Environmental, Social, and Governance (ESG) – What does it Mean?
ESG data is a booming market, projected to hit $1 billion by 2021, according to a study conducted by Opimas. ESG investing was first introduced in early 2004 when former UN Secretary General Kofi Annan wrote to 50+ CEOs of major financial institutions, inviting them to participate in an initiative to find ways to incorporate ESG into the capital markets. A year after this initiative, a report entitled “Who Cares Wins,” by Ivo Knoepfel was published emphasizing that the environmental, social and governance factors in capital markets equals good business sense and sustainable markets. Sixteen years later, everyone is still trying to invest more responsibly.
ESG data shows how corporations respond to things like:
- climate change
- how they treat their employees
- benefits that their management/board of directors receive
- how they manage their supply chains
- how they built trust with the consumer base
There are many drivers for the increased interest in ESG investing like expanding regulations, the data being available to investors as a result of improving company disclosures, etc. This type of data also allows investment firms to incorporate non-financial, non-traditional type of data into their analysis. For example, asset managers are using ESG data for portfolio selection, voting practices, risk management, etc. The report, ESG Data Market: No Stopping Its Rise Now highlights the following:
- ESG market hit $617 million in 2019 and is expected to grow annually by 20% along with 35% growth for ESG indices
- ESG spending is concentrated in Europe (~60%) but is expected to gain greater traction in the US and Asia. In Europe, the growth has been supported by the regulators
- Asset managers in Europe will be required to integrate ESG considerations into their fiduciary duties by 2021. Many companies in the US have already included this initiative in their corporate filings
- Financial services companies are the biggest buyers of ESG data. This group includes: buy-side, sell-side brokers, consulting firms and investment advisors, as well as some corporates
- ESG market is divided into the following categories:
- Data providers such as Bloomberg, Refinitiv or MSCI
- ESG specialist or research firms like Sustainalytics or Carbone 4
- Asset managers with ESG expertise in data, ratings and analytics
- Credit rating agencies like Moody’s
- Stock exchanges like London Stock Exchange
- ESG data vendors should aim to provide a qualitative layer on top of their ESG ratings numbers
- It is anticipated that sell-side institutions will incorporate ESG data in their company specific fundamental research
ESG = Environmental, Social, and Governance
The environmental, social, and governance aspects of any private or public company have significant impact on how that business performs and is viewed externally by the outside world/consumers/investors. ESG criteria provide insight into a company’s overall health and performance. All of the standards are set by government regulations to ensure that companies are run in a sustainable, fair and equitable manner:
- Environmental – this is measured against how well a company upholds regulations that protect the environment
- greenhouse gas production
- carbon reserves
- water stress
- renewable energy usage
- Social – this is based on the standard with which a company treats its own employees, customers, vendors, and communities it is based in
- gender equality
- employee turnover rates
- Governance – this relates to a company’s tax audits, its shareholder rights, and salaries of management, as well as the controls it places on internal company policies
- management structure
- improving employee relationships
- fair compensation of employees
- business ethics and fraud
How is ESG Data Sourced?
ESG data is derived from:
- company websites
- annual, ESG, and proxy reports
- NGO/government reports
- government websites
- news outlets
- social media platforms
- company reviews by consumers
Why are ESG Scores so Important?
Typically, the ESG score is correlated with a company’s ability to continue operating. A poor score may damage a company’s brand, reputation, and stock price. The S&P Dow Jones Indices launched an ESG version of its S&P 500 Index last year in an effort to meet increased investor demand for sustainable-investment U.S. equities. The S&P 500 ESG Index measures the performance of securities from the S&P 500 that meet the ESG criteria.
Let’s use Facebook as an example. During 2019, Facebook was accused of collecting and sharing user information without having proper consent from end-users of the platform. As a result, Facebook was removed from the list of socially responsible companies from S&P’s Index. This impacts the company’s reputation and stock price.
Having a poor ESG rating has 3 major consequences:
- increased consumer opposition to the brand, turning away consumers and existing/potential investors
- reputation damage through lightening spread of negative news
- stock price decreases with current investors pulling out and younger investors choosing not to purchase shares
How Asset Managers Implement ESG Integration in their Investment Decisions
ESG data, just like alternative data and fundamental research, feeds into the investment mosaic when making a decision on which companies to invest in and which ones to avoid. Investors assess the sustainability and ethical standards of a particular company and compare it to its peer companies. The focus is placed heavily on management and company leadership teams as well as social and environmental aspects that are most important for consumers (who pay money for the product or service offered).
- Fundamental Strategy – ESG data used to forecast financials (such as revenue, operating cost, asset book value and capital expenditure) or company valuation models (including the dividend discount model, the discounted cash flow model and adjusted present value model) for the expected impact of ESG factors
- Quant Strategy – construction of model with ESG factors and other factors such as value, size, momentum, growth, and volatility
- ESG factors and scores can be used to build a portfolio to create risk-adjusted returns, reduce downsize risk, or enhance an ESG risk profile
- Sell-side Research – broker research includes ideas and investment themes to integrate ESG factors into investment recommendations (BUY/HOLD/SELL) and into forecasted company financials like revenue, cost, asset, liabilities or models
The interest in ESG data has increased rapidly among asset managers, sell-side brokers, data providers, potential investors and companies.
Investors and consumers alike are educating themselves more on ESG and demanding increased corporate focus on sustainability efforts. This all places the burden on the corporation to create and meet particular ESG guidelines. There is a potential risk that investment firms will reallocate portfolios towards companies with better ESG ratings, thereby overvaluing or overpricing those stocks. Or, a company with squeaky clean reputation and high ESG rating is suddenly hit with an unforeseen event that causes the ESG data to be flawed. This may cause significant consequences for the company and all investors.