Commentary: Is data the problem or the answer for ESG investors?

In the past few years, we have seen an explosion in the amount of ESG data being produced — third-party providers with ratings and rankings of companies on their ESG performance, databases with everything from carbon emissions to human capital data and companies themselves producing a plethora of sustainability and ESG reports. Regulators and industry initiatives are also mandating and calling for more ESG data from investment managers and companies. If the ultimate goal is to reduce systemic risk and identify sustainable companies, is more ESG data the answer?

Certainly, more ESG data can help to gain a better understanding of a company and an investment, but is this enough?

We have seen DWS given top scores from the UN PRI and then seen their offices raided by regulators for greenwashing within their investment funds. After corporate scandals like FTX, Wirecard, boohoo, Volkswagen and SVB, we heard ESG data existed and may have averted investors' losses and yet was not taken into account.

So, while yes, more data will certainly help, there are two core concepts investors need to understand when it comes to ESG data: (1) context is key to understanding the data; and (2) there are always trade-offs when it comes to ESG. It is never win-win as some advocates will have you believe. Therein lies the complexity of ESG analysis and due diligence.

While more data may be helpful, the context surrounding that data is key to creating meaningful insights. Within the investment industry, leading investors and asset managers are those that are able to turn information into valuable insight. This insight then feeds into sourcing, analysis, investment decisions, risk management and valuations. While more ESG data will certainly increase the amount of information on a company, it will not necessarily increase the level of insight about that company. The only way to do that is to understand the context around the data which is done by performing a comprehensive ESG due diligence review as part of any investment analysis.

For instance, a company may report that they are improving health and safety data, or they may report that they are reducing their carbon intensity. However, without an understanding of the context around the data, it is inherently difficult to understand whether these are actual improvements or whether there are other issues at play. Has the company improved their health and safety practices, or have they changed the way they report accidents? Analyzing corporate governance practices could help uncover this. Has the company reduced their carbon intensity because they have implemented more sustainable, energy efficient practices, or have revenues increased and therefore their carbon intensity has decreased because they are measuring their carbon emissions per million dollars of revenues? Understanding how the company is measuring and accounting for their absolute emissions would be necessary to understand this.

Without the context, we cannot understand how a company is truly performing on most ESG issues, which is core to finding hidden value, identifying hidden risks and assessing the long-term resiliency of a company.

Secondly, there are always trade-offs when it comes to ESG. A company may be focusing on creating value or mitigating risk by focusing on improving performance on certain material ESG issues yet at the same time end up creating negative externalities.

For instance, an oil and gas company may manage their Scope 1 and 2 carbon emissions, the health and safety of their employees, and their board's diversity very well and yet produce a product that has very negative externalities for the environment.

On the other hand, a company may be considered a sustainable company because of the product it produces and yet be a laggard when it comes to managing internal ESG issues such as human capital and corporate governance. We have seen this very situation with Tesla Inc. being removed from the S&P 500 ESG Index while ExxonMobil Corp. remained.

Every investment has an exposure to E, S and G issues — positive or negative, intended or unintended. The trick is to identify which ones are material, from a risk and value creation standpoint, and which ones are acceptable from a risk-adjusted return basis. Identifying and assessing these issues is key to how we perform ESG due diligence on companies to enable insight into the risk-adjusted returns of an investment. For instance, we look at the severity of the risk, the probability of the risk arising over the investment period and any mitigation factors to arrive at an overall risk score for each material ESG issue, including systemic issues such as climate change impacts.

There will never be universal consensus as to what constitutes a sustainable company or investment, nor what is an acceptable level of risk, including ESG risk, for an investment. That is a decision to be made between investors and their fund managers.

More data, frameworks, standards and taxonomies will certainly help frame and guide the conversation. However, without understanding the context around the data and without identifying and assessing the various trade-offs and risks this data is representing, more data is not the only solution and certainly not a substitute for comprehensive ESG analysis and due diligence.

Tamara Close is founder and managing partner of Close Group Consulting Inc., a global ESG strategy and due diligence advisory firm that works with asset managers, general partners, asset owners and corporations. She is based in Montreal. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.