Author: VendEx Solutions – vendexsolutions.com

An early mentor once told me that there are seldom any truly new financial instruments created – most are rebranded, reconfigured a bit, or recycled. While in my experience this has largely proven true, as the 2000s unfolded and technology, connectivity, and increasingly sophisticated data began driving investment decisions, there were notable exceptions, for example, programmatic trading, cryptocurrency, and distributed ledger technology.

Additionally, execution is happening in a far more digitized format, data sets are more integrated, and semi-structured data, once inaccessible, has become part of the market data equation. Analytics, portfolio management, improved risk management, and settlement technology have enabled increased volume and velocity that was not previously possible.

As ESG is not a financial instrument in and of itself but rather a practice or discipline, a direct analogy may not be obvious. But many of the data and technology achievements of the last decade have served to support ESG applications for finance and investment. The real opportunity for change is investors’ ability to use this more highly evolved data and technology to take advantage of investment decisions, as opposed to checking off a tick box for reporting.

Parallel Paths or New Precision?

It is interesting to look at the parallel paths that ESG analysis and information and traditional financial analysis have seemingly taken. ESG non-financial analysis is evolving similarly to many of the principles of traditional financial and credit analysis.

I cannot help but wonder – how much of this is genuinely new? Or have technology and increasingly sophisticated, integrated data sets laid the foundation for a far more scientific approach to risk management? Many of the qualitative aspects dimensioned in the three pillars of ESG (Environmental, Social, and Governance) have been looked at for decades, e.g., environmental risk, country risk, fraud, management independence.

That said, ESG has become woven into the fabric of investment decisions and is increasingly difficult to ignore. Initial providers of ESG scores at the company level began to offer instrument and asset class level scores. The trend accelerated as investors made the connection between ESG scores and supplemental data and the linkage to portfolio performance scores and analytical tools to perform portfolio sensitivities.  Furthermore, investors have been spurred as funds with defined ESG criteria outperformed the broader market from a risk-adjusted return point of view within the first year of the covid pandemic.

The demand for these capabilities has been further evidenced by the fact that virtually every large provider of market data and financial services technology has purchased at least one ESG information provider in the last three years, with many acquiring two or more.

In most cases, it has been to round out one or more of their ESG pillars. For example, a firm may cover the environmental aspects of ESG but lack a model for Social and Governance. In some cases, it is to shore up a capability that was lacking or needed improvement or complement some part of their existing model, e.g., diversity within the social score.

Other acquisitions served to add additional capabilities. For example, a company that offers ESG scoring might offer scoring aggregation, positive screening, materiality, and other components of an ESG risk evaluation schema, to offer their clients a one-stop-shopping capability. As ESG funds and investments are increasingly integrated into investment firms, having the capacity to provide ESG scores and analytics alongside other portfolios and offerings is increasingly desirable.

Almost all these acquisitions have been fully integrated, save for a few where the incoming brand was strong and therefore preserved; still, in most cases, the capabilities were integrated into a holistic suite of offerings.

An Evolving Landscape with Lingering Challenges

While ESG has gained considerable adoption and mindshare, and quite a few of the early offerings have been acquired by larger providers, this remains a fragmented space. There are over 300 ESG information and technology providers, of which approximately half have some form of ESG scoring capability.

In addition to the information maze this creates, this presents several challenges for buy-side risk managers and investors. Methodologies and risk weightings for each pillar and each criterion within individual pillars vary widely among providers.  Therefore, scores can be quite disparate among the various providers for the same issuer.

The advice from consultants and analysts in the ESG space is to engage with more than one scoring company; in fact, to use several and understand each score and provider’s underlying assumptions and methodology. Finally, ensure that the overall view aligns with the firm’s goals. Several ESG and CSR (Corporate Social Responsibility) aggregators have also presented solutions to bring together and normalize broad ranges of scores across providers and data sets.

Screening is another focal point for ESG Investors and has changed materially over time. Although buy-side investors have been performing negative screening for decades (i.e., we won’t invest in tobacco, firearms, gaming, etc.), negative screening has yielded to positive screening. Investors now seek out the best companies based on a roster of scientifically weighted criteria instead of simply eliminating the worst.

One issue that has gotten a fair amount of attention in ESG is Greenwashing, the process of reporting false or misleading information about the environmental soundness of a company’s business practices. Companies in the ESG space have developed capabilities, using artificial intelligence in some cases, to screen for this practice.

The needs around reporting and disclosure also present challenges. ESG disclosure on private companies is currently somewhat opaque. For example, in terms of how they offset carbon emissions, many are looking at comparables, sector-wide information, or other rolled-up aggregates to make judgment calls. Regulation and investor reporting requirements are also critical drivers for the ESG landscape, including PRI Collaboration, SFDR, and upcoming EU taxonomies, which increase transparency and surveillance.