Defective data is a big problem for sustainable investing
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Sustainable investing has been on a roll. Once a marginal concern, it has become an important component of many successful investment strategies.
More than six in 10 institutional investors have changed their approach to voting or have incorporated environmental, social and governance criteria in the past 12 months, according to Edelman, the marketing company.
Those who control more than a quarter of global assets under management seek to integrate sustainable principles, according to McKinsey, the management consultancy.
While sustainable investing is becoming big business, behind the scenes the challenge is how to embed sustainable factors as an extra way to see the risks in a portfolio, whether by providing early signs of a scandal or identifying where the cost of pollution or climate change may come back to bite.
But performance metrics for ESG are in their infancy compared with financial statements. Almost seven in 10 asset managers say the lack of high-quality information is the biggest challenge in adopting ESG principles. Without progress, the momentum in sustainable investing may stall.
For markets to do their job, we need more information to be visible. Investors need better-quality, comparable metrics woven into company reports.
Studies of the returns of sustainable investing are rarely definitive, in part because of gaps in the data. Taking into account sustainable issues should improve the risk/return trade-off of investments. An intriguing paper by AQR Capital Management suggests ESG factors may be twice as effective for detecting stocks to avoid (or go short) than invest in. This makes sense, for example a company with poor governance or lax environmental controls may become involved in a costly scandal or malpractice.
ESG may provide an additional lens on the risks that asset managers run. Many have responded to the challenge of index investing with concentrated high-conviction portfolios, often held for the long term; take the example of notable investors, Jana and Calstrs, writing to Apple on the issue of children addicted to iPhones.
One-size-fits-all scorecards can be misleading. Volkswagen was ranked the most socially responsible carmaker by Dow Jones Sustainability Indices in 2015. Then the VW emission scandal broke, the stock price fell sharply and the company was ejected from the index.
A proliferation in surveys and standards is an issue for companies, and it risks confusing investors, too. At the World Economic Forum sustainable impact summit in September, BlackRock highlighted that many companies suffer “survey fatigue”. The International Trade Centre identifies at least 230 corporate sustainability standards initiatives in more than 80 sectors.
Technology provides many new data sets and better processing. Without industry-wide or business-wide standards, however, investors and intermediaries struggle to weave them into a useful picture. Moreover, executives can cherry-pick criteria to make their companies look good.
More companies need to go from words to numbers. Markets will be better informed if relevant, sustainable measures become part of the fabric of corporate reporting, alongside their financial statements. Investors will have an important role in working with companies, policymakers and the accounting bodies to shape a smaller number of high quality and relevant standards.
There is much great work to build upon. A good example is the Task Force on Climate-related Financial Disclosures (TCFD), convened by the Financial Stability Board and chaired by Mike Bloomberg.
This voluntary programme has already enabled more than 500 global institutions to disclose high-level climate-related exposures and run scenario analysis on a consistent basis. This work revealed that the demand exists for more detailed and reliable data on how climate change may affect business. Nonetheless, only 10 per cent of investors and executives surveyed this year were aware of TCFD disclosure, according to HSBC research.
As with any new standard, it will take time, advocacy and hard work to become embedded in company and investor thinking. Policymakers too can play a role in driving new standards.
What is important is materiality. The questions and importance of answers on ESG topics will vary widely between industries and companies. Companies should not be overburdened with excessive requirements. A test of materiality needs to be enshrined for sustainable measures.
We are in the early stages of a sustainability revolution. As every investor knows, if you can’t measure it, you can’t risk-manage it. Better data will help investors seize the opportunities of sustainable finance.
Huw van Steenis is senior adviser to the governor of the Bank of England. He writes here in a personal capacity
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