Sustainable, socially responsible investing has become a worldwide phenomenon in recent years, accelerated by the COVID-19 pandemic and increased attention to social and governance issues.
But the definition of ‘sustainable’ investing is anything but black and white, and ESG investing contains many shades of grey. The financial industry is increasingly looking to eliminate that ambiguity by using particular measurement criteria to score investments on a consistent scale and clarifying metrics that investors can use to compare funds in a meaningful way.
This blog will explore the issues surrounding ESG investment data and why we believe the movement toward digitalisation is the best path forward.
What is ESG Investing?
ESG stands for Environmental, Social, and Governance investing and looks at how investments or companies perform in various categories related to long-term environmental and societal impact. These include ‘green’ elements such as conservation of natural resources, social factors like inclusivity, and governance considerations regarding how a company is run.
ESG aims to rank investment opportunities with a wide range of sustainability metrics in mind, from green energy initiatives and waste management to fair labour practices, board member diversity, and executive pay.
There’s no longer any question about the returns possible from sustainable investing. A 2019 white paper by the Morgan Stanley Institute for Sustainable Investing compared the performance of sustainable funds with traditional funds from 2004 to 2018. They found that total returns from sustainable funds were similar to those of traditional funds but with lower downside risk, regardless of asset class. During turbulent markets such as those seen in 2020, ESG funds often performed better than their traditional counterparts.
As the demand for ESG-driven investing rises and becomes more nuanced, data providers have followed suit—each with their own varying information, reporting components, and levels of transparency.
The wide variety of available data has created some confusion by giving investors a lot to sift through. It’s far from simple to determine the magnitude and direction of an individual company’s ESG-related activities.
Concern at the sheer volume of ESG methodologies and datasets has prompted investors to call for a more transparent and consolidated framework. This framework would focus solely on the ESG-related business issues that could impact their portfolio’s investment return.
The Challenges of ESG Data
The universe of existing ESG data is rife with quality challenges spanning materiality, comparability, and reliability. Data is often neither standardised nor audited, and due to a lack of prescribed formatting, data must often be interpreted manually before it can be meaningfully digitised.
The European Fund and Asset Management Association’s (EFAMA) feedback on the challenges that inhibit the integration of ESG data (from vendors) into investment decisions are as follows:
1. Cost, balance of power, and market concentration of data vendors.
2. Transparency regarding methodology and data sources.
3. Associating data and ratings with the right entity. (In other words, data is aggregated at too high a level.)
4. Calibration problems between sectors, and ESG considerations when simplifying into a single rating.
5. Unreliability and no limitation statements.
To produce scalable disclosure data, funds will need to understand the context of any final rating rather than digesting a simple numeric score.
The Irish Funds seminar on the 5th February 2021 presented feedback on the availability of the Sustainable Finance Disclosure Regulation (SFDR) principal adverse impact indicators among vendors’ data, and the level of vendor consensus on the measurement of the indicator. The resulting discussion highlighted a low level of correlation between vendors in calculating many sustainability indicators.
This is a challenge not easily overcome. Due to the current level of inconsistency and fragmentation, the cost of retrieving and using a company’s public information for ESG information gathering is prohibitively high. The information must come from disparate sources in multiple formats, requiring research through various documents, all of which makes the process extraordinarily costly and labour-intensive.
Apart from that, simple data collection isn’t enough on its own. Unstructured data is everywhere—by 2025, we’ll be looking at over 180 trillion gigabytes of it worldwide. Regulations and trade behaviours must shift to identify and compare meaningful data points to assess ESG performance and inform wise decision-making.
Finally, once you’ve collected relevant data and pulled out the most meaningful points, investors must be able to cross-reference it meaningfully. Language around ESG performance isn’t currently standardised, so it’s not always clear whether you’re comparing apples to apples. There is also no universal standard definition of ‘sustainability’—in fact, there are as many as 400 assessment techniques for analysing ESG in the market today.
If the industry is to capitalise on the benefits of ESG-driven investing in a manner that is (for lack of a better term) sustainable, we must collapse and standardise the data we measure in order to draw meaningful comparisons.
Of course, this is easier said than done.
Digitalisation Could be the Answer
Although too much data is part of the problem, digitalisation is also the solution. Digital formats are being mandated for financial statements through European Single Electronic Format (ESEF) regulation to significant effect, and the ‘CleanTech’ industry is developing to fill the gap for ESG data retrieval and reporting.
Digitalisation offers enormous opportunities for trade at large, and we see massive potential for ESG to join forces with, and be bolstered by, that movement. Platforms such as IQ-EQ Compass bring together various ESG factors and ensure that fund managers have actionable intelligence at their fingertips.
The increasing sophistication of big data, artificial intelligence, blockchain, and the Internet of Things (IoT) has a long list of potential implications for ESG investing, from verifying the provenance of goods to certifying the ethical behaviour of supply chains.
And progress is already underway. There is an active push toward an EU-wide classification system for sustainable economic activities, and the Monetary Authority of Singapore has proposed a taxonomy to identify green (or trending green) activities. In September 2020, the World Economic Forum and International Business Council announced another set of standards, which have the backing from the ‘Big Four’ accounting firms. These standards look to create a list of standardised “Core” and “Expanded” metrics, aligned with the Sustainable Development Goals (SDGs) and principal ESG domains, with “the aim of amplifying the rigorous work already done by standard-setters instead of reinventing the wheel”. And finally in October 2020, the United Nations Development Programme released its own set of voluntary standards as well, which are aimed at private equity, venture capital and debt funds and how they can contribute to the SDGs.
While there is still work to be done, we’re optimistic about the future of ESG-driven investing and the opportunities increased digitalisation will provide.