ESG (environment, social, governance) investing is being embraced more widely by both investors (retail and institutional) and their asset managers. Sustainable investing assets globally now total USD30.7 trillion (at the beginning of 2018), having grown by 34 per cent in the last two years alone.1 For asset owners, returns are a key criterion behind ESG investing but so too is their growing awareness about the risks associated with climate change. Likewise, regulators are also attempting to expand sustainable investment practices at financial institutions as they increasingly recognise the financial implications of failing to address climate change-related risks. While ESG is attracting widespread institutional support, the data metrics and measurables underpinning it need to be examined carefully before being used.
“E” data is good; “S” and “G” needs more work
Measuring the environmental footprint of a particular investment is fairly straightforward as the underlying data – whether it is carbon emissions or water toxicity – is based on a clear methodology. In contrast, scoring a company or a fund manager based on its social or governance factors is much harder to quantify as the analysis tends to be more subjective and interpretive in nature. “Data transparency and coverage is improving. However, we are starting to see a divergence between the E, S and G. E has increasingly clear coverage, G is improving, but S is lagging,” explained Sarah Peasey, Investment Strategist at Legal & General Investment Management. Computing ESG scores in aggregate is therefore quite challenging for institutional investors.
The issue is complicated further by the absence of standardisation in the ESG methodologies adopted by third party data providers, said Chris Johnson, Product Management, Market Data at HSBC Securities Services. “There is a lot of variability across different providers. I am unsure if there will be much convergence as many research companies have got their own proprietary ways of analysing ESG, which is fairly hard-wired,” he said. As ESG methodologies at data companies are interchangeable, so too are their analytics. For instance, FTSE ranked Tesla last in its global auto ESG benchmark whereas MSCI said it was the best, while Sustainalytics shoehorned it in between the two.2
Inconsistencies in fixed income markets
There are significant variations in how sustainability is applied across different asset classes. Michael Ridley, Global Head of Green Bond Research at HSBC, said that green bond investing arrived in the fixed income space before ESG took off. As a result, a number of institutions are trying to integrate these two different investment styles. Many asset managers are aiming to buy green bonds from entities that themselves score highly on ESG criteria3 but this can be quite challenging. This is because many bond issuers – which often include local municipalities or sub-sovereign bodies – are not scored by external ESG rating providers.
However, change is happening. In 2019, S&P Global Ratings announced it would roll out ESG scores for some corporate issuers. These ratings will be based on both qualitative and quantitative criteria. In July 2019, Moody's also published details of their governance assessment tool (GA) which assesses the corporate governance characteristics of publicly traded non-financial corporations.4
Regulators react to ESG
While the financial services industry is moving towards ESG standardisation, regulators are looking to accelerate this trend through initiatives such as the Financial Stability Board’s (FSB) Task Force on Climate Related Financial Disclosures. Elsewhere, the European Commission (EC) announced an Action Plan on Sustainable Finance in 2018.5 As part of this programme, there are proposals to create a unified EU classification system – or taxonomy – outlining a set of harmonised criteria for determining whether an economic activity is environmentally sustainable,6 in what should bring about more clarity on ESG at institutions. In addition, the benchmark could also play a crucial role in sheltering investors from greenwashing activities, namely being mis-sold products masquerading as being “green”.
“The taxonomy could help minimise greenwashing. The EC has a huge amount of work to do on this, so it is focusing mainly on the ‘E’ elements to begin with, as it is an easier place to start with due to the ready availability of environmental metrics. Once the EC has created a solid framework for an environmental taxonomy, I expect it will move onto the ‘S’ and ‘G’ components,” said Peasey. Central to the taxonomy are proposals on establishing an EU green bond standard along with an accreditation system to further enhance the trustworthiness of the guidelines.7 Just as the EU launched UCITS which evolved into one of the world’s leading mutual fund wrappers,8 Ridley said an EU green bond standard could eventually morph into a global label, assuming the regime is flexible and user-friendly.
ESG going global
There is cause for optimism about ESG’s application in financial services. Firstly, data inconsistencies are likely to converge, at least to some extent, as regulators roll out taxonomies. It is not just Europe and North America that are implementing ESG reform. Stephanie Maier, Director, Responsible Investment Specialist at HSBC Global Asset Management, highlighted APAC is increasingly embracing the concept, citing Australia in particular. With sustainability now becoming a pivotal factor in the investment decision-making process, financial institutions and corporates have little choice but to augment their ESG data gathering and analytics.
1 Global Sustainable Investment Alliance – 2018 Global Sustainable Investment Review
2 FT (December 6, 2018) Lies, damned lies and ESG rating methodologies
3 HSBC (January 9, 2019) Green Bond Insights 2019 Market Outlook: Rise of the ESG investor
7 EC (February 28, 2019) Green bonds
8 HSBC Securities Services – A Guide to alternative UCITS