The evolution of ESG is one of the most marked shifts of our generation. There is no turning back. The vast majority (90%) of institutional investors now attach greater importance to ESG performance in their decision-making than they did before the COVID-19 pandemic, according to an EY report, heralding a new economic and regulatory environment.
This evolution has naturally invited scrutiny, most recently from lawmakers, politicians and the media who question whether ESG funds and strategies are, in fact, a marketing ploy. The politicization of ESG investing, the quality and availability of ESG data, and gaps in standardization are factors that have created a confusing environment for investors leading to questions as to whether an investment is truly ESG or simply greenwashing.
These critics have a valid point. Environmental, social and governance investing is in a crucial “hockey-stick” phase of development, transitioning from early adoption to accelerated growth. Asset owners and managers are making bold commitments and rapidly developing new processes and products, but much remains to be done. Many firms in the asset management industry can’t claim to have gotten it right yet, but there are several reasons to believe we are quickly improving.
Regulators worldwide are seeking to tighten up ESG standards. In the United States, the SEC’s proposals on climate disclosures are intended to level the playing field for how ESG information is reported on by investment companies and other reporting entities. At the heart of this move is the need to ensure the stability of our financial system. A lack of aligned, transparent and rigorous standards can lead to risk, inaccuracies and an inability to effectively direct capital to those companies that are most effectively addressing climate risks.
A good comparison is the 2002 Sarbanes-Oxley Act, which introduced more consistency into accounting practices and helped to protect investors from fraudulent financial reporting in the wake of the Enron scandal, among others. In other words, this is a classic example of the evolution required of immature systems, where improved governance benefits us all in the long run.
For that reason, the standardization of reporting is a welcome advancement. It is vitally important for regulators to work closely with the standard-setting bodies to ensure reporting harmonization as to avoid multiple regimes as this could be especially onerous for global firms. The industry has been proactively working towards more and better ESG standards for a while, for instance, by informally collaborating through Climate Action 100+ and the Net Zero Asset Managers’ initiative.
Tighter ESG reporting standards will beget better data management. Asset managers need to seek out high quality data, analyze that data and ensure their investment teams are integrating it in a meaningful way for it to be effective. The ability to analyze large data sets is a competitive advantage; investors want to know what the data looks like and what conclusions can be drawn from it — for instance, the impact of certain social information or greenhouse gas emissions on their investments risk profile. Of course, data is not without its problems. Long-standing lack of availability, consistency or, in some circumstances, relevance (ESG information that is material for one company or asset class may not be relevant for another) continues to be an issue.
This requires a rethink of how an asset manager operates in order to create an ecosystem of data management. Third-party technology platforms are already available, but given the complexity, many asset managers are looking to build their own proprietary, cross-functional systems in-house to achieve what they want for their clients. They are hiring different profiles from what ESG teams have traditionally looked for — for example, IT and data experts who sit within ESG teams supporting this advanced analysis. Some have gone so far as to acquire data management companies in order to build their in-house capability faster.
The scale and scope of ESG data is growing at an exponential rate. We are now seeing a once-in-a-generation shift as the industry moves toward more IT and data-centric organizations. Enhancements to data quality, integrity and processing capabilities will further accelerate the pace of adoption of ESG investing.
One of the main criticisms of ESG investing is the “black box” approach by third-party rating providers: How are ESG scores calculated, why is there so much dispersion, and can the data and methodology be relied upon? There are a range of approaches across the industry that reflect the nascency of the field and has led to a lot of questions.
Developing an aggregated ESG score for a company is a challenging undertaking due to the multitude of variables across sectors and assets. The data on greenhouse gas emissions is the most advanced, with clear engineering standards for establishing Scope 1, 2 and 3 emissions. Even so, climate science is complicated, and there can be a lot of assumptions that go into the modeling. Further, many other social and governance factors can be difficult to measure and/or rely upon the judgment of an analyst or team.
So, while third-party ESG rating providers can play a valuable role in contributing their information and research, many asset managers have taken a proprietary approach to ensure that their ESG scores reflect their own expert opinions by weighing material factors for a holistic view of ESG in their investments. We believe that this approach allows asset managers to apply their own research views on the risks and opportunities of ESG.
ESG has taken many forms over the years — corporate social responsibility, sustainability, fiduciary duty — yet it is no coincidence that it was brought into the mainstream when we are witnessing a pandemic, social unrest, changing technologies and continued environmental catastrophes on a global scale. With these events rising to prominence, critical voices have entered the room. It’s good to have constructive debate, as that is how creative solutions will be found. But make no mistake — ESG is here to stay.
Anna Murray is global head of ESG at SLC Management and co-chairwoman of the Real Estate Advisory Committee for United Nations-supported Principles for Responsible Investment, ased in Toronto. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I’s editorial team.
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