With Environmental, Social and Governance (ESG) criteria-based investing growing rapidly in recent years, investors who specialize in ESG investments are finding a lot of operational issues to consider. First, they need to make sense of all the sources of data on ESG-compliant investments. Second, they need to know what is required to comply with regulations, such as the EU’s SFDR, which aim to authenticate that investments promoted as ESG-conscious really do follow those principles. Third, investment firms need to know what their operational demands are for publishing ESG data and reports, and how they can effectively meet those demands. This last step is complicated by the lack of standards for rating ESG compatibility.
Many of the previously independent data providers specializing in data about companies following ESG principles have been bought by larger data or service providers in the past few years. S&P acquired Trucost, FactSet acquired Truvalue Labs, Moody’s acquired Vigeo Eiris and backed Four Twenty Seven, SIX has backed Orenda Software Solutions, and Morningstar acquired Sustainalytics. There could also be more consolidation in the next 12 to 18 months. Major data vendors all want to provide universal services that include ESG investment grade information, because this area of investment has gotten such intense focus and demand in the past couple years. If they cannot add that to their offerings, successful data vendors could lose their standing in the market.
ESG investment information rules
Regarding ESG investment information rules, starting with SFDR (Sustainable Finance Disclosure Regulation) for example, data providers are trying to fathom what is actually required. The SFDR’s principle adverse impacts (PAI) template cites 18 data points, but there may be more information in each of those points that needs to be broken out separately. Any global company or investor doing business within the EU and claiming environmental sustainability credentials needs to know the SFDR rules.
SFDR includes taxonomy regulation – namely the recently refined ‘EU Taxonomy’ guideline – that defines what economic activities qualify as environmentally sustainable. These activities and their definitions in the regulation could be different from how companies define or name what is environmentally sustainable.
Varied ESG scoring systems
Another measure of how well a company is following principles for environmentally sustainable economic activity is ESG scores. The methodologies the issuers use can produce different results for the same company and the scales they use can vary such that it is impossible to compare high level metrics. For example, some use scores from 0 to 100, while others use rankings in relation to a company’s peers and others use letter ratings like a bond rating. Combinations of letter grades and percentile rank scores are also in place. This variety, or lack of standardization, makes it difficult to compare such metrics without looking into the way underlying data points are used to arrive at a high level metric. A way to relatively determine the significance of an ESG score or rating for one’s investment goals is by comparing a company to others in the same sector, with the same credit ratings. But this is only relevant when comparing scores from a single data vendor.
On top of all these different scoring systems, these ESG arbiters have anywhere from a few dozen to thousands of indicators or questions used to rate companies. So this means there is a wide range of evaluations possible, many of which are just for the six environmental EU Taxonomy objectives. This leads to a need for a horizontal view across materiality maps, which can be generated through GoldenSource ESG Impact, so any investor or fund can determine which ESG factors and ratings are most relevant to its goals for environmentally sensitive investments. It’s important to note that any investment element that requires or involves data from numerous domains can be difficult to evaluate without a single, consolidated data application. For ESG, that unified understanding of the proprietary materiality maps can help organize the data.
Monitoring and review of ESG investment metrics
Although SFDR stipulates annual reporting, an ESG score isn’t something investors just need to check at the end of a year, or even a quarter. Ongoing monitoring and reviews are necessary. These scores can fluctuate and need to be regularly monitored for indicators that they are moving away from a fund’s stated investment remit, or the restrictions of a specific mandate. Checking ESG scores for your investments at the end of a quarter or year can be shocking if you’ve missed a significant jump or change in a company’s ESG scores, or adverse movement in some of the underlying metrics. Realistically, ESG data will have to be reviewed monthly, giving portfolio managers time to actively address investees of concern and/or to identify investment alternatives that have better ESG metrics and at least as good a credit rating.
Comply or explain
Beyond getting and understanding an ESG investment rating, smart investors need a dashboard that shows when ESG scores go in the wrong direction. SFDR indicates that firms should be able to ‘comply or explain’ why environmental sustainability may have gone in the right or wrong direction. This includes showing the history of the investee company’s ESG performance.
The surplus of ESG rating sources and the lack of standards can make the field of ESG investment hard to evaluate and understand. Investors need to be able to link instrument and issuer data, in addition to positions and portfolios/funds, with ESG data. Committing to ESG investment, as you can see from the operational, regulatory, and data demands just discussed, requires a complex mix of data management and monitoring for numerous pieces of information. You need a trusted provider with the knowledge and expertise to support a commitment to investing in ESG-dedicated companies.