Sustainable Finance and ESG have taken a hold of the market and are moving from niche to mainstream by now. Asset Managers (AMs) are changing the once recurrent question of why integrate non-financial factors—notably Environmental, Social & Governance—to ‘how’ it is actually done.
For all financial market players, going into depth regarding the integration and analysis of ESG data in granular detail is a timely and consequent decision.
This way, they can anticipate the proposed amendments to the existing EU directives UCITS and AIFMD and, in particular, advance the compliance with the already published Sustainability Disclosure Regulation.
Accurate ESG data is crucial to incorporate both sustainability factors and risks into business models. Likewise, they are necessary to account for how market players have incorporated non-financial criteria into their processes, and to report on the adverse impacts of their investments. This way, regulatory requirements are fulfilled.
The recent EU Taxonomy-related publications as well as the latest draft Regulatory Technical Standards (RTS) of the Sustainability Disclosure are giving clearer guidance on what being environmentally sustainable is, and which the indicators to be reported on are.
In this article, we discuss the importance of ESG data quality and why having a governance system in place is key to the upcoming reporting on ESG.
ESG Data: what does the market offer?
The Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector sets the deadline for firms to disclose sustainable investment products on 10 March, 2021.
This pressing deadline raises questions about the collection, handling and practical implementation of non-financial data to analyse a portfolio’s impact on sustainability, and report accordingly. Compared to the availability and quality of data for financial analysis, that is already well developed, the ESG data offer differs significantly.
As ESG data demand is relatively new to the market, numerous providers offer very different datasets. Without any standardization or little, data points for the three dimensions—E,S and G—are not the same or are (already) interpreted differently.
Until now, the best practice has been making use of pre-calculated ESG ratings or scores that data providers sell to AMs.
Data providers vary in terms of 1) the underlying methodologies to interpret the collected non-financial information of companies, and 2) the underlying data elements themselves that data providers use to calculate the ESG ratings/scores per company, which aren’t always shared with the end users.
Regarding the methodologies, they are often opaque and not very comprehensible. In fact, it isn’t very straightforward for AMs to understand the approach behind the data sold. In addition, they differ significantly from each other, with the subsequent problem of comparability across different ESG ratings/scores.
As a result, the practice of relying on an ESG rating or score provided by different ESG rating agencies during the screening phase and investment analysis process has changed only recently.
What’s the new trend in ESG data processing?
We have lately seen asset managers using untreated ESG database of ESG ratings/scores—directly. By putting their hands on and taking an active part in the processing of data, they can develop in-house methodologies and, thus, a proprietary ESG rating or score that answers the investment decision-making process better.
Treating ESG data does not only concern the investment decision-making process, but also the integration of ESG into the risk management process.
One objective here is to be able to enhance transparency and detect potential adverse sustainability impacts or risk factors as well as maintaining the highest flexibility in terms of handling different investment mandates with different ESG methodologies. Additionally, through identifying ESG risks, appropriate measures can be taken to mitigate those risks. All of this will be part of the necessary reporting requirements in the near future.
Get started with ESG data processing
In summary, the Market players’ challenge is twofold: having access to ESG data and learning how to integrate it in the value chain’s conventional processes to streamline them.
AMs need to find out how to get a hold of the right data to check their portfolio’s compliance with the EU Taxonomy and disclosure requirements.
The still lack of standardization not necessarily translates into lower data quality of some data, but in certain practicalities that AMs must take into consideration.
There is the need for sound data governance to make the required data available, usable and susceptible to be integrated into the existing systems.
With proper internal data procedures in place, the usage of data can be defined more clearly. Since the topic is growing at a rapid pace and AMs must use different datasets, they need to be able to critically evaluate the availability and reliability of the information received to avoid any risk.
Using non-financial data without proper controls can lead to mis-selling, or even to unknowingly sell investors some products that are inaccurate.
As the asset management industry is now starting to use non-financial data as an equally important decision-making factor as the financial data, it is more and more essential this data to be reliable and accurate when used in business operational processes.
Having the right framework in place to assess ESG information
Since ESG data is rather younger and, therefore, naturally less developed than financial data, it is even more important to have the right framework in place to evaluate ESG information critically and appropriately. This also translates into being able to acknowledge potential subjectivity when assessing non-financial data.
AMs face several challenges in choosing an ESG data provider. Is it necessary to choose one or several of them? Today’s common market practice is using several providers, which information, analysed in-house, is processed to draw a unified outcome.
Even though they vary significantly, there is no right or wrong methodology as there is no standard definition of what integrating ESG risks & factors for AM is, so far.
On top, the EU commission wanted to set a uniform EU-wide classification framework to enable financial market participants (FMPs) to identify which economic activities and investments can be considered as ‘environmentally sustainable’ and treated accordingly. These criteria are not and will not be a mandatory list of activities in which to invest.
It is up to each AM to individually define how they plan to integrate ESG factors across their processes and how these processes align with the overall investment policy. However, keeping certain flexibility is recommendable for AMs to consider requirements for individual investment mandates.
These considerations fall under the larger aspect of ESG Data Management and Governance.
In relation to the upcoming Disclosure Regulation, datasets need to be complete and more and more comparable for regulators and investors to understand how non-financial data is used across the financial services industry.
Needless to say, transparency will be key to informing investors on how ESG data is taken into consideration. It’s essential not only for the financial industry but also for policymakers to understand what can be tracked in the first place, and ‘what is sustainable’ according to the EU taxonomy – a classification system on sustainable activities to give clarification to investors.
ESG Risk Reporting is key
The foundation for reporting can be a materiality map linked to the data points of a provider. This will allow for assessing the material dimensions per industry and to acknowledge the differences among them.
By focusing on the material ESG indicators per industry, AMs can easily assess ESG risk exposures within their portfolios, which is the base for investor reporting.
As mentioned, based on the upcoming regulatory amendments to UCITS and AIFMD, not only will reporting become a mandatory requirement, but also the integration of ESG risks and factors across organisational processes, operating conditions as well as within risk management.
What we think
ESG Risk Assessment will become essential for Asset Managers and ManCos to integrate sustainability risks and manage ESG risk exposure of their portfolios. The foundation for a solid ESG Risk Assessment is in the methodology behind which should be focusing on materiality of ESG factors for different sectors and industries.