Paradoxically, ESG data methodologies are generally considered flawed, inaccurate, and unstandardized, yet its capital markets’ utility has broadened and become increasingly more influential.

Optimizing ESG disclosures and its corresponding narrative, if executed properly, provides far more benefits over the long-term, despite the various short-term implementation headaches.  That said, let us call out the notion of ESG for what it is.  Few participating in the capital markets really enjoy ESG, and many understandably struggle to identify, much less agree upon, its material characteristics.  They may appreciate ESG, but it is probably not a stretch to assume sheer amusement is few and far between.  

That does not mean it is a bad thing, it just means that ESG strategy, disclosure and conveyance is just one more task we all must add to our daily schedule, like compliance training or financial reporting.  Additionally, it seems the ESG goal posts are constantly moving, which they are.  The data is generally considered inconsistent, there are far too many frameworks and everyone operating in the ESG space seems to be doing their own thing.  “Why bother?” is a reasonable question, especially as COVID-19 has generally instituted a much more difficult set of macro dynamics for management teams to oversee.    

The complexity of the ESG landscape undoubtedly presents a variety of recent challenges, but effective and efficient execution can assist in attracting quality incremental capital, augment competitive differentiators, and allow a management team to regain control of the investment narrative.

From a strategic perspective, the decision tree associated with ESG disclosure offers two discernable avenues – “check-the-box” v. optimization.  In the short-term, check-the-box may alleviate a variety of the angst and relative inconveniences related to non-fundamental disclosure.  However, check-the-box is very much a band-aid, and a poor one at that.  As ESG continues to evolve, management teams who opt for short-term ease will continually find themselves hitting reset, probably on an annual basis.  On the other hand, the optimization route requires a little more time and attention, yet those efforts yield much higher returns on invested time and provides companies with a solid foundation they will be able to build upon in the future.    

Building blocks of ESG are important to consider when sketching out an ESG implementation strategy.  Unfortunately, if management teams do not attempt to proactively convey a set of guiding rules and context, the relative infancy of ESG data allows other entities, including detractors, to establish them.  When organizing a strategic approach, it is fair to assume the following attributes of ESG:

1) The staying power of ESG is not going to wane over the foreseeable future.

2) As ESG data and frameworks continue to evolve, trend analysis will not only materialize, but receive a heavier weight within conventional financial analysis.

3) Investors are increasingly finding a variety of unique uses for ESG data that spans across risk management, insurance underwriting, credit evaluation, competitive assessment, and valuation.

ESG strategy and implementation should center on “disclosure optimization,” defined as the ability to present an ESG profile in a fashion that quantitatively highlights the specific nuances of the business model, objectively conveys economic reality, and complements the long-term strategic directive of management.

Piecing together the ESG puzzle

ESG implementation is not necessarily hard, but it is time consuming and incredibly complex.  Incorporating a material ESG narrative within a traditional investment thesis can be arduous for any sector, but the difficulty is probably most evident within the traditional energy and energy transition network.  Energy transition, at best, is a multi-decade undertaking.  And regardless of what detractors think or say, traditional energy will continue as a global economic necessity for quite some time.  Ultimate success will only be able to be determined in literally decades, which essentially flies in the face of a conventional capital markets mentality that is generally fixated on months and quarters.  

If a reasonable proxy for materially significant and impactful innovation can derive from actual green patent production, then empirical research suggests that we should first look to oil, gas, and energy producing firms.

It is safe to assume that ESG’s influence will only mature and the notion of it being a fad is yesterday’s news.  Approaching ESG as a “check-the-box” exercise also happens to be yesterday’s news and will most likely result in further headaches for management teams.  Outlining the blueprint for successful ESG integration is a function of three key milestones:

1) Ensuring the discrepancy between ratings data and economic reality is mitigated to the greatest extent possible.

2) Ensuring external stakeholders are aware of and provided the appropriate context for evaluating a company’s respective ESG profile.

3) Ensuring the ESG disclosures, narrative and data points are mapped to the specific nuances of the business, especially as it relates to the fundamentals, strategic directive, and unique competitive differentiators.

The good news is that ESG, for the time being, remains in its relative infancy and no clear-cut winners have been named.  There are some groups that are obviously winning, but that status certainly does not ensure future success and is also predicated on materiality perspectives and data points that will inevitably change.