Confluence explores upcoming ESG-related regulations, operational solutions, and actionable takeaways for building a competitive ESG approach for the future
ESG investing is still evolving and will continue to do so for years to come. As part of that evolution, ESG frameworks are emerging to standardise the reporting and disclosure of ESG metrics across as many as 140 jurisdictions around the world, with the EU’s Sustainable Finance Action Plan leading the way.
Managing ambiguous ESG data requirements is proving to be a monumental task. Investment managers and asset owners need a practical, data-driven approach to solving their near- to long-term ESG challenges.
Although progress towards this goal has been initially centred on meeting ESG taxonomy, disclosure and reporting, companies have an opportunity to create a strong ESG strategy while driving positive change. Technology is the key to solving how the investment community can implement sustainable investing.
Technology is the key
ESG regulations take hold in Europe with other regions set to follow. The EU’s comprehensive sustainable finance action plan aims to mandate that companies integrate sustainability risks into their investment management and disclosure processes, including their impact on the market environment.
Its goals are to provide greater transparency on ESG investment products, use a taxonomy to set a common definition of sustainable activity, and set market standards for financial products including green bonds, benchmarks and eco labels.
Companies are regulated under the Non-Financial Reporting Directive (NFRD) and soon the Corporate Sustainability Reporting Directive (CSRD), while financial products will be regulated under the Sustainable Finance Disclosure Regulation (SFDR).
As displayed above, the EU is imposing an aggressive timeline for compliance over the next several years, including major milestones that are imminent. A key challenge is the discrepancy in the timing of disclosure requirements: financial firms are being required to report ESG information which relies on data from corporates — who themselves are not required to disclose that data until later dates.
Meanwhile in the UK, climate-related disclosure requirements have been drafted for the financial sector and corporates, and their dates of implementation follow closely on the heels of EU requirements.
Contents of disclosures are based on the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), which have emerged globally as the prevailing approach outside of the EU.
The US has also issued climate-related disclosure requirements for both financial firms and issuers. Based on global frameworks such as the TCFD recommendations and the GHG Protocol, the U.S. Securities and Exchange Commission’s (SEC’s) rules are scheduled to be implemented in stages, beginning in 2023, and require specific climate-related data to be provided in registration statements, periodic reports, fund prospectuses and other filings.
All these regulations are positive developments designed to enhance and stabilise climate-related disclosures, while generating more data to assist all parties with assessing companies’ performance and to drive regulatory reporting.
ESG data challenges
Regulations are ultimately present to protect investors, and regulators want to ensure the data presented to them is digestible, offers clarity, and provides the best possible view of risk and performance.
However, many firms are struggling with ESG data challenges as they attempt to meet their reporting obligations. The main challenge is the ambiguity and inconsistency of data used for various disclosures, and the way in which it is presented to investors. Fortunately, the outlook is positive for solving these issues.
The SEC’s proposals require the companies themselves to report on their risks related to climate transition across its three scopes. This will help ensure better data quality from the disclosure phase to the downstream investors. Even at this relatively early stage, data quality, consistency and normalisation are improving, as more companies participate in reporting and engage in the topic of data-driven ESG disclosures.
The way data is presented through different ratings providers is also a significant issue. Investors are tasked with making sure they have a true understanding – beyond top-level ratings – of the captured key performance indicators (KPIs), the intention of the framework used, the company’s risk through an ESG lens, and the amount of risk to society in general.
From there, they will need to reconcile those differences in a more meaningful way.
Thankfully, we are beginning to see different standards consolidate through the International Sustainability Standards Board.
The cost of ESGNaturally, the cost of ESG weighs heavily on the minds of all industry participants, especially as it becomes more embedded in different use cases and value chains. Data licensing is at the heart of this challenge.
Firms are integrating ESG into their investment management strategies while also complying with ESG disclosure regulations that are relevant to them. Firms also need to report their required disclosures (including for risk management and investment policy), and often the challenge is that the licence held on one side does not always allow it to send data to the other.
This implies that both the asset managers and the management company are buying some of the same data. Discrepancies may develop regarding what must be disclosed and the additional cost will be passed on to the investors. In addition, data costs depend on the providers’ different offerings.
Generally this is split into the following categories: procuring raw data from multiple disclosures (and providing it to certain organisations based on their needs), as well as procuring raw data, contextualising, and normalising it, and filling the gaps with estimation models.
Firms need to evaluate their specific raw data needs, how they plan to interpret the data using their internal capabilities versus how much help they will need from the vendor.
In addition, data must remain consistent at the company, fund, portfolio and benchmark levels. Therefore, a good level of cohesion is needed between different use cases where ESG data will be embedded – from creating the fund to selecting it and reporting.
The end goal is to encourage greater convergence between different frameworks, and define ESG risk versus ESG impact to reach a common understanding and consistent results in terms of liquidity and transparency. This way, investors will truly understand what it is they are investing in.
Private markets have even more unique challenges
Up until now, public markets have been the primary focus of ESG disclosures. However, private markets face different challenges, such as connecting the data in a standardised way when dealing with private equity funds.
The obvious challenge is that data is currently based on self-reporting. Small companies may not realise they have the data they need or that it may not be in an easily accessible format.
In addition, firms must understand the data points they need and have a solid framework for what they can realistically measure. Private market investors struggle to find the right KPIs and regularly get inconsistent views of data from each of their investment companies, as a result of the data often residing disparately across regions and industries.
In this infancy stage, interpretations of data through tailored diagnostics, focused on relevant ESG issues, will reign supreme, provided firms have knowledgeable people to analyse and understand the data and the methodologies behind the analytics, and then make the best use of all available data sets.
The technology innovations underpinning sustainable finance investing
Technology tools and processes are emerging to help streamline ESG KPIs and support ESG analytics across the front and back offices. The front-to-back challenge stems from use cases around screening investments, building, and monitoring portfolios and reporting on them to investors, distributors and asset owners.
Large firms that are already well advanced in their journey towards full integration of ESG processes, often have a dedicated team and the means to integrate ESG data into their portfolio management systems.
These firms have typically had an established core ethos ready to be applied to sustainable investing, with eco-green credentials and strong governance.
Smaller firms tend to be less ESG-mature and therefore struggle with disseminating volumes of information to multiple stakeholders and meeting regulatory obligations. A ready-to-use tool that aggregates structured and unstructured data, analyses ESG risk and performance, and manages reporting, is key for these firms.
Technology can help firms improve data procurement and fulfil gaps around disclosures. It can also pave a path for new product offerings that bring ESG along, such as direct indexing.
Enhancing the connection between ESG data and a technological solution where audiences can engage with personalised ESG investing, such as separately managed accounts, is the goal. In the private equity real assets market, tools and frameworks are also emerging to help structure the process of aggregating data and intelligence, and structuring companies’ ESG approaches.
ESG investment strategies
Regardless of where you are on your ESG journey, avoid diving into reporting too soon. Set a clear roadmap starting with defining your level of ambition. Jumping straight into the EU taxonomy may send you on the wrong path if you are just starting out.
Think through the whole value chain. When ESG strategy and sustainability goals are built together – from the investment manager to the management company and authorised fund managers – all entities will be able to meet their obligations throughout the process.
Learn all you can about ESG; all market participants should keep up with the latest ESG trends. Once you appreciate the value of ESG as an investment tool, challenges will seem more manageable. Know that ESG is not an isolated discipline. Ultimately, people are engaging with ESG across the firm, from managing risk exposures to driving capital into positive areas of impact.
Focus on your ESG objective. Understand the exact intention or objective of what they are trying to capture within your strategies, and remain steadfast in your reporting.
Consider data licensing implications — the licensing of data should ensure consistency across the value chain while also reducing data costs.
Be aware of greenwashing risk. Stay consistent within your investment activity, build funds using intentional KPIs that align with your objectives, report on those and ensure your story remains consistent.
The outlook for ESG
Demonstrable improvements in the breadth and depth of ESG information, tools and frameworks are evident throughout the investment management community. While a significant amount of work has been completed, there is still a long way to go.
Market participants can optimise efficiency and control across their investment lifecycles, from portfolio analytics, to compliance and regulatory data solutions (including investment insights and research) to meet the evolving needs of asset managers, asset servers, and asset owners who are making ESG a valuable part of their investment process.
