risks – are only useful to investors if they have confidence in what is reported. The research uncovers significant appetite for expanding the scope of assurance to provide that credibility and confidence.

This suggests that the investor community, given its reliance on nonfinancial information, will play an active part in pushing companies toward nonfinancial assurance. Companies that want to access capital and communicate their story to investors will need to respond to this investor-led demand.

Building confidence in green investment disclosures

In today’s market, there is demand for consistent and in-depth information on how companies are deriving revenue and growth from environmental solutions. But a significant number of investors are concerned that the information they receive is limited. It is perhaps not surprising, therefore, to find that there is significant appetite for assurance of this information: 82% of investors surveyed say it would be useful to have independent assurance of the impact of green investments and, of those, 34% say it would be “very useful.” These findings suggest that the investor community, given its reliance on nonfinancial information, will play an active part in pushing companies toward nonfinancial assurance.