Integration of environmental, social, and governance (ESG) factors is gradually becoming the new normal, and more and more asset managers are factoring them into their investment decision-making. This trend has brought about a multi-fold increase in demand for high-quality and reliable ESG data. Corporate disclosures around ESG have also improved significantly in the last decade. According to a report published by the Global Sustainable Investment Alliance, global socially responsible investment (SRI) assets under management (AUM) grew from $13.3 trillion in 2012 to $30.7 trillion in 2018. The segment is expected to remain buoyant, with investment anticipated to reach $35.0 trillion by 2020.
Given the sheer size of investment and the potential impact of ESG ratings on capital allocation, the reliability of ESG ratings generated by rating agencies remains a key question. There is definitely a need for a standard approach that provides consistent and uniform investment information. To bridge this gap, asset managers are approaching ESG rating agencies in the hope of gaining a better understanding of non-financial risks that may impact their investments.
A recent study by MIT Sloan found substantial divergence in ESG ratings provided by Sustainalytics, RobecoSAM, Vigeo-Eiris, KLD, and Asset4, with an average correlation coefficient of 0.61 (vs. 0.99 for credit ratings by Moody’s and Standard & Poor’s). Apart from limitations of availability, transparency, quality, and investment application of ESG data, the agencies apply different methodologies. In addition, traceability and lineage of sustainability data are equally blurred.
A case in point is a recent news of a prominent asset manager who named its data provider as the culprit for a screening methodology error. The lapse resulted in two ESG ETFs holding a number of securities that should have been excluded for almost two months. While the percentage holding was not material, the incident led to increased public scrutiny, while raising questions about the integrity and quality of underlying data.
In a third-party environment, ESG data comes in the form of stand-alone ESG ratings, supported by close-end questionnaire responses sourced from corporate disclosures – this is where consumers (i.e., investment managers) lose traceability. ESG research expertise becomes critical in such cases where data is unknown or cannot be validated. The investment community is awaiting a much-needed uniform reporting standard (such as GRI and SASB driven by industry-wide action) that would make it easier for both raters and investors to analyze / consume ESG information.
Meanwhile, to cater to immediate requirements and alleviate growing concerns, bespoke ESG ratings furnished with underlying data are a viable and scalable solution. Customized ESG ratings use more granular scores, along with auditable raw data (which can be traced back to corporate disclosures / publications) for specific data points (custom identified to meet a portfolio’s investment objective) spread across each of the ESG parameters. Raw data can be used to augment data validation and / or integrate directly into models. Asset owners / asset managers can also use it to weigh factors based on values and issues that have greater significance.
Customized ESG ratings would enable investment managers to make prudent and more informed decisions, rather than just relying on composites.