In recent years, interest in environmental, social, and governance (ESG) investing has exploded. This increased interest is a result of a growth in global business risk, as well as a higher desire among investors for environmentally sound, socially conscientious, and long-term business investment options. The trend toward ESG investment could be a welcome bright light for the financial services industry, which tends to place a premium on profits over values. However, when it comes to providing ESG investing alternatives to their clients, banks and investment institutions encounter a number of fundamental problems. These issues require careful study and planning in order to achieve investment objectives while remaining compliant with ESG rules.
Understanding ESG Investing
ESG stands for three core sets of criteria:
- Environmental – How committed a company is to preserving and conserving natural resources
- Social – How committed a company is towards building positive relationships with employees, suppliers, customers, and the communities where it operates
- Governance – How a company approaches leadership, executive compensation, internal controls, audits, and shareholder rights
These ESG criteria have two main functions:
On one hand, ESG criteria are used by banks and investment professionals to analyze business risk. In this situation, ESG is being used to assess a company’s ability to operate in an increasingly uncertain environment. A slew of worldwide concerns are jeopardizing business assets, operations, and reputations. Climate change, environmental degradation, increased regulatory requirements, economic uncertainty, population transitions, and threats to data privacy and security are among the problems. All of these obstacles have the potential to ruin an unprepared organization and its operations, putting investors at greater risk.
Socially aware investors, on the other hand, utilize ESG criteria to analyze possible investments in search of companies that share their values or mission. Many younger investors prefer to put their money into companies that are concerned about environmental, social, and operational issues.
Steps for Successful ESG Transition:
- Work with clients to understand their ESG preferences and the variety of options available to incorporate Client’s ESG preferences into the investment screening process
- A due diligence process should be set up to draw the list of ESG factors for consideration. This should be accompanied by a periodic review of ESG factors
- Institutionalize process of providing guidance and support to managers lacking in ESG skills with feedback mechanism
- Identify ESG data vendors who provide coverage for the selected ESG factors and the investment universe. It should be bear in mind that it may be necessary to deal with multiple ESG data vendors to get the desired data coverage
- Define hierarchy and weights to ESG factors in ESG vendor feeds to arrive at a golden copy of ESG metric consolidated at the enterprise level
- Automate the workflow of hierarchy rules and DQ rules so that operations do not spend too much time to produce desired ESG metrics
- Define clear ESG Objectives
- Set clear KPA’s and KPI’s for the internal investment staff
- Train the internal investment staff on ESG factors
1. Standardization of ESG Data and Ratings
There are a number of third-party data providers (over 150) that provide statistics and ratings on firms based on a variety of ESG aspects. Incorporating service provider ESG ratings necessitates a thorough understanding of the data sources, criteria employed, and data weightage for various indicators in the final score. It’s worth noting that the number of indicators used by different service providers may vary. To arrive at these ratings, each of these companies use its own approach for obtaining and quantifying data. Computer-driven algorithmic models, analyst-driven estimations, and a hybrid method are all possible rating models. As a result, the rating for a single organization can vary dramatically amongst providers.
The number of companies covered, the analytics provided, and the coverage of ESG factors vary by service provider. There are service providers who specialize in only one area, such as the Environment or Society and Governance. Selecting a service provider who provides data that meets your requirements necessitates considerable effort. More often than not, investors will have to rely on more than one service provider to obtain the information universe needed for their decision-making.
3. Setting Internal ESG Investing Standards and Goals
To different institutions and financial professionals, ESG investing means different things. Client segments will have different needs and preferences. As a result, the definitions of environmental, social, and governance will differ to some extent from one financial institution or firm to the next. It may also differ within the institution depending on the targeted investors.
To determine ESG investment goals, banks and investment firms will need to conduct a thorough audit and risk assessment. These institutions must also define the criteria that will be used to ensure that portfolios and the investments contained within them meet the stated objectives. For example, how will the institution balance improve ESG credentials with factors like credit risk, cost reduction, and consolidation?
4. Getting Reliable Data
ESG analysis is becoming more important as a component of the ESG investment process. Each organization and industry has its own set of ESG risks and opportunities. The use of ESG criteria during due diligence processes is a method of evaluating potential operational, reputational, or regulatory risks. This can only happen if accurate, reliable, and relevant ESG data is available.
One of the most difficult challenges for investors is that this information comes in a variety of forms and requires a variety of sources that must be constantly updated. Financial data, operational and organizational data, environmental impact metrics, and market data are some examples. These figures only scratch the surface.
In brief, ESG investing offers financial institutions and investment organizations an opportunity to decrease investment risk while also catering to values-driven investors and promoting greater ethical standards. While there are difficulties to ESG investment integration that must be addressed, the long-term benefits of ESG will benefit both firms and society as a whole, and they will undoubtedly surpass the costs.
5. ESG Data Accessibility
ESG data is easily accessible or inexpensive to obtain. Because not all companies provide data and measuring procedures differ, comparing metrics among companies, even for the same indicators, can be challenging. Furthermore, not all of the information provided is granular or relevant enough to be useful in making credit or investment decisions. While standardization would be beneficial, businesses should be proactive in designing and executing ESG data and reporting plans while also keeping an eye on the changing landscape.
It’s important to note that responsible investing does not advocate investing only in one sector or company, nor does it advocate for abandoning financial gains in order to satisfy moral or ethical concerns. It basically tries to incorporate ESG data into investing decision-making in order to ensure that all relevant elements are taken into consideration when calculating risk and return. It backs the premise that responsible investing should be pursued even by investors whose main goal is to make a profit, because neglecting ESG elements means disregarding risks and opportunities that can have a major impact on investment outcomes.
Several initiatives are underway by various bodies such as the Global Reporting Initiative (GRI), CDP, formerly the Carbon Disclosure Project, Sustainability Accounting Standards Board (SASB), FSB Task Force on Climate-related Financial Disclosures (TCFD) which are providing guidelines on disclosures related to ESG factors to enable data standardization. The Sustainability Accounting Standards Board (SASB) has in November 2018 issued industry-specific standards designed to assist companies in disclosing financially material, decision-useful sustainability information to investors.
While regulations strive to improve company data disclosures, it is important to ensure that reporting requirements are made simple without jeopardizing data quality. Similarly, investors should have better clarity in comprehending the ratings and rankings published by service providers, as well as in understanding the variances in ratings while keeping the proprietary methodology hidden. More investors should be able to include ESG elements into their decision-making process as a result of this.