Exploring the world of data within the integration of ESG
A firm may have multiple different aims and objectives for integrating environment, social, and governance (ESG) practices into their investment process. Some of them may include:
- Meeting requirements under fiduciary duty or regulations
- Increasing investment returns
- Improving the quality of engagement and stewardship activities
- Depreciating reputation risk at a firm and investment level
- Meeting growing client and beneficiary demands
- Ethical responsibilities
Aims will differ depending on the type of firm, but many investors seek to integrate ESG into the investment process to enhance understanding and lower investment risk. A global survey by the Financial Analysts Journal suggested that more firms do so to lower risk rather than enhance returns, but some do both.
ESG analysis can be qualitative or quantitative, and these cover different kinds of strategies, such as passive, systematic, fundamental, active, and different asset classes. Qualitative analysis is likely to be used in the investment process based on company specific research, fundamental analysis, and stock picking. Quantitative analysis is likely to be used in processes focusing on quant models to identify attractive investment opportunities.
ESG data is included mostly in the quantitative investment process and could result in the upward or downward adjustments to the weights of securities. Investors can also try to assess relationships in existing ESG third party scores as well as proprietary scores. For example, algorithmic approaches use ESG data from internet news articles to adjust company or sector weights after dissecting the data through rule-based formulae. However, there are multiple challenges that come with integrating ESG into the investment process, with regards to availability and consistency of data.
The sources of data to assess ESG investments varies across different tools. Data can be collected directly via:
- Company communication and reports
- Presentations and public documents
Or indirectly via:
- News articles
- Third party reports and rating agencies
Data sets: What are the challenges to ESG integration?
Data acquisition fits into the research stage of the investment process and overcoming disclosure and data related challenges is a necessary step to fully integrate ESG into the process. The challenges include data inconsistency, data scarcity, incomplete data, and a lack of audited data. Challenges also include the lack of comparability between ESG rating agencies, comparing across different accounting standards, as well as across geographies, cultures, and inconsistent use of terminology.
ESG factors can be judged material and useful, but also the data may be incomplete. For example, carbon pollution is often judged material, but it can be measured in at least three scopes: Scope 1, Scope 2, and Scope 3. Currently, in the top 2,000 companies in the world, there is little data on Scope 3. As of 2018, 10% of companies reported Scope 3 and in 2020 this had increased to 18%. Yet, there is evidence that Scope 3 makes up for more than 50% of the worlds carbon pollution impact.
So, ESG data can be incomplete, unaudited, unavailable, or incomparable between companies due to different reporting methodologies. This makes assessment of factors much harder. A lack of data or a company unwilling to disclose information can make identification of relevant ESG factors difficult.
The below diagram shows the challenges and aspects related to ESG data integration and reporting.
The Financial Stability Board (FSB) created the Task Force on Climate-related Financial Disclosures (TCFD) to improve and increase reporting of climate-related financial information. The idea being that financial markets need clear, comprehensive, high-quality information, and for this, there needs to be accurate market information and timely disclosure from companies. Back in 2017, the TCFD released climate-related ﬁnancial disclosure recommendations that are structured around four thematic areas: governance, strategy, risk management, and metrics and targets. Since these recommendations, the FSB has asked the Task Force to continue its work. This includes promoting adoption of the TCFD framework, providing further guidance, supporting educational efforts, monitoring climate-related financial disclosure practices in terms of their alignment with the TCFD recommendations, and preparing annual status reports. Statistics from the October 2022 TCFD Status Report: Task Force on Climate-related Financial Disclosures show that more than 3,800 organizations have become supporters of the TCFD recommendations, and “these include over 1,500 financial institutions, responsible for assets of $217 trillion. TCFD supporters now span 99 countries and nearly all sectors of the economy, with a combined market capitalisation of over $26 trillion.”
Of course, the momentum must continue for reporting to become the “norm” and The FSB has asked the TCFD to publish a further status report in 2023, reviewing disclosures by companies in their public reporting for 2022. Disclosing TCFD aligned data seems like a healthy way for companies to highlight that they are serious about their ESG reporting practices, and lead to greater transparency in what can sometimes seem like an opaque market.
So, where can ESG data be found and how consistent is it?
ESG data for evaluation does not have a long history and a “standardized” method of evaluation is not yet established. There are now a variety of ESG data providers, with some of the biggest being:
- LSE (FTSE RUSSELL)
- Real Impact Tracker
- World Bank
A study by Chatterji et al showed only a 0.3 correlation between ESG data providers. Another study by Berg et al showed a range of correlations as well. Berg looked at a dataset of ESG ratings from six different rating agencies and found that the correlations between the ratings were on average 0.54 and range from 0.38-0.71, highlighting the inconsistencies.
These studies highlight that investors should perhaps not treat ESG scores as facts. Perhaps the problem is not the ESG ratings themselves, but that they can be used as objective truth. The correlation may well change over time as providers evolve the ways in which ratings are produced. This evolving process also makes comparisons difficult. Many factors are still debated by investors, such as what the correlations are, the timeframe over which they are studied, and the relevance of them. There is also the possibility that high correlations could lead to group think and a lack of meticulous thinking, and that low correlations mean that using one provider versus another could alter the outcomes significantly. So, it could be that simplicity may bring more credibility to ESG ratings and give more consistent messages to companies.
How do investors and market participants use ESG data in practice?
In the wider asset allocation process, allocators are increasingly integrating ESG factors and expectations into their manager selection process. For example, pension funds have multiple manager strategies focusing on building a platform of strong individual fund managers. Due diligence around this selection process combines both the qualitative and quantitative aspects of data and metrics. Things such as the existence of an ESG policy, affiliation with investor initiatives, the Principles for Responsible Investing (PRI), ESG reporting capabilities, and the degree in which ESG is integrated into the investment process are all factors.
Committing to measuring and making ESG data available to the public is a way to provide a sense of trust for future investors and customers, which can then help to identify new business opportunities. Ultimately, companies can establish a routine of calculating their ESG data and reporting it; this establishes transparency, trust, and accountability to environmental, social and governance led goals and investors can determine whether a company is in alignment with their values.
An ESG “score” is a measure of how well a company addresses risks with respect to environmental, social and governance issues in its day-to-day operations. ESG scoring systems do vary, but tend to include measures like addressing climate change, diversity, inclusion, and human rights. These ESG scores are set by ratings agencies as previously discussed and standard setting bodies as well internal ESG scores set by company’s themselves, usually via a scorecard. High ESG scores are a moving target as the scores are frequently impacted by the performance of other industry players, macro industry trends, and alterations to the scoring platform’s internal methodology. These ESG scores allow investors and other players to effectively “rate” a company’s ESG practices and decide if it’s aligned with their expectations.
When it comes to trading, there are ways banks or the buyside can use ESG data and scores in their trading decisions. One way for a bank to ensure they are engaging with “green” counterparties is to use a methodology to put clients into different pricing brackets based upon publicly available ESG data. Clients with a better “green” ranking receive more competitive prices. For example, ING automatically links a client’s ESG behavior to the pricing the bank offers for FX transactions. Specific FX transactions are not linked to ESG targets, but all its electronic FX prices are based on the overall ESG behavior of its clients.
As shown in the chart below, according to consultancy Opimas, the global market for ESG data surpassed $1 billion for the first time in 2021 and continues to grow.
What ESG data is available?
ESG data is primarily gathered through publicly available information through various sources. Ratings are available through the agencies mentioned previously and the methodologies for such continue to evolve. Direct contact with companies, corporate sustainability reports, in-house research, and ESG product trading data are all ways ESG data can be obtained and analyzed.
At CME Group, trade products are designed to address the growing environmental interests of customers across financial and commodity markets. As more investors consider ESG factors for their strategies, CME Group is developing tools to provide access to emerging ESG markets and their data. CME Group provides community commitment, corporate stewardship, and ESG trading data through a variety of different channels. Featured ESG products include the E-mini S&P Europe 350 ESG futures, which can provide an efficient new way to capture benchmark European equity exposure and integrate ESG exposure into the investment process. This contract complements CME Group’s growing suite of sustainable investing products, including the liquid E-mini S&P 500 ESG futures. The Nasdaq Veles California Water Index futures can also help manage the price risk associated with the scarcity of water in the largest water market in the United States. The CBL Global Emissions Offset (GEO) futures also provide delivery of physical carbon offset credits that have undergone stringent screening. This contract helps the global market base access standardized and validated instruments for the emerging voluntary emissions market.
Pricing, volume, and quote data can be found for all these markets on CME Group ESG solutions web page. CME group’s data can be accessed via licensing agreements or via the cloud, offering an hourly fee model for cloud-computing usage, and facilitating the use of real-time and delayed market data in the cloud. CME Group Data can also be accessed via the Google Analytics Hub and via DataMine.
How can Derivative Exchanges promote ESG data development?
As the leading derivatives exchange, CME Group supports the effort by the Sustainable Stock Exchanges (SSE) initiative, and this has represented a major step forward. The SSE initiative is a UN Partnership Program organized by the United Nations Conference on Trade & Development (UNCTAD), UN Global Compact, UNEP Finance Initiative, and the Principles for Responsible Investing (PRI). The SSE’s mission is to provide a global platform for exploring how exchanges, in collaboration with investors, companies, regulators, policy makers, and relevant international organizations can enhance performance on ESG issues. Alongside this, the aim is to also encourage sustainable investment, including the financing of the UN Sustainable Development Goals. The SSE seeks to achieve this mission through an integrated program of conducting evidence-based policy analysis, facilitating a network and forum for multistakeholder consensus-building, and providing technical guidelines, advisory services, and training. The SSE’s work on sustainable finance, ESG disclosure, responsible investing, risk mitigation, and benchmarking has provided a template on sustainability for exchanges worldwide. Actions including partnership engagement, standardization, enhanced transparency, ESG data products, and listed tradeable ESG products are all ways exchanges can promote sustainable development.
There are many techniques for ESG integration across asset classes and data plays a huge part in the process. The lack of consistency across ratings and disclosure methods can make it harder to identify relevant factors, therefore it does come with its challenges. As core marketplaces for the design and trading of new products, exchanges must be at the heart of the focus on sustainability for genuine change to take place. The field of ESG data and ratings remains dynamic, and while it is not yet highly commoditized, techniques and tools for analysis continue to evolve.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.