As momentum builds for sustainable investing, asset managers are bringing environmental, social, and governance (ESG) data and metrics into the investment decision making processes.
In one of the fastest-growing sectors in the fund business, there has been an explosion in the number of exchange-traded funds related to ESG issues such as clean water, boardroom diversity, and equal access to education. According to CNBC, ESG exchange-traded funds (ETFs) attracted over $21 billion in the first quarter of 2021. That growth occurred at a faster rate than 2020 when ETFs accumulated $51 billion for the entire year.
But portfolio managers are still encountering issues with data and lack of standardized reporting for climate risks and other sustainable criteria. Despite the boom in ESG investments, ESG metrics are not necessarily consistent across data suppliers and providers may calculate the metrics differently, according to recent industry webinars.
In a survey sponsored by the Index Industry Association (IIA) of 300 U.S. and European asset managers published in July, 63% of respondents pointed to difficulties in agreement on standards and the lack of data coming from corporations which prevents investors from determining whether an investment is in line with ESG criteria.
ESG Data Challenges
“The main problem around sustainability today is the lack of standardization. It’s incumbent on companies to know when and how to disclose sustainability metrics,” said Junta Nakai, Global Industry Leader for Financial Services at Databricks, a cloud-based big data and AI platform during a webinar on AI in the world of ESG.
A second challenge is the lack of monitoring. “We see managers leverage ESG data for initial security selection, but many don’t have ability to monitor performance over time,” said Nakai who advocates taking a data-driven approach to operationalize sustainable investing.
Experts discussed the state of ESG data and corporate reporting standards across the globe and the potential for convergence on a recent CRISIL webinar, “Bracing for convergence in ESG Reporting Standards”.
While panelists agreed the current ESG data and reporting landscape is inconsistent, they cited significant regulatory momentum toward standardization. Yet, from a standards-setting perspective, “It’s still an alphabet soup,” said Stephen Bullock, Global Head of ESG Product Innovation & Analytics, Trucost, part of S&P Global, speaking on the CRISIL discussion forum.
Experts estimate there are as many as 100 different organizations producing ESG ratings from the likes of the United Nations Principles for Responsible Investing (UNPRI) to the Sustainability Accounting Standards Board (SASB).
Mark Purdy, Managing Director of Purdy & Associates, speaking about the IIA survey on the MSCI Perspectives podcast, said, “That creates a number of problems – one is that a lot of the data and the ratings aren’t easily comparable.”
“More standardization on a core set of ESG metrics that are relevant to business will help with some of the challenges and also allow data providers and financial service institutions to do advanced analytics,” said Bullock of Trucost on the CRISIL discussion forum.
Calls for developing disclosure standards have intensified from institutional investors over the past few months, noted panelists.
The pendulum swings whenever it comes to ESG and regulation depending on which political party is in charge, said a buy-side speaker on the panel. “Right now, with the Biden Administration and democratic control of the legislature, we’re seeing increased level of attention paid to climate exposure particularly with some existing regulations that have been on the books for a while,” said Glen Yelton, head of ESG Client Strategies, North America at Invesco Ltd., who spoke on the forum.
Now a series of European regulations and steps by the Securities and Exchange Commission (SEC) to require more disclosure of climate data could result in more uniform reporting standards and require asset managers and banks to prove their ESG practices.
ESG Regulations Heat Up
In 2021, the European Union brought out rules to regulate the fast-growing field of sustainable investing for the first time, reported the Wall Street Journal. This means that investment firms that invest in sync with ESG guidelines will need to provide “a tangible, measurable plan for how they plan to do so,” wrote the WSJ. The EU’s Sustainable Finance Disclosure Regulation (SFDR), which went into effect on March 2021, applies to fund managers, insurers, and banks that provide financial products in the region, including U.S. asset managers, not based in the EU, according to International Banker.
Even if the U.S. government does not legislate or mandate standards on these types of issues, Invesco’s Yelton said: “There is going to be a feedback loop as to how global asset managers do business with the European Union with SFDR.”
While the EU has taken the lead with ESG reporting rules, the SEC is catching up. In June, SEC Chairman Gary Gensler asked his staff to put together mandatory disclosures on climate risk and on certain workplace-related metrics.
“I’ve asked staff for recommendations for our consideration around governance, strategy, and risk management related to climate risk. In addition, staff are looking into a range of specific metrics, such as greenhouse gas emissions to determine which are most relevant to investors,” stated Gensler in a speech at London City Week.
With the proliferation of ESG products, the SEC is looking to protect investors against efforts such as “greenwashing” whereby a fund exaggerates or provides misleading claims about being environmentally friendly. Gensler said SEC staff will examine “how firms are marketing themselves to investors as sustainable, green and ESG and what factors undergird those claims.”
Integrating ESG Ratings
With the lack of clarity in corporate disclosures, investment managers have developed their own methods of measuring performance against ESG criteria. Some asset managers practice faith-based or ethical investing by screening out companies in certain products such as tobacco, alcohol, fossil fuels, and firearms. In recent years, there’s been a shift toward asset managers picking stocks based on ESG criteria in the belief that ‘doing good’ can have a material impact on the company’s long-term investment returns.
In Atlanta’s metro-area, Decatur Capital Management (DCM) has done research with S&P 500 companies showing that by excluding the bottom 20% that have the worst ESG scores, the firm’s portfolio managers can add 60-to-100 basis points in performance, said Steven Davenport, Director of Alternative Investments at DCM. Instead of earning 10% for the client, by picking stocks with the best ESG ratings, the firm could deliver 10.6%, he said.
So how does an asset manager use ESG data to assess sustainable companies that meet its financial criteria?
DCM signed on to the United Nation’s Principles for Responsible Investing, known as UNPRI, about three-and-a-half years ago. Pointing to the importance of “people, planet, and prosperity” as outlined in the book “The Green Swan: The Coming Boom in Regenerative Capitalism,” by John Elkington, Davenport said the firm believes there is a connection between ESG values and higher returns over the long-term. It uses Truvalue Labs for ESG research and ratings data. Truvalue (recently acquired by FactSet) provides Decatur with security level data, rating public companies on the 17 characteristics under criteria developed by the Sustainable Accounting Standards Board (SASB). Using AI and machine learning, Truvalue evaluates news on companies and how the news is related to the ESG factors; if the news is negative or positive, it affects the factor score, said Davenport.
In a two-step process, Decatur filters companies for quality of earnings, quality of valuation and quality of earnings expectations, to pick the best names. Then it examines the Truvalue scores to ensure it picks names with the highest ESG ratings and calculates a total score. “When it comes down to picking company A versus Company B and one has a Truvalue score that is higher, we’re going to pick the one with the higher ESG score,” said Davenport. If one company has a profit margin that is two-to-three percent higher, but it has lawsuits against it, that stock is not viewed as sustainable, said Davenport.
Demand for ESG Data & Transparency
Data providers have seen a spike in demand for ESG data and analytics and are working with investment managers to create ESG workflows and customized metrics within the investment process.
One obstacle toward meeting the needs of financial institutions is that data relevant to ESG is not necessarily in digital format. “About 80% of all disclosed ESG data and metrics is non-numeric – it’s unstructured. That is why it’s difficult to take a holistic approach and difficult to understand the data,” said Junta Nakai of Databricks during the firm’s webinar.
ESG tools are relied upon to extract information using machine learning and natural language processing (NLP). Many sophisticated asset managers utilize platforms leveraging all that data which is publicly available in order to see where a particular company ranks against its peers, said Nakai in the webinar “Data + AI in the World of ESG.”
Meanwhile, CRISIL released a whitepaper in which it identified about 45 indicators which can be picked for a converged global ESG reporting standard, and another 15 that may become mandatory in the EU.
“In our opinion, over the next few years, we will start to see generally accepted principles of ESG reporting come through at a global level. This will be led by a concerted effort by both standards setters and regulators globally,” said Abhik Pal, Practice Head, Fundamental Research, CRISIL Global Research and Risk Solutions on the forum.
However, even if core metrics are agreed upon, data gaps may persist, said panelists. When a large container ship was stuck in the Suez Canal for six days in 2021, investors saw how strong winds and physical risks could disrupt the global supply chain, said Invesco’s Yelton.
“Things like location-specific information are needed to give an indication of risk exposure at the local level – such as water risk or physical risk,” said Bullock. “We might see those in alternative data sets like satellite images, providing those useful insights to fill the gap,” he said.
Another gap is that ESG data is equities biased, whereas institutions invest in multiple asset classes. Referring to sectors such as corporate bond markets, municipal bonds, sovereign debt, real estate, and commodities, Invesco’s Yelton said, “there is no consistent data across many of these asset classes.” Panelists agreed that more data is needed to address ESG investing in fixed income such as green bonds and real estate. “If you are a credit analyst looking for a better corporate bond portfolio, ESG can help you mitigate some of the downside risks,” said Raman Aylur Subramanian, MSCI’s Head of Solutions Research on the MSCI podcast.
In the meantime, asset owners are pressuring investment managers to explain how they integrate ESG into their investment offerings, and the SEC is focusing on what defines an ESG product, observed Invesco’s Yelton. “Where convergence is likely to play out first is in labeling ESG products,” said Yelton. “It’s not the convergence of ESG disclosure but what it means to be an ESG product or use ESG or sustainable or low-carbon with your name. That is where I can see convergence (happening) much quicker than with data,” said Yelton.
Looking to the future, panelists are optimistic about the evolution of ESG ratings and more uniform standards. However, the buy side could grapple with lack of consistency in ESG ratings and numerous standards bodies for many years, unless there is consolidation among the providers. Regulators will inevitably step in to define corporate disclosures on climate risk and other social and governance factors to protect investors. But given the uncertainty, this is likely to weigh on the sustainable investing industry, creating more demand for data and analytics providers, which could be the ultimate winners in the ESG megatrend.