Integrating ESG into investment decision-making demands good data. Valborg Lie and David Evans explain their approach.
ESG (environmental, social and governance factors) integration has become a household phenomenon in the world of asset management. Claims of integration abound but, in the end, there is a reliance on data as to what companies disclose, which is set against a backdrop of constantly evolving ESG reporting standards. One can argue that the ESG integration can only be as good as the underlying ESG-related data.
Taking a pro-active approach
LGPS Central shares concerns that are debated in the investment community around the availability of robust ESG data and the quality and comparability of that data. However, we would caution against a stance that is too dismissive. While companies, industry standard setters and rating agencies are grappling with KPIs, reporting metrics and methodologies, we would urge investors and other users of data to take a pro-active approach and look for ways to encourage standardisation.
It is also critical to recognise that the ESG acronym covers a multitude of sub-factors that span a vast risk spectrum from climate change to human capital management. Knowing why you need the data and what lies behind that data is a necessary starting point.
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Sourcing data
At LGPS Central neither we, nor our external managers, rely blindly on headline ESG ratings. From the outset, we seek data that is material to the investment/asset in question and we will assess where we can best source this data.
Taking carbon emissions data as an example, we are cognisant of the fact that there are some inconsistencies or differences in opinion from different providers. While there has been significant improvement in the number of companies that report carbon emissions, there are still many companies that do not, or where the information is incomplete.
In an attempt to provide meaningful data, ESG data providers tend to use estimation models which rely on different methods. While we encourage standardisation of methodologies, it is important to bear in mind that carbon emissions is not the only area within the financial world where estimates are used. Analysts have differing expectations and use a variety of methodologies to assess company earnings and credit ratings agencies have different approaches to assessing the credit worthiness of an organization. However, this does not prevent investors using this information to make meaningful investment decisions.
At the very least, while not without its flaws, carbon emissions data can provide an indication of the “direction of travel” or the way a company is reacting to the climate crisis, and can help to assess what progress the company is making in this area. It can also help investors to understand the risks and opportunities that exist within a company. This can also feed into a program of engagement where investors can work closely with companies to encourage improvements in their performance and their overall approach to climate change.
The LGPS Central All World Equity Climate Multi-Factor Fund
In October 2019, LGPS Central launched the All World Equity Climate Multi-Factor Fund. The fund tracks the performance of the FTSE All World Climate Balanced Comprehensive Factor Index.
The index reduces exposure to companies that emit high levels of CO². However, the methodology of the index compilation doesn’t rely on carbon emissions data alone. It also reduces exposure to companies that are involved in the fossil fuel industry and increases the weight of companies that produce goods, products or services that allow the world to adapt to—or reduce—the impact of climate change on the environment.
The index further increases the market cap weight of companies that score well against five chosen style factors. Compared to the FTSE All World index, the All World Climate Balanced Comprehensive Factor Index has resulted in a reduction in exposure to carbon emissions of 42%, a reduction in exposure to fossil fuel reserves of 68%, and an increase to companies producing low carbon solutions of 74%*.
FTSE are well aware of the problems caused by the inconsistencies of output from the various estimation models. Therefore, rather than relying on a single model, they have designed four models based on established approaches to emissions estimation. Each model has a distinct methodology and they run all models in parallel. Disclosed emissions are taken before they default to the models, but they believe that utilizing multiple methodologies allows for greater flexibility and transparency.
The importance of engagement
The LGPS Central All World Equity Climate Multi-Factor Fund does not exclude sector and industry groups. This allows us to engage with companies, a tool that we consider to be of vital importance in order to affect company and sector-wide change in line with our and our Partner Funds’ investment beliefs.
We hold the view that financial markets could be materially impacted by climate change and the response of policy makers. Responsible investors should proactively manage this risk factor through stewardship activities, using partnerships of likeminded investors where feasible.
Alongside fellow Climate Action 100+ engagers, we ask companies across high emitting sectors to set a clear net-zero by 2050 target across their own operations and for their customers. We see this as a necessary shift if we are to achieve the goals of the Paris Agreement and to achieve an orderly transition to a low-carbon economy.
Encouraging signs
We believe that the quality and availability of ESG data has improved significantly over the last few years. However, we would welcome further improvement and would also encourage greater consistency across data providers.
We are encouraged by the news that the European Union is planning to create a platform to give investors access to financial and sustainability corporate information in one place. This is meant to counter what the EU perceives as a “lack of easily accessible, reliable, understandable and comparable public information.” Similarly, the UN-backed Principles for Responsible Investment (PRI) and the World Business Council for Sustainable Development have recently forged a collaboration to create enabling conditions for a sustainable financial system.
The collaboration will, amongst others, serve to complement existing regulatory and standard-setter work towards a globally harmonised system for ESG disclosures focusing upon investor needs and strategic corporate communications. We would also welcome any additional analysis and research from various actors across the investment chain that can shed light on how to navigate the highly complex ESG field with its multitude of interplaying variables.
In conclusion, and despite the variances, we believe that ESG data provides investors with material information that enriches investment decisions and helps navigate the risks and opportunities associated with, for instance, climate change.
Valborg Lie is stewardship manager and David Evans is investment director for passive equities at LGPS Central.
*Source: FTSE 31/3/20
Photo by Markus Spiske on Unsplash
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