ESG Data – What you need to know

green leaves symbolising sustainability and esg data

As the market sees significant growth in Sustainable strategies and ESG funds, accelerated by the impact of Covid19, Reformis’ Head of Advisory, Tom Cunningham examines how the ESG data which underpins these strategies and funds faces significant challenges itself.

Introduction

In recent years we have seen significant acceleration in the development of sustainable and responsible investment (SRI) strategies as they gain more mainstream institutional traction. The traditional concerns about the limited number of ESG funds, and the view that these strategies caused a potential drag on performance, are now in a minority.

It is becoming more important than ever to understand how companies are being rated in these sustainable areas. However, the problem with most ESG data is the data itself and the lack of any codified standards.

What is ESG Data?

ESG data is an abbreviation of Environmental, Social and Governance metrics. In effect, Environmental criteria show how green the company is, Social criteria look at treatment of employees, suppliers, and the community, and corporate Governance deals with corporate areas such as bribery, corruption, and executive pay.

What are the ESG Factors?

A typical breakdown of ESG factors can be seen below:

Ratings Agencies

A small number of ESG ratings agencies, including MSCI ESG, Sustainalytics, and RepRisk (ISS) are the primary gatekeepers for this investment capital. However, dozens of companies make the evaluations that feed into the composite picture. MSCI, a leading provider of ESG ratings, has stated it provides ratings for 46 of the top 50 global asset managers.

Each agency uses a different methodology, metrics, and weighting, and there are different perspectives about what constitutes ESG.

This means that ESG ratings remain subjective to each rating agency. Added to this is the issue that many ESG rating agencies disclose only a few of the indicators they evaluate, and few disclose the actual material impact of each indicator. It is ironic that the agencies demanding transparency from the companies they research are less than forthcoming in terms of transparency themselves. Therefore, comparing ESG ratings and metrics becomes even more complicated.

Instead of too little information, investors may now find there is too much, but it is often conflicting, with few ways of objectively comparing results.

How a company scores can vary widely depending on which body is awarding the rating. As the ratings are not regulated and can be subjective, it is not unusual to get two ratings from different agencies that are wildly different about the same company.

Score divergence

While some ESG standardisation organisations like SASB (Sustainability Accounting Standards Board) and GRI (Global Reporting Initiative) do exist, companies have not adopted their recommendations when reporting.

As the area is only regulated to a limited degree, most companies carry out self-reporting, with the data framed in a favourable manner. Companies also change what they report on and how they report it from year to year. Coupled with the limited data history in some cases, due to its relatively youthful lifespan, makes it difficult to gather useful insights.

A good example of the divergence in ratings is the electric car maker Tesla. MSCI rates Tesla as “A” but JustCapital rates them in the bottom 10% of all companies. The difference in this case comes down to how heavily they rate workers’ rights and MSCI’s decision to attach more weight to the companies’ environmental record.

Before its collapse, Wirecard also gained median ESG ratings from MSCI and Sustainalytics. Legal & General gave the company a fairly neutral ESG score. As a Dax 30 company, Wirecard got picked up by some big ESG traded funds, at the end of April 2020, an ishares ESG ETF worth $2.4b and a Vanguard ESG ETF worth $978m both held Wirecard stock. However, Insight Investments gave Wirecard its lowest ESG score as it prioritises governance and accounting concerns.

Bias

As well as lacking in standardization and disclosure requirements, ESG ratings also suffer from company size, geographic, and industry biases.

Ratings agencies also have a preference towards larger companies, partly because they can dedicate more resources to preparing their disclosures.

Regulatory requirements vary by geographic region and it is not uncommon to get two companies, in the same sector, producing similar products to get different scores depending on where their headquarters are located.

Industry Sector Bias is reflected in company-specific risks and differences in business models that are not accurately captured in composite ratings.

Greenwashing

As investors are not able to effectively compare investments which are marketed as sustainable, this gives rise to the problem of greenwashing. Greenwashing (sometimes referred to as Green Sheen) is a form of Green marketing spin which seeks to persuade the public that an organisation’s products, aims, and policies are environmentally friendly and therefore better than their competitors. It is important to remember that ESG disclosures are often handled by a company’s investor relations or marketing team.

The drive towards Regulation and Taxonomy

Regulators, including the European Commission, are now looking closely at the oversight of ESG ratings.

In 2018, the European Commission published an action plan on sustainable finance.

The plan defines ‘sustainable finance’ as any form of financial service that integrates ESG criteria in business and investment decisions to provide sustainable benefits for customers and society in general. This regulation establishes the conditions and the framework to gradually create a unified classification system (‘taxonomy’) on what can be considered an environmentally sustainable economic activity. This is due to take force from March 2021.

In the context of Brexit, it is important to note that the UK has yet to put forward any legislative proposals around this and the December deadline is quickly approaching. It is likely that the EU rule book will come into play before the UK framework. This may have huge implications in terms of compromising the UK’s credentials as a hub for sustainable investing as the European market moves to the forefront in terms of Sustainable regulation.

Disclosure and Transparency

Another aspect to consider is that the rating agencies have no jurisdiction across the wildly different regions where multi-nationals now operate and therefore must rely on information companies voluntarily disclose.

To incentivise voluntary disclosure, ratings agencies often reward disclosure itself more than whatever actual risk those disclosures might reveal. Hence, a company with significant historical violations of ESG criteria can boost an ESG score by temporarily adopting more robust disclosure practices, despite having a higher overall ESG risk.

ESG information already disclosed in regulatory filings should be standardized to incorporate risk. As this begins to happen, investors will want some third-party verification and assurance of the data quality. The Big Four accountancy firms are already trying to make a play for this space.

However, after the latest round of audit scandals, the appetite to use them might be sparse.

Illustration of disclosure and transparency aspects of ESG data

Conclusion

Therefore, in an environment where it is difficult to correlate ESG investments between rating agencies – due to subjective analysis, a lack of transparency on indicators, and the bias reflected in industry, size and geographic location – it makes sense to blend the analysis from multiple sources to achieve a level of objectivity.

Divide ESG data into peer groups, regional sectors, industries, and sub-sectors, for example, to limit bias and enable correlation

Decide on the materiality of each rating, build correlation matrices which weight KPI’s differently for each peer group, giving more weight to KPI’s with significant correlation to financial metrics.

Alternatively, you can buy this as a service from the few ESG data aggregators now operating in the market.

Whichever way you choose to proceed, be sure to do your research, as Sustainable, Responsible Investing in ESG funds and strategies is becoming mainstream.

For more information and guidance, learn more about Reformis Advisory or contact us today.

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