ESG Metrics that Should Matter Most to Investors

Todd Cort, Lecturer in Sustainability at Yale School of Management, on the factors that best predict the financial impact of environmental and social risks

Many alternatives investors agree that ESG considerations play a key role when making investment decisions. Indeed, 61% of LPs polled by Preqin believe that ESG will become an integral part of the industry over the next three years. But without a standardized approach to ESG that applies across the alternatives universe, how should investors determine which ESG considerations to focus on? How important are factors like management system quality and accountability?

To address these questions, we spoke to ESG data and metrics expert Todd Cort. A Lecturer in Sustainability at Yale School of Management, Dr Cort works with investors and fund managers to help them effectively integrate sustainability into public and private market investment strategies, including venture capital.

What are the main stumbling blocks for alternatives investors and fund managers wanting to integrate ESG into their investment strategies?
A key challenge we see is that many of the causal pathways between ESG and the financial impact – or the corporate benefit – are indirect. There are, of course, direct pathways: for example, by boosting energy efficiency, you reduce costs, which improves financial performance. But if there’s a human resources scandal within a company, the way that impacts financial performance is indirect. That’s why it’s hard to mitigate.

But if a company has good management structures, it’s possible to avoid the financial impact of material environmental and social risks. Even if those risks are always present, they only become a financial reality when the company’s management systems fail. This where the empirical data comes in: we've got about 27 metrics that we're testing.

We think metrics around management system quality, control system quality, accountability, and governance are important predictors of financial impact for environmental and social risks. We're testing that hypothesis using historical performance data and current governance structure data that several private equity firms have given us. 

What led you to focus your research on ESG data and metrics that drive value?
Before coming back to academia, I was a consultant for two decades, working in corporate sustainability. I started out implementing sustainability management systems. My clients would say, “It’s great that we’ve got a sustainability report, but we're getting all these questionnaires from investors, and they want different data.” I started working with investor relations teams, and then with the investors themselves, to understand what they needed to know, and what data they required.

When I came back to academia five years ago, I was working right at that cusp between what investors wanted and what investor relations teams were trying to deliver. My early research was centered on “What are the metrics that correlate to financial performance?” My team and I hacked away at that question, studying hundreds of thousands of correlations between ESG metrics and financial performance across a lot of different sectors. We thought we could solve this through a big data approach, but nothing came of it, because testing correlations doesn't work unless you also test causality. That’s when we realized we needed a rethink. We formed the Yale Initiative on Sustainable Finance to focus more deeply on the correlation of ESG data and metrics. 

At this stage, how far along can you get in predicting the financial impact from social and environmental risks?
In individual cases, we can predict the risks for specific environmental and social aspects, but writ large, with ESG, it's not easy. There's a lack of verification of the data; there's a lack of standardization. Your company's carbon emissions are not the same as my company's carbon emissions, so I can't compare them. There are huge gaps because ESG data is voluntarily reported, for the most part. In future, I think it's likely that there's going to be a carve-out of 2-5% of ESG metrics that are going to be regulated.

A key trend in sustainable investing is the rise of ‘value investors’ – those who are seeking an attractive rate of return – alongside traditional ‘values investors,’ or those focusing on investments that reflect their values and ethics. How is the surge in ‘value investors’ shaping the sustainable investing space? 
There’s been a lot of growth in impact investing, but the real explosion has been the integration of ESG factors. The GSIA (Global Sustainable Investment Alliance) has said that about a third of all assets under management – including public and private – use some sort of ESG integration now. We're probably ramping up toward 50% of the entire global economy that is now integrating ESG.

What other key ESG metrics are investors looking for?
A really important one is calculating value at risk. Let's say you’ve invested in a privately held alcohol distillery in Jamaica that’s in an area where there’s a risk of water scarcity. What is the value of that risk? How should it be calculated and put on a financial statement? What’s the percentage on revenue, on profitability, or on cost of capital that this risk presents to LPs? 

Those are the kinds of question LPs increasingly want answered. They want fund managers to summarize these risks in a comparable way, so that they can look across the board and say, “I've got 20% ESG risk sitting on my asset value over here. But this manager's managed to reduce that down to 2%.”

Converting risks to value at risk is challenging. Right now we’re looking at qualitative assessments of financial risk. But there's the potential that this will be quantitative in the future. Once the conversions are standardized, and accepted, then LPs can start to ask their different fund managers to track value at risk in the same way.

About Todd Cort
Dr Cort is Faculty Director for the Executive MBA track in sustainability, Faculty Co-Director for the Center for Business and Environment at Yale (CBEY), and the Faculty Co-Director of the Yale Initiative on Sustainable Finance (YISF). 

Dr Cort works at the intersection of corporate responsibility and sustainable finance. In this space, his research focuses on the environmental, social, and governance (ESG) data, metrics, and information that flow between corporations and investors. His objective is to reduce the barriers to moving capital to more sustainable investments. 

Dr Cort also educates and collaborates with corporations, asset owners, and asset managers to effectively integrate sustainability into investment and management strategies. 

som.yale.edu/faculty/todd-cort

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