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Making sense of ESG data - Part 1

Climate change is one of the most important ESG topics in asset management right now.

We know that everyone is looking for the easiest way to assess the environmental, social and governance (ESG) characteristics of an investment. However, ESG data can be complex and not always reliable.

In our first of two videos, SEI’s Sustainable Research expert Aruran Morgan discusses how we consider ESG data, metrics and reporting. 

Want to watch the second video in our series? Making sense of ESG data - Thinking about carbon data

How do we assess reporting around ESG?

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Hi, I’m Sarika, and I’m part of SEI’s Institutional Group. I’m here today with Aruran Morgan, who is Head of Sustainable Research at SEI. Welcome Aruran.

A: Thanks Sarika - I’m glad to be speaking with you today.

S: Today we are going to be discussing data, metrics, and reporting around ESG, focusing on some of the challenges the industry faces at the moment.

S: We all know how important and topical ESG is to our industry, and everyone is looking for the best way to assess the environmental, social and governance characteristics of an investment. There are numerous data vendors and ratings providers that aim to help investors measure, for example, a company’s carbon emissions or how a security rates on the ESG scale. Aruran, can you describe this approach a little, going into any potential benefits but also sharing any challenges those of us newer to the space should be aware of?

A: Thanks Sarika. It’s a great question. I think it’s really important when we think about this topic to distinguish between raw data and the ESG ratings assigned to companies and funds by rating providers.

The ESG data landscape is changing rapidly. In recent years, we’ve seen tremendous growth in both the quantity, and quality, of ESG data. This has been driven, in part, by greater focus from regulators, fund managers and investors. We believe data is improving from an accuracy, disclosure and integrity perspective and we think it can be used to assist decision making on the investment side. Indeed, we think ESG data should be considered when making an investment, alongside the traditional financial metrics that are found in a company’s income statement or balance sheet. But it’s also important to understand where the data come from – most of it is voluntarily reported by companies, which means it often hasn’t been audited or verified. Other data are estimated based on similar companies. Not all data are created equal and we spend a lot of time trying to identify data providers that we think are credible, not only to assist our investment decisions, but also to assist our stewardship practices and our reporting to clients.

We view the ESG ratings from 3rd party vendors slightly differently. Most ESG ratings are backward-looking and focused on assessing corporate risk which, while important, is only one piece of what asset owners are trying to assess. There is little to no focus on impact or opportunity. And even in the case of corporate risk, the methodology used by vendors, and their final assessments, can vary quite considerably. For instance, if you look at the correlation between company ESG ratings from MSCI and Sustainalytics, it’s close to 0.3, which is surprisingly low. Just for comparison’s sake, the correlation between the credit rating agencies when they formally rate the credit quality of a corporate or sovereign is north of 0.9.

When we evaluate portfolio managers for our funds, we have found that those on the leading edge are actually creating their own ratings using that underlying data that I discussed. We see firms developing their own point of view on what is important from an ESG perspective rather than adopting a third party's qualitative assessment about what is important.

S: It’s really interesting to hear you draw that distinction between data and ratings. Can you describe the process ratings providers go through to evaluate a company on ESG, and why we see such variation between final ratings or scores?

A: It really comes down to the fact that third-party rating providers in the industry each have a different methodology for evaluating a company. There are three main reasons why you get divergence in the ratings – and they build on each other. First, providers may use different data points or indicators to assess a topic. Take, for instance, labour management – metrics can range from data on diversity, turnover and injury rates, to qualitative assessment of things like grievance mechanisms, professional development programs and paid leave policies. Second, providers may have different views on what issues are material for a given company or sector. Third, even if the metrics and material issues were the same, providers may put different weights on them across companies, sectors and geographies. Subtle differences can compound quickly.

The other thing I’d highlight, and we haven’t talked about this much yet, is ESG fund ratings. Data providers often just aggregate the underlying ESG ratings of all the securities held in a portfolio to create a fund ESG rating, and sometimes normalize them across asset classes or other factors. We disagree with this approach. We spend a lot of time when assessing the ESG credentials of a fund trying to understand the thought process of portfolio managers when they select securities, and we think this is a better way of assessing the “ESG-ness” of a portfolio, particularly given some of the challenges I’ve highlighted around third-party ESG ratings. It also allows us to assess other critical aspects around ESG-related investing, such as stewardship and engagement, which a simple analysis of holdings in a portfolio does not capture.

S: One of the most important ESG topics in asset management right now is climate change. Can you share your thinking on climate-related data and what investors should know?

A: The first thing I’d say is that we believe carbon data are getting better. There a lot of forces driving this, including regulation (most notably in Europe), investor engagement and client interest in the topic.

When the industry talks about carbon data, they often break it down into Scope 1, Scope 2 and Scope 3. Scope 1 emissions relate to direct emissions from sources that are controlled or owned by an organization, such as company facilities and company vehicles. Scope 2 emissions are indirect emissions from the generation of purchased electricity used by an organization. And Scope 3 emissions relate to upstream and downstream emissions that occur throughout a business value chain – everything from raw-material sourcing to employee travel to consumer use. We’re starting to see much better disclosure of Scope 1 and 2 emissions by companies which gives us more comfort in this data, with some countries beginning to require it from listed companies. Scope 3 disclosure is less robust. The methodology for calculating it is less standardized and quite frankly there are some real challenges to actually capturing supply-chain data given suppliers for large companies can be very small, geographically diverse, and have multiple tiers. And I’d add generally that, when it comes to disclosure in the ESG space (both carbon and other metrics), small companies tend to report less data than large ones.

S: Is there a concern that some companies are ‘greenwashing’ or deliberately not counting their Scope 3 emissions?

A: I’d separate the two issues. I think greenwashing, the idea of a firm overstating its sustainability credentials, is definitely a challenge. There is often an incentive for companies from both a financial and reputational standpoint, if they can get away with it, to greenwash by drawing attention to a few sustainability issues while ignoring the most material impacts of their business. Similarly, asset managers are racing to label products as “sustainable,” even when the portfolio hardly looks different than the index.

On the Scope 3 emissions side, I think it’s a slightly different issue. It’s an important metric and at times, for sectors like the banks, Scope 3 emissions can make up over 95% of the total carbon footprint of a company*. But it’s so hard to measure and any calculations have a number of assumptions associated with them that we may just have to accept that we’re not there yet in measuring these types of emissions. A further challenge for Scope 3 emissions in the asset management industry is that one company’s Scope 3 emissions are another company’s Scope 1 or 2, and vice versa. Scope 3 reporting for a diversified portfolio may result in double-counting emissions.

S: It sounds like, alongside quantitative metrics, understanding carbon emissions is a mix of art and science. How does SEI use ESG data?

A: SEI’s investment process starts with manager research, and so much of the data we use is proprietary and based on our in-depth ESG due diligence process. Beyond that, we subscribe to ESG data sets from a few different third-party providers and use them in several ways. One is to ensure funds with exclusions are in compliance with their guidelines. Another is preparing for new regulatory reporting requirements. We also use ESG data to inform our engagement program – for example, ESG data can help identify companies to engage with on a topic like climate change - (for example, which have high levels of emissions relative to their peers in the sector, or which are lagging their industry on disclosure).

And finally, whilst we don’t necessarily believe that the rating methodology of third-party providers is always the right way to look at the ESG credentials of a fund, monitoring ratings can help us challenge our own thinking.

S: It seems like ESG data are going to continue to be a big topic of conversation for some time. What’s on the horizon for 2022?

A: I think the focus is going to be on disclosure, whether its regulators in the UK increasingly asking pension schemes to report against TCFD recommendations or managers placing more of an emphasis on engaging with companies to get better disclosure on topics such as climate emissions or gender equity. We’ve also seen investors increasingly voting against management on ESG topics in shareholder meetings in 2021, and I expect that to continue into 2022. In Glasgow last fall, the International Sustainability Standards Board was announced to coordinate global sustainability reporting efforts. Improving the consistency, transparency and robustness of disclosure on ESG matters is a key focus for both the industry and SEI over 2022.

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