Mining ESG data: the rise of technology

Chirag Patel, State Street: the root of an informed valuation is the disclosure of relevant information

The focus on environmental, social and governance (ESG) factors as a means to sustainable value creation is on the rise.

When it was formed in 2006, the United Nations-backed Principles for Responsible Investment (PRI), a global investor initiative included 100 signatories with $6.5 trillion in assets under management (AUM). Today, this has increased dramatically with 1,600 signatories representing $62 trillion in AUM (as at the end of 2016).

A recent report by McKinsey has suggested that more than a quarter of the world’s $88 trillion in AUM is invested according to ESG principles – a year-on-year rise of 17%. A recent study by US SIF Forum for Sustainable and Responsible Investment estimates $8.72 trillion of ESG investments in the US alone, up 33% from 2014. ESG investing now represents about 20% of total assets under professional management in the US, according to the US SIF data.

Despite this, ESG factors such as a company’s carbon footprint, the number of women on its board and the labour used in its supply chain are not numbers you would necessarily find in a financial report, but they are of increasing importance in determining an investor’s exposure to risk. With this in mind, outside of alpha generation, ESG factors are also increasingly seen as a signaling tool for volatility and risk.

The casualties of this lack of data around non-financials? One case study comes in the form of an energy company that publically rejected climate science a few years ago and actively funded groups that opposed environmental regulations – it saw a 99% drop in share price over the course of five years and ultimately filed for bankruptcy under Chapter 11. Investors lost millions, but they didn’t have to.

Another example is a pharmaceutical firm that increased the price of several prescription drugs by 200-800%. As a result, it was perceived as extorting chronically ill individuals and its share price dropped 88% in six months.

Having sight into a company’s non-financial profile is increasingly important to the growing number of investors and regulators who recognise the impact ESG factors can have on a company and an investment portfolio’s risk and returns.

The root of an informed valuation is the disclosure of relevant information. Increasingly, such data is not necessarily readily available.

Research released by State Street last year, “The Investing Enlightenment: How Principle and Pragmatism Can Create Sustainable Value through ESG”, has shown the primary barrier to full ESG integration is the lack of standardised, good quality data – with 80% of retail and institutional investors believing there is a lack of standards around ESG integration. Additionally, more than half (53%) of institutional investors feel the lack of data on ESG performance reported by companies is a concern when investing – with 92% wanting companies to explicitly identify ESG factors that materially affect performance.

However, supply is slowly meeting demand as financial institutions and regulators alike increasingly seek relevant ESG information and analytics. For example, in Europe alone:

• the European Parliament passed a directive that mandates large publicly-held entities to issue sustainability information;
• the UK’s largest pension funds joined forces to publish a reporting guide ensuring asset managers deliver on the responsible investment assurances;
• the Norwegian stock exchange requires listing company ESG reporting;
• Spain has introduced initiatives supporting the adoption of sustainability reporting based on use of the Global Reporting Initiative (GRI) Standards;
• and in France, the government passed Article 173 introducing mandatory climate change-related reporting for institutional investors.

The definition of value and how to effectively identify it in order to generate alpha has shifted staggeringly over the past few decades; and investors will increasingly need to develop the ability to incorporate non-financial ESG attributes in their assessments of value across asset classes. Furthermore, there is emerging evidence that ESG factors can also help drive alpha generation – as longer histories of ESG attributes becomes available, we are beginning to see divergences in performance between traditional market-cap weighted portfolios and those that incorporate ESG attributes. For example, over the past ten years, the S&P500 divested of fossil fuels would have outperformed the market on average by 6.17% (data source: Thomson Reuters Eikon, as of December 2016).

As such the appetite for new technologies that can provide an easy look-through into their investments using an ESG lens is significantly increasing.

Investors want to perform well while being responsible, and they need access to ESG data to do that effectively, by providing a new dimension to investing, giving them more information than ever before about the DNA of a company.

As more data becomes available, separating the investment signals from the noise is critical. Finding tools that provide access to data, but also insights that have not previously existed will be what truly enable investors to quickly and easily identify value.

Investors should explore the offerings of different data vendors (both general and specialised), including some new ESG scoring capabilities coming to market based on new technologies, such as natural language processing (NLP)based machine learning (ML) techniques, and determine which ones best meet their needs. While a specialist ESG group can do the background work, sector portfolio managers and analysts need to take ultimate responsibility for this decision.

Echoing the desire for greater standardisation in ESG data, according to our research, 40% of institutional investors believe that greater uniformity among ESG data providers would be useful.

Whilst investors may not be able to mandate any of these transformations, they can certainly be key drivers in helping bring about these changes. Strong empirical data, in the form of realised performance of ESG integration funds and studies by the academic community, will help make the case for full ESG integration in the practice of investment management.

By Chirag Patel, head of innovation and advisory solutions EMEA, State Street Global Exchange and State Street Associates, EMEA