ESGREPORT

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www.fii-institute.org

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REDEFINING ESG:TOWARDS ACHIEVING INCLUSIVE GLOBAL SUSTAINABLE DEVELOPMENT

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MESSAGE FROM THE CEO 4

SUSTAINABILITY ON THE GLOBAL AGENDA 6

THE “ALPHABET SOUP” OF ESG REPORTING 8

THE CONUNDRUM OF ESG DATA 10

ESG RATINGS: HOW USEFUL ARE THEY? 11

DIGITIZATION IN ESG: UNIQUE OPPORTUNITIES 12

EMERGING MARKETS: ESG CHALLENGES 13

INCLUSION OF EMERGING MARKETS IS KEY TO GLOBALSUSTAINABLE DEVELOPMENT 15

CONTENT

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As we continue to battle a global pandemic, we need to rethink our approach to sustainability. For despite the progress achieved since the 17 Sustainable Development Goals (SDGs) were adopted, and the growing alignment of Environmental, Social, and Governance (ESG) principles with the SDGs, achieving just and inclusive sustainable development remains one of the major global challenges of our time.

In 2020, companies that had strong governance structures and responsible social policies in place demonstrated greater resilience in the face of a global recession. This accelerated the rate of ESG integration and enhanced the quantity and quality of ESG disclosures around the world. Nonetheless, commitment to disclosing ESG performance remains generally low, and the absence of a universally accepted sustainability reporting standard makes identifying strong ESG performers challenging for investors, who continue to be faced with unreliable, contradicting, and often incomparable data and ESG ratings.

In 2021, we need to build more sustainable markets and ensure that economic activities align more consistency with the SDGs. Harmonizing sustainability frameworks and standards, improving ESG rating transparency and consistency, enhancing integrated reporting - linking financial and sustainability reporting, and minimizing biases in scoring ESG performance can help propel the world in the right direction.

We at the Future Investment Initiative Institute believe that the “ESG system”, as it stands today, does not fully consider the unique environmental, social, and economic realities, challenges, and stages of development of emerging markets, even though holding companies in emerging markets accountable to standards that are relevant to their specific realities is key to effective risk management and inclusive growth. We believe that market nuances – including varying value systems

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and political realities - need to be considered when judging the ESG performance, risk exposure, and sustainability prospects of companies within the context of their operating environment. At the same time, current ESG principles and definitions that are rooted in the values, cultural, and political norms of developed countries need to adapt and account for the diversity of beliefs, cultural norms, market structures, and the social, economic, and political realities of different markets.

The lack of a truly inclusive and equitable ESG system is a challenge to global sustainable development and inclusive growth, as participation in a non-inclusive system is likely to remain low. We call on all stakeholders to engage so that the current ESG system can evolve into an inclusive system that incorporates the realities, priorities, and limitations of all markets and bolsters positive, just, and inclusive sustainable development for all.

Richard AttiasCEO - FII Institute

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A report published by ISS EVA in January 2020 argued that ESG management is linked to improved financial performance as companies with higher ESG ratings are associated with higher profitability and lower risk.i The growing realization among the global investment community that a company’s long-term financial health is closely linked to its ability to manage ESG related risks and opportunities across the value chain is leading many investors to price ESG risks and favor investing in companies that reduce ESG risk exposure. More sustainability-focused capital allocation can be expected in 2021 as ESG awareness among investors and communities continues to grow.

International sustainability regulatory frameworks are also proliferating. The SDGs, Paris Agreement, EU Taxonomy, and many other global, regional and local frameworks have come into effect in the past five years and have shaped the global conversation on sustainability. As of December 2020, almost half of the stock exchanges on the planet have provided or have committed to providing ESG reporting guidance to their issuers according to Sustainable Stock Exchanges.

While ESG is an important value driver in emerging market investments - the MSCI Emerging Market ESG Leaders Index has consistently outperformed the broader MSCI Emerging Market Index since 2008 - participation of emerging markets in ESG, and representation of voices from emerging markets in major ESG conversations and decisions, remain limited in comparison to developed markets. The low level of inclusion and participation of emerging markets in the development of ESG frameworks is counterproductive to global sustainability.

SUSTAINABILITY ON THE GLOBAL AGENDA

i https://www.issgovernance.com/file/publications/ISS_EVA_ESG_Matters.pdf

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At the same time, given the subjective nature of ESG definitions, a “one size fits all” approach risks alienating companies in countries that do not adhere to the same definitions of “good” and “bad” that are dominating ESG conversations today. For example, companies in emerging markets often receive blanket negative scoring for ownership structures that are common in those markets (e.g., family-owned businesses and State-Owned Enterprises (SOE)) because such companies are presumed to be all risky despite evidence that commitment to sustainability in SOEs is higher than among other firms.ii

Blanket negative ESG scoring of market and company structures and norms that do not adhere to the standards of developed markets, without rigorous investigation of the financial materiality of a perceived risk, could create a bias against alternative market structures based on developed markets’ values and presumptions rather than actual ESG risk exposure. In 2021, the development of unbiased ESG definitions and principles, as well as conducting nuanced analysis, and actively and constructively engaging with emerging markets is necessary to improve understanding of the true resilience of companies within their own operating environments.

When we look at accounting, it took decades for the world to agree on common standards. I hope we don’t have to wait that long for ESG.

Loh Boon ChyeCEO, Singapore Exchange, Singapore

ii https://www.oecd-ilibrary.org/sites/5ad33666-en/index.html?itemId=/content/ component/5ad33666-en

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In recent years, more than 80 ESG general and focused frameworks and reporting standards addressing different aspects of sustainability have been developed across the world using different assessment methodologies and approaches, creating complexity and uncertainty for investors and companies alike.

The current lack of standardization presents investors with uneven disclosures by companies based on a var ie ty of f rameworks and standards. The diversity in content, methodology and emphasis will continue to limit a true understanding of a company’s performance. Companies will continue to be overburdened by multiple data requests from investors and rating agencies using different frameworks. At the same time, resources will continue to be wasted on trying to navigate the opaque ESG reporting landscape. This is particularly problematic for smaller companies in emerging markets, who might not have the resources required to collect and report ESG data using various standards.iii

Standardization of sustainability reporting will help companies around the world disclose ESG performance in a manner that helps investors better assess a company’s or an investment portfolio’s exposure to legal and regulatory risks, climate-related financial risk, systemic disruptions, and other ESG-related risks. In 2020, several steps towards global ESG standard-sett ing and mainstreaming sustainabil i ty accounting were undertaken. Despite attempts of convergence and attempts to create mandated sustainability reporting based on a common set of global standards, consensus is still lacking.

THE “ALPHABET SOUP” OF ESG REPORTING

iii https://www.responsible-investor.com/articles/we-mustn-t-miss-this-crucial-moment-to-create-a-global-sustainability-standards-board

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The European approach favors the inclusion of more stakeholder-centric models of reporting (i.e., in line with the Global Reporting Initiative (GRI) and SDGs). The Anglo-Saxon approach, however, favors building ESG reporting upon investors’ needs (i.e., in line with the Sustainability Accounting Standards Board (SASB)) and particularly around climate risk.iv The recent step by the International Financial Reporting Standards Foundation (IFRS) to standardize sustainability accounting, if successful, will be applied across most of the world’s jurisdictions. However, emerging markets’ inputs need to be taken into account in the development of global sustainability standards through effectively engaging the IFRS’ Emerging Economies Group and enhancing their participation in the process.

Alignment on ESG principles and definitions would also improve ESG adoption and reduce the subjectivity of ESG definitions and the existing biases in ESG scoring. To be effective, standardization efforts need to balance the sustainability priorities of different markets as well as investors’ focus on enterprise value creation and societal concerns for sustainable development that extends beyond investors focus.v

The IFRS’s foundation recent proposal to develop a global sustainably standard is an opportunity to build on their own global governance and their links with securities regulators.

David SchwimmerCEO, London Stock Exchange, UK

iv https://www.responsible-investor.com/articles/a-new-dawn-for-mandatory-esg-reporting-how-it-came-about-and-what-to-expect-next

v https://hbr.org/2020/12/the-future-of-esg-is-accounting

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THE CONUNDRUM OF ESG DATA

Investors are continuing to sound the alarm over the poor quality and fragmentation of ESG data, which reduces their ability to make informed investment decisions. The absence of a required auditing process in some markets negatively impacts data reliability and has led some investors to develop alternative data sources. For example, in 2020 Microsoft and BlackRock announced joint research grants to improve ESG data quality, State Street plans to bring together a “critical mass of asset managers” to work on climate data, Dutch investment house Robeco adopted ‘spatial’ information, and Allianz and S&P joined forces to offer a free-to-access, open-source ESG data and analytics platform.

Other challenges persist with data availability, reliability, and integrity. Risk of greenwashing by companies, alongside difficulties with ESG benchmarking and with providing accurate and consistent ESG ratings continue to hinder progress. At the same time, while publicly listed companies in many markets are coming under pressure to report on their sustainability performance, privately owned companies are not legally required to report their sustainability performance in most markets. Thus, limiting the availability and comparability of voluntarily reported ESG data.

A one-size-fits-all approach to scoring companies on environmental, social and governance standards is inhibiting the progress of firms wanting to adapt to more sustainable business… We are chocking them from the capital they need to evolve.

Scott MinerdGlobal Chief Investment Officer, Guggenheim Partners, USA

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ESG RATINGS: HOW USEFUL ARE THEY?

ESG ratings and scores developed by third-party providers using ESG data are used by investors to analyze the performance of companies in their portfolios and make investment decisions accordingly. However, the lack of convergence in ESG ratings between providers has led to criticism and reduced usability of ratings. In addition, ESG rating agencies generate profit by selling their detailed ESG ratings and anonymized benchmarks to interested parties. To enhance the availability of data on a wide scale, most of the big ESG providers made their ratings free in 2020. Yet, while top-line ratings are now freely accessible, the transparency of ratings is still questionable as underlying ESG data used for the analysis is not always available and only high-level ratings are being reported.

ESG rating agencies have different approaches to calculating ESG scores – leading to limited comparability of ratings. In addition, differences exist in coverage and scope as not all rating agencies cover all ESG pillars. Other issues include high heterogeneity of themes and key performance indicators, and different weighting methodologies. Because of differences in rating methodologies, major indexes can differ in up to 1 in 5 cases and can even be contradictory. Finally, the data aggregation process by ESG rating agencies can be opaque, leading to difficulties for third parties to understand and interpret the ratings.

Overall, the issues surrounding the consistency and comparability of ESG ratings reduce trust in the ratings from users and cause negative reactions to the ratings from companies. In addition, inaccurate and confusing ratings could lead to a higher ESG risk exposure than anticipated, creating risk blind spots for investors.

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COMPANY COUNTRY RANKING FROM AGENCY 1 RANKING FROM AGENCY 2

BAE Sysem PLC High ESG Risk (34.4) AA (Leader in ESG)

Huntington Ingalls Industries Severe ESG Risk (41.3) A (above average ESG performer)

Bunge LTD High ESG Risk (35.6) AAA (Strong leader in ESG)

Northrop Grumman Corporation High ESG Risk (30.4) AA (Leader in ESG)

Kansai Paint Corporation Severe ESG Risk (43.2) AA (Leader in ESG)

Sumitomo Chemicals Corporation High ESG Risk (33.7) AAA (Strong leader in ESG)

Giant Network Group Low ESG Rish (17.5) CCC (Strongly behind in ESG)

Eiffage SA High ESG Risk (35.3) AA (Leader in ESG)

Bouygues SA High ESG Risk (36.5) AA (Leader in ESG)

Limited Data Reliability – Examples of contradiction between major rating agencies

1) Not exhaustive

DIGITIZATION IN ESG: UNIQUE OPPORTUNITIES

Application of technology in ESG has significant potential to help with overcoming ESG related challenges. Technology can, for example, reduce the subjectivity arising from manual scoring, and enable high-frequency assessments to support timely investment decisions through improving data collection, ESG reporting efficiency and ESG rating processes. Moreover, artificial intelligence technologies such as natural language processing, remote sensing image analysis and machine learning allow for larger and faster data collection from all sources. Similarly, live monitoring of environmental and geospatial data using sensors based on the Internet of things (IoT) technology can enable real time data generation. Finally, increasing transparency of supply chain sustainability effects through block chain transactions and enhancing investment decision using self-learning models - to increase reporting frequency, data accessibility and allow trend forecasting – could aid investors with a better decision-making process. Thus, accelerating the speed of digitization of ESG data collection, analysis, and reporting will improve the quality of the information used by investors and the accuracy of ESG ratings.

Country ESG scores are positively correlated to the level of digitalization and robotization. This is particularly important for enhancing ESG reporting and integration in emerging market as digitization levels remain low relative to developed markets, thus negatively affecting ESG data availability and quality. More importantly, the high cost of manual ESG data collection and reporting for companies in emerging markets is often stated as a key obstacle to sustainability disclosures especially for smaller companies. Technology transfer can offer solutions and help track and measure ESG data for companies in emerging markets efficiently and cost-effectively. At the same time, investing in ESG reporting enablers for emerging markets is crucial to accelerate progress towards increased sustainability reporting and improved ESG performance in those markets.

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Limited Data Reliability – Examples of contradiction between major rating agencies

1) Not exhaustive

EMERGING MARKETS: ESG CHALLENGES

While ESG adoption is increasing in emerging countries, and regulators in key emerging markets are requiring sustainability reports for listed companies in Brazil, China, Hong Kong, India, and Malaysia, many stock exchanges in emerging markets fall short of mandating sustainability disclosures and only encourage voluntary ESG reporting or offer no guidance at all. Many emerging markets also face a shortage of expertise and human resources to lead sustainability initiatives and lack roadmaps and capability building plans or programs to develop sustainability capabilities in the long-term. As a result, overall adoption of ESG reporting in emerging countries continues to be low.

This is despite the fact that emerging economies tend to have a higher ESG risk relative to advanced countries, including higher vulnerability to environmental disasters, political instability and limited social inclusion, as well as limited access to foreign capital required to transition to sustainable practices. Some emerging markets also have underdeveloped regulatory frameworks, limited expertise in ESG reporting and integration, and higher likelihood of ESG issues impacting market performance.

At the same time, country ESG score biases in ESG ratings negatively impact the scores of firms in emerging markets to a larger extent – limiting the integrity and fairness of the ratings. A recent study by FTSE Russell, shows that nearly 50% of the ESG score is explained by three factors: country, size, and activity.vi Since a company’s ESG performance is generally affected by its size, sector, and country, the country bias increases the variance in ESG scores between companies in different countries, often because of matters outside of the direct control of the firms being rated.

The existing country ESG score bias negatively affects emerging market firms at a higher rate also because of the nature of their economies. Presently, industrial sectors that have the lowest ESG scores are mostly in developing countries, while advanced countries have the “cleaner” parts of the value chain. This places them at a higher risk of marginalization and reduced attractiveness to foreign capital, which is needed for their continued development. Removing the country bias from ESG ratings would help to alleviate the correlation between country ESG scores and company ESG scores and would thus enable a fairer representation of companies in emerging markets. It would also encourage better ESG performance and compliance.

vi https://content.ftserussell.com/sites/default/files/esg_scores_and_beyond_part_1_final_v02.pdf? ga=2.75185426.1815646875.1610380939-1756408866.1610380939

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ESG challenges for emerging countries – Methodological biases

AGENCY 1"The analysis found that, on average, almost half (%46) of a company’s ESG score can be explained by its size, sector and country.

"To take the country bias as an example, much of the variance in ESG scores between companies in different countries disappears once the bias is removed"

AGENCY 2

Wide spread of company scoresBased on a pool of +800 companies, the methodology used by the rating agency limits the correlation between country ESG scores and company ESG scores – allowing for a fairer representation

AGENCY 3

Wide spread of company scoresBased on a pool of +800 companies, the methodology used by the rating agency limits the correlation between country ESG scores and company ESG scores – allowing for a fairer representation

It is likely impossible to create a global ESG framework that entirely avoids some of the inherent biases in the ESG system because ESG ratings of companies operating in high-risk markets will generally suffer regardless of their specific sustainability performance. Nevertheless, it is crucial to point out the existing biases and address them in the analysis of corporate sustainability performance because of their potential for creating reputational damage and confusion on whether emerging market companies have low ESG scores because of non-sustainable activities or due to their underprivileged environments. The distinction is important to prevent capital flight and increase attractiveness of such markets to foreign investments needed to finance their sustainable development journey.

When engaging with companies on their ESG performance, stakeholders need to be cognizant of the constraints and challenges companies face when trying to improve their ESG score while a significant part of their rating is in fact out of their control. Focusing engagement on what a company can do rather than strictly focusing on the ESG rating of a company will lead to more constructive engagement on ESG.

The standardization of ESG is going to be welcome by the corporate and investor community as long as those standards are created by both these communities so that they take into consideration some of the differences between industries and geographies, and make sure they are practical.

Adena FriedmanPresident and CEO, NASDAQ, USA

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INCLUSION OF EMERGING MARKETS IS KEY TO GLOBAL SUSTAINABLE DEVELOPMENT Onboarding emerging markets in the development of a global and inclusive ESG system is key to achieving global sustainability. This involves greater inclusion of emerging countries’ institutions in the ESG frameworks and standards setting discussions taking place around the world. Emerging markets not only face higher ESG risks than developed markets, but they also have different market structures, company structures, value systems, cultural norms, historical experiences, and stages of development. Designing a “one size fits all” global ESG framework and reporting standard, without taking into account the diversity of markets, risks alienating key players and discouraging cooperation and compliance to the detriment of global sustainable development.

To improve ESG performance in emerging markets, the development of initiatives and programs, including ESG enablers, by international institutions (e.g., developing capabilities, providing funding, advancing technologies, etc.) and the creation of partnerships with developed countries to share expertise and knowledge will further advance progress towards sustainability. In 2021, we need to foster effective platforms for global collaboration, sharing of best practices and ESG knowledge transfer.

Global sustainable development cannot be achieved using a system that does not incorporate the needs and realities of all markets. Because companies in emerging markets sometimes receive blanket negative scoring for their unique market attributes, some emerging markets started developing local rating systems and local ESG principles and guidelines that address their specific requirements. In June 2020, Ping An Group announced the creation of a CN-ESG

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Smart Rating System for the Chinese market, providing a suite of smart ESG investment tools with comprehensive, intelligent and practical features that are China-specific.vii Frustration with the current rate and quality of disclosures, as well as the lack of alignment between the standards of disclosure from different regulatory bodies and assessments by rating agencies which fail to rate ESG performance of companies in emerging markets in the context of their operating environment, can be expected to lead to more local efforts in emerging markets and further lack of standardization in the global ESG system.

A new and improved ESG system needs to emerge and find ways to reward companies that generate positive impact where it is most needed. Some rating agencies, like Trucost, have added a country-based SDG boost to their scoring for companies that generate positive impact related to the SDGs in countries where that contribution is most needed. This provides an incentive to domestic companies and enables investors to maximize the real contribution of their investments to local economies.

It is in the interest of global sustainability to advance widespread adoption of ESG reporting and integration and improve standardization. Stakeholders in all markets need to cooperate to encourage widespread adoption of global ESG standards that are fair and inclusive. The pace of ESG adoption needs to be considered too as it would be unrealistic to think that all companies in emerging markets can apply developed world standards today, especially given the varying stages of development.viii

It is time to have a global conversation on how the global ESG system needs to evolve in order to advance global sustainability and enhance inclusion and equitable participation by all for the benefit of all markets. The recovery effort that the world is embarking on is a unique opportunity for improving global sustainability. The world needs to ensure a just transition towards a sustainable recovery that is efficient and effective at creating jobs, upgrading infrastructure, and delivering financial returns. Without a balanced and equitable application of ESG, reaching our common sustainability objectives will remain elusive.

vii https://www.prnewswire.com/news-releases/ping-an-builds-china-specific-esg-smart-rating-system-to-promote-responsible-investment-in-china-301081066.html

vii https://am.jpmorgan.com/content/dam/jpm-am-aem/global/en/insights/portfolio-insights/jpm52432-investing-sustainably-2019.pdf

ESGREPORT

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www.fii-institute.org