Sustainable investing could become a victim of its own success.
Institutional investors are bullish on assets that seek to protect the environment and promote greater equality. Indeed, 65% of inflows into European exchange-traded funds were for sustainable vehicles during 2022, up from 51% a year earlier. This growth came despite the underperformance of such strategies, highlighting pension schemes’ long-term view.
Yet this could have been higher. Investor confidence in achieving their sustainable targets appears to be plagued with fears of greenwashing. Almost half (49%) of respondents told a Capital Group survey that a lack of robust ESG data is deterring them from increasing their exposure to such strategies.
But while demand to build sustainable portfolios has grown rapidly on the back of stakeholder concerns, regulation has not moved as fast. The result is a lack of clear standards of what information corporates must disclose to help investors assess and monitor their ESG performance.
There are disclosure frameworks, such as the Sustainability Accounting Standards Board, the Global Reporting Initiative, CDP and the Principles for Responsible Investment, which are all voluntary.
Then there are stock exchanges, which require some ESG information to be disclosed, but this information varies between exchanges.
“Unfortunately, even to this day, because it is self-disclosed data and is often not audited, it is incomparable. It is not perfect at this point,” says Hideki Suzuki, director of sustainable investing for public markets at Manulife Investment Management.
Companies, even those in the same country, are not uniformly reporting on the same aspects of their non-financial performance, if they are disclosing such data at all. And not all of what they do report is audited.
“There is quite a high level of inconsistency in corporate reporting,” says Dror Elkayam, global ESG analyst in the investment stewardship team at Legal & General Investment Management (LGIM), who explains that some companies issue specific information one year, but not the next.
The age of data can be another challenge. Companies report at different times, so the latest emission results for one corporate could be a week old, while the same data for another could have been published more than a year ago making a comparison impossible.
Aon, an investment consultancy, helps its clients dive into the detail of individual assets or companies they invest in, and examine the data disclosed across portfolios. “One of the challenges for pension funds and asset owners is getting a handle on the quality and nature of the data that is being aggregated to give you that portfolio view,” says Tim Manuel, Aon’s head of responsible investment.
An issue made all the more challenging considering the inconsistencies in disclosures when assessing a portfolio. “There is a big challenge in how to ll in the gaps with data in a fair, representative and appropriate way,” Manuel says.
A material issue
Yet it appears that despite these issues, the quality of non-financial corporate data has improved, Elkayam says. “Ten years ago, I would have said that standards were concerning or pretty low, but it has improved drastically over the past five to seven years.”
He puts this down to more companies committing to improving their ESG profile and wanting better relations with investors. “They are more engaged with data providers,” Elkayam says. Such commitments are ending Europe’s dominance in this area, with Elkayam saying that companies in North America are closing the transparency gap.
As evidence, he points to the MSCI World, FTSE100 and S&P500. “If you compare some of the more critical ESG indicators, and how they have been reported on between 2017 to 2022, then you will see a gradual improvement in terms of consistency,” Elkayam says.
But it is not perfect and, it appears, that non-financial data needs to be given the same level of importance as other disclosures to achieve the change needed. “Ultimately, we want ESG data to be treated as financials by companies,” Elkayam says, adding that he sees the need for further progress when comparing the standard of ESG data to financial reports.
“We do not consider ESG to be non-financial,” Elkayam says. “ESG is material, so it’s good to see that the number of times it’s been mentioned in corporate calls has exponentially increased over the last five to six years.”
Can we fix it?
One of the issues here is that British pension funds have been mandated to disclose how they are protecting savers from the impact of climate change. They need such data, whereas corporates are yet to receive the same ruling on proving how they are shielding their shareholders from such risks. Reporting on a gender pay gap is one exception for corporates in the UK and shows that such a ruling can be made.
Mandatory reporting of consistent, audited data which is released within a certain timeframe and standardised across all regions is needed to help investors form an accurate picture of the ESG risks they are exposed to.
But achieving this could take time. Manuel points out that there are differences between the EU’s green taxonomy and the version due to be launched in the UK.
“Most asset owners invest on a global basis,” Manuel says. “It is not, therefore, helpful if they are gathering information on underlying companies and portfolios which have reported across a patchwork of different disclosure frameworks.”
Standard setters, like the International Sustainability Standards Board, are trying to set a universal standard in the ESG data space, but would regulators adopt such a benchmark in their jurisdiction?
“It needs a framework for mandatory disclosure,” Manuel says. “It needs jurisdictions to work together in bringing some consistency to what they are asking corporates and investors to disclose.”
This is not just about reporting data, it’s what is reported alongside it that is the issue. When carbon emissions are disclosed, typically, what is released alongside the data is a measure of quality. It is just as important to refer to the quality indicator as it is to refer to the metric itself. “The thing with ESG data, like with any data, is that when you receive it, it’s important to also receive information on the quality of it,” Manuel says.
The timeliness issue of such reporting also needs to be considered. “A company could disclose fiscal year 2021 data today, as opposed to in 2022. There are no set rules on this,” says Hideki Suzuki of Manulife Investment Management.
“[Regulators/standard setting bodies] need to send a clear message on not just what to disclose, such as the gender pay gap, but when to disclose it,” Suzuki adds. “It needs to be representing the consolidated group basis data on a fiscal year end basis.” Without this, how can such data be comparable?
“There are a lot of regulations around what to disclose, but not much emphasis on how to disclose it,” Suzuki says. “Regulators are not sending a clear message. The data released needs to be on par with financial disclosures in that it should be audited and aligned with the fiscal year end.”
Responsible investing is not just about carbon. Boardroom diversity, water consumption and waste management are other issues that help create an ESG profile.
The performance of an asset’s social factors is not as easy to form a picture of compared to measuring climate impact. Reporting how many employees a company has and where they work in the corporate structure is not good enough to assess its social impact.
“When investing in a company, a component of what it is delivering in terms of impact is the nature of the jobs it provides,” Manuel says, adding that corporate reporting likely does not include anything about the nature or the quality of those jobs. “It doesn’t give information on contracts, if they are permanent, temporary or zero hours.
“And there is little reporting around things like the living wage or a safe working environment,” Manuel adds. The reason why carbon emissions come under more scrutiny than other environmental factors, such as water consumption, and the social elements of responsible investing is due to the impact it has on our world.
Harmful gas emissions are also easier to measure than a social impact. “There is a greater standardisation of methodology there, which contributes to the greater focus that carbon data receives,” says Jennifer O’Neill, an associate partner at Aon. She adds that investors are in danger of developing a “carbon tunnel vision”.
“In other words, investors and interested parties focus on carbon data because of that clarity and greater standardisation,” O’Neill says. “But there is a risk of missing out on significant other forms of data to consider when you are thinking about constructing a sustainable portfolio.
“For instance, biodiversity loss is intrinsically linked to climate change, so focusing solely on carbon emissions doesn’t necessarily do anything to address that issue,” O’Neill adds. Another issue on why some issues, such as carbon emissions, have more transparency than other elements is due to their maturity.
“Some datasets can be more challenging, because they are newer, while some are more mature,” Elkayam says. “The independence of directors or women on the board, for example, are quite mature datasets, so the quality is fairly high.”
This is evident in the S of ESG. “In diversity on the board or at an executive level, we are seeing an evolution in the way diversity is being measured, not just from a gender perspective, but ethnicity, too,” Elkayam says.
“This is a relatively new element of disclosure and we expect it to increase in coverage, accuracy and quality” he adds. “But this is one of the most important growing elements in the S, along with paying a living wage and how you onboard employees considering their background and equality in the business.”
What’s the score?
Data is not just about corporate disclosures. The other side of it are the opinions of third parties on how an asset is performing, commonly known as ESG ratings or ESG scores.
When it comes to sustainability there is more to a company than what it sells. Tesla is an example. One ESG ratings provider points to its positive climate impact because it makes electric-powered cars. Yet another points to the chief executive also being the company’s largest shareholder, which is far from ideal from a governance perspective.
So it is common for providers to form different conclusions about a company. “Depending on the methodologies ratings providers use, your opinion could be different,” Suzuki says. “You could disagree with one provider but agree with another. It is a matter of being comfortable with the providers we utilise.
“This is why we only use the ratings as a starting point. It is not the end result,” he adds. “You have to unpack it because there is no one simple number that explains everything about a company’s ESG activities. That is impossible, but it gives you an idea.”
ESG scores are also weighted differently depending on sector and the provider’s proprietary methodology. “Investors need to be aware of that, understand what it looks like and the rationale for it to determine which provider they wish to use,” O’Neill says.
“It’s not simple, and it shouldn’t be,” she adds. “Sometimes simplicity creates pitfalls.” LGIM produces its own ESG ratings. Elkayam is confident that the data LGIM has is of good quality. This is partially due to the asset managers working with policymakers and regulators on certain aspects of ESG disclosure in a bid to improve the quality and breadth of ESG-linked disclosures.
Manulife Investment Management also sets its own ESG ratings, which Suzuki describes as “not easy but doable”. “As long as we have the company disclosed quantitative data, we are able to aggregate that on the portfolio level,” he adds. “It becomes challenging when there is not much data for us to work with.”
He points to gender pay gap, which less than 20% of MSCI World index constituents disclose. “When there is a noticeable data gap, there is a challenge in interpreting the result of aggregated data.”
Manulife Investment Management is also active when it comes to making an assessment. The asset manager researches companies beyond just reading a provider’s research report by consuming primary sources disclosed by companies and also engaging with those companies, Suzuki says.
No right or wrong
When it comes to data, no matter how much you do or do not have, it is what you do with it that is important. “There is a danger in saying the data is right or wrong,” Manuel says. “The data is what the data is. It is what has been collected.
“The challenge is using that data effectively for the decisions we are trying to make,” he adds. “How does this piece of data t into the overall puzzle to support the decisions we are trying to make as a pension fund?
“We are not being driven by the data, we are being informed by it to the extent that we understand the nature and the quality of what is being provided,” Manuel says.
It depends on what investors are using ESG data for: Investing? Engagement? Research? It is about what is underpinning the ratings, what goes into it. How has it been calculated? What indicators does the provider use?
“ESG scores or ratings mean different things,” Manuel says. “If you are going to use them properly, you need to understand exactly what they are. Too many shortcuts and too many simplifications in how they are applied runs the risk of those ratings or scores being misused. There is no shortcut to digging into what these scores mean.”
The rapid growth in the level of capital targeting sustainable assets has made this a mainstream asset class, but when such growth occurs the infrastructure and supporting elements do not always improve at the same pace.
Regulation and standardisation of non-financial data needs to improve, but it took decades for a universal financial accounting standard to be agreed. The quality and transparency of ESG data has improved and will continue to do so, but investors will need to be patient.