Our review of an article published in the Journal of Environment Investing, including 5 tips on what to consider when selecting ESG vendors.
The investment world is paying more attention to ESG data than ever before. (We think this is great, by the way.) Companies provide data in corporate responsibility reports, government regulations mandate reporting of socially responsible investments, and social media makes companies’ ESG behavior public knowledge, giving this data the power to “make or break” a company’s image. Facebook, for example, made the news last month when it was removed from an S&P index tracking socially responsible companies due to “various privacy concerns, including a lack of transparency as to why [it] collects and shares certain user information.”
According to a 2017 paper published by Douglas, Van Holt, and Whelan in the Journal of Environment Investing, ratings providers use quantitative and qualitative data to assess companies along environmental, social, and governance criteria. The specific issues evaluated span from climate change, and energy efficiency to nondiscrimination. The two largest market data providers are MSCI and Bloomberg, with MSCI retaining a market coverage of more than 6,000 firms, and Bloomberg retaining upwards of 10,000 firms.
Unregulated and Inconsistent
However, there is little (if any) consistency in the way ratings are determined, and different ratings providers weight ESG factors differently, making it difficult to fully understand sustainability criteria.
The challenges ESG data presents, then, are subtle yet increasingly pertinent. As long as information remains unregulated and rating methodologies remain opaque, the burden of due diligence falls on users and data providers to ensure that this information can realize its true potential in helping investor and management decision making.
Types of ESG Providers
Douglas, Van Holt, and Whelan examine several ESG data providers, from market-focused to specialized. Their methodology involves a sampling of more than 150 ESG providers, an analysis of the providers taking into account the objectives, data quality, and rating metrics of each, and a breakdown of the key differences between each data provider.
Companies may choose to report on material or immaterial ESG factors, and can choose whether to use globally acknowledged standards like GRI to evaluate their performance. This, of course, makes the job of investors far more difficult. How can allocators and managers evaluate portfolios when there is no “true” and dependable metric for success?
The blurry connection between financial performance and ESG data dilutes investor confidence even further. While reporting standards developed by the Sustainability Accounting Standards Board (SASB) improve data quality and transparency, there is a tradeoff. Much reporting is voluntary and selective, creating a deceptive system that allows highly-rated companies to flaunt their successes while failing to disclose their shortcomings. Data providers’ engagement with the companies evaluated creates a possible risk of bias as well, especially if the providers are accepting advisory fees. This is an issue that can only be solved if companies have a third-party audited report following the regulations of the SASB and other regulatory bodies, such as GRI or IIRC.
An Investor’s Domain
These problems illustrate why understanding the criteria behind ratings created by market data providers is essential—but what can be done about the issue from an investor perspective? How can we ensure that ESG information is unbiased, and truly indicative of a socially responsible portfolio? Douglas, Van Holt, and Whelan provide five steps that investors can take to ensure that their ESG-related portfolio decisions are morally and factually sound:
- Seek data providers that are positively rated by a third party for meeting industry standards.
- Evaluate providers based on independence from rated companies.
- Develop a better understanding of possible issues or discrepancies in the rating process, so that allocation decisions can be made independently and strategically.
- Consider providers that use future-oriented metrics, as they are less likely to ignore or miss future risks or constraints.
- Consider combining information from several different providers for greater breadth of data.
ESG with the Novus Platform
Despite the disparity of methodologies and confusion caused by rating inconsistencies, the field of ESG will (and must) continue to evolve. Data abundance, despite the lack of standardization, is a great problem to have, so long as investors are willing and able to pick what matters to them and move forward. The Novus Platform currently fills the vacuum that exists in the field of portfolio analysis using ESG, by offering investors the ability to directly and efficiently visualize the effects of ESG data, both in terms of exposure and risks. The platform allows users to utilize scores from several reliable, trusted scoring companies to map out gross exposure as a function of ESG rating, risk, and attribution metrics. (MSCI’s abundant tracking of indicators has proved it an ideal partner and data provider for many Novus platform users, although our platform is vendor-agnostic, strictly speaking.)
With Novus’s tools, users can examine over- and under-exposure by ESG rating versus a broad equity benchmark (Figure 2) allowing for a deeper analysis of the correlation between ESG factors and asset performance. They can also evaluate contribution by security rating type (Figure 3).
Novus’s Event Analysis framework also enables investors to evaluate the impact on price trajectories of re-rating due to major incidents. In this way, Novus is taking steps to accomplish what few other data platforms are able to generate, thereby working to solve the problem of transparency and clarity in the world of ESG investing.
The Future of ESG
Governance data and regulations are likely to increase the wealth of ESG-related information that’s available. It is also probable that more companies will request data related to environmental concerns as the social popularity of ESG themes continues to rise. As more investors prioritize ESG-related factors in portfolio assessment, data quality is likely to improve as well.
This being said, Douglas, Van Holt, and Whelan conclude that there remains a necessity for some sort of industry certification, a standard that can be applied to data providers across the board that would allow ESG analysis to expand beyond the constraints currently burdening it. There also needs to be a method developed to keep track of the correlation between ESG factors and financial performance, as well as more regulatory bodies similar to the SASB to ensure consistency in evaluation metrics.
How users can best use ESG data is slowly coming into focus for the investment industry. By evaluating data providers and doing the research necessary to ensure these providers are meeting a certain baseline standard, investors can do their part to take full advantage of the benefits ESG provides.
If you are interested in enriching your portfolio with industry-leading ESG metrics, and performing advanced ESG analytics on your portfolio, drop us a line.Published on July 19, 2019