Climate change has already begun to affect business, with extreme weather, flooding, wildfires and drought threatening company assets and supply chains. As the environment evolves, companies that improve their energy efficiency and create new products and services will survive and companies that are slow to change will struggle. The financial services community is keenly aware of this challenge, and many professional money managers are now looking for ways to integrate environmental, social and governance data into their investment approaches to better manage risk and find opportunities in a changing world.
Increased investor appetite and the potential for outsized risk-adjusted returns has boosted total assets in sustainable investment strategies to $12 trillion in the United States, or one quarter of all professional assets under management, according to the US SIF 2018 Trends Report. The amount is up 38% from 2016, with more double-digit growth expected in the years ahead.
But while sustainable investing has become a more mainstream concept, investors in the sector face challenges. One of the most pressing issues is a lack of access to reliable and consistent ESG data.
Investors rely on ESG data to identify which companies may be best positioned to succeed in a sustainable world. However, the lack of consistent reporting standards for ESG data presents a major barrier to the increased adoption of sustainable investing. This hurdle forces investors to expend an excessive amount of already limited resources trying to standardize and interpret unstructured data, slowing down experienced investors and inhibiting new entrants from joining the field.
While it may be years before ESG data becomes fully standardized, the investment community can take steps now to access more meaningful and actionable ESG data to make better informed investment decisions.
The case for standardization
One of the main issues for ESG-oriented investors today is the lack of standardized data in the market. Businesses reporting their own ESG performance metrics are trying to satisfy increasing investor and stakeholder demand for more and better data. Meeting this demand is especially challenging given the plethora of reporting platforms and requirements and lack of consistent reporting standards for sustainability performance. As a result, different data points may be reported across companies in the same sector. Similarly, different data points being could be reported by the same company from one year to the next.
Investors now face the challenge of how to evaluate more company-generated data, including a wider array of sustainability reports, documents, filings and websites, further adding to the confusion and level of effort required to make sense of these new ways of evaluating how company management creates or destroys value. Despite these inconsistencies in the data, organizations such as the Sustainability Accounting Standards Board have made immense progress in creating reporting standards. SASB recently released 77 industry-specific accounting standards that help investors understand how material sustainability issues can impact a company's financial performance. These standards have been publicly adopted by a dozen major international companies. And while SASB and organizations such as the Global Reporting Initiative — whose standards are utilized by 75% of the world's 250 largest companies — enable real action and positive material benefits for all, they also create more information to sort through. This influx of unstructured data presents a need for a data provider to package and present this information in an easily consumable format.
Some data vendors, like Bloomberg, fill this gap by providing investors with access to high-quality ESG data in a format designed for easy integration into the investment process. This standardization process improves and expedites sustainable investors' decision-making process.
Another challenge with current ESG data sets is that some companies produce — and some data providers publish — ESG information that is only partially measured and accounted for. For instance, one company may report the carbon emissions of its entire business, while another firm may only report the carbon emissions for its headquarters but not for its other locations or operations.
Transparent scoring equals smarter investing
As the sustainable investing movement has evolved, so too has the pervasiveness of ESG scores, which provide a single metric by which to evaluate companies on a range of ESG issues. These scores proved to be a useful metric for easily grading and evaluating investments. However, these scores are now falling out of favor with investors due to their lack of transparency, among other issues.
Many institutional investors are expressing a desire to move beyond using third-party generated scores, which often reflect not only a company's reported data, but also the opinion of the analyst creating the score. Another issue with the scoring methodology is that ESG scores are often created using a one-size-fits-all approach that disproportionately weights certain factors toward a company's overall ESG score. In fact, for nearly two-thirds of all securities in the Russell Global Large Cap index, fewer than 25% of the data items used to calculate their ESG scores are even considered material, according to a Russell Investments study that used SASB standards to determine materiality.
These inconsistent standards are why scores can vary wildly among well-known ESG rating platforms. Many of these discrepancies result from not just the specific scores awarded to each component (E, S or G), but also how each platform chooses to weight each score to determine the cumulative ESG ranking. Recognizing the shortcomings of this black-box approach, sophisticated investors today increasingly prefer raw ESG data to ESG scores because it allows them to customize the data sets for their needs. This is why asset managers are increasingly integrating individual ESG factors into their traditional credit and equity research and portfolio management processes. In particular, quants have shown a great interest in incorporating ESG data into their models since they commonly rely on historical data sets to back test their investment models, and an extended track record of dependable data will allow these firms to make better-informed investment decisions.
A better approach to this data challenge is one that allows investment management firms to assign their own scores to public companies. Working with ESG data directly reported by companies can help to meet this need, by allowing investors to weight factors based on their values and the issues they believe will have the greatest financial impact on a sector-, industry- or company-specific basis. For instance, a gender-focused fund can select firms with strong boardroom diversity, while a manager that feels strongly about social issues can apply greater weight to a company's labor practices.
Data that caters to all investors
A growing number of investors are coming to realize the positive correlation between sustainability and financial performance and want to get involved. However, looking at current ESG data may only lead to more confusion. Either investors are overwhelmed by the mountain of unstructured data, or they are drawn to contradictory third-party ESG scores that make it difficult to decide where to invest.
As the ESG marketplace grows and expands through the asset management industry, forward-thinking investors want to take a more sophisticated approach. Sustainability-focused investors no longer want to rely solely on outside recommendations and ESG "scores," while those new to the space are wary of so-called greenwashing, where managers make unwarranted claims about ESG integration. For the sustainable investing movement to continue to grow, it's critical that all parties work together on improvements in the quality, quantity and accessibility of ESG data.
Brad Foster is global head of enterprise data content, New York, and David Tabit is global head of equity data, Princeton, N.J., at Bloomberg LP. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.