Author: FINBOURNE– finbourne.com
Key takeaways from the article:
- Availability and standardisation of ESG data are the biggest challenges faced by the Buy Side today.
- Investment firms must transform technology and processes to effectively meet ESG objectives.
- The Sustainable Finance Disclosure Regulation (SFDR) is an effective first step but aggregating divergent ESG methodologies and criteria is critical for ESG investment success.
- Effective data management can deliver the efficiency and insights asset managers need for reporting and meeting investor transparency.
As COP26 draws to a close, it is clear that the urgency for change, together with investor demand for greater transparency and new reporting requirements, will significantly shape the future of Sustainable Finance, which is fast becoming mainstream within the investment industry. According to the Global Sustainable Investment Alliance1, ‘sustainable investment has reached USD35.3 trillion in assets under management (AUM), having grown by 15% in two years.’ This marks an industry that is fast transforming, impacting not only the shape of ESG products but also the investment operations that support them.
And while the majority of firms have seen value in aligning their investment strategies to the triple bottom line (people, planet and profit), there is currently a minefield of ESG data, including non-standardised data sets from the mass of ESG data vendors in the market, that must be overcome, if they are to be successful in driving meaningful change to society.
To understand what it takes to do so, FINBOURNE, speaks to Sue McLean, (Partner – Technology and Outsourcing) and Caitlin McErlane (Partner – Financial Services and Regulation) at Baker McKenzie, a leading global advisory and legal firm, and ESG specialist. The interview explores their perspectives around the critical roles of technology and data, and the impact of ESG regulation on buy-side firms.
FINBOURNE: In your experience, what are the biggest challenges in the investment industry, as it seeks to incorporate ESG data into the investment process?
Sue McLean: Coming from the tech side, there is a very big data challenge. Companies struggle to collect, analyse, and report on their ESG data. Many large, global corporations have complex structures with different business units all across the world; for those companies it is a time-consuming process to identify all of the relevant ESG information in order to provide valuable aggregated data. However, data collection and aggregation is only part of the challenge; measuring that data against clearly defined goals and demonstrating progress against ESG-related strategies is equally proving a difficult process.
Looking outside company-related data, gaps remain in the availability of ESG data. Many would argue that inevitably what companies are disclosing is likely to be somewhat partial and only satisfying minimum requirements. For instance, abuses of specific environmental policies or laws are generally less likely to be reported.
This presents a challenge for the investment industry in assessing ESG performance accurately, because their analysis will be based on the data available from the investee company’s self-reporting and relevant available data beyond this (for example, from public sources). The core issue is identifying what data is materially relevant and how you collect it.
Finally, there is a fundamental lack of standardisation in terms of ESG scoring from the multitude of data vendors in the market. Even in circumstances where an investment firm has sourced data there is the issue of correlation, because of the disparate ratings and methodologies that ESG data vendors employ. Establishing a common language for ESG data is critical: managers need to understand if they are comparing apples with apples. It is a problematic process and standardising the data is proving the hardest task, not least because of the vast volumes of data involved.
FINBOURNE: Caitlin, from a technology perspective, are there any additional obstacles asset managers are facing in this endeavour?
Caitlin McErlane: Data availability is a good starting point because technology is only as good as the data it consumes, and this is equally true in the ESG space. We have seen a host of regulatory consultations come out over the past two years and technological solutions will be vital for compliance with these increasingly complex regulatory requirements. As Sue has covered, the repeated concern expressed by the market is that ESG data is incomplete or unavailable, and this has a knock-on effect on the technology and processes concerned.
Where data is available, for example from corporate annual reports, there are tools in the market which can increase ESG data fidelity – for example, through the use of artificial intelligence. These tools analyse reports in an effort to pull out relevant data and fit it within a particular ESG disclosure framework. However, some of those tools are not operating quite as effectively as the market would have hoped, and firms still need to fall back on what is an often arduous and manual undertaking to sift through the data.
Effective technology needs to serve a need or purpose. Tools must be able to achieve the goals set by the user. One of the difficulties at present is that the approach of the investor community is evolving almost on a daily basis as new ESG regulations, such as the SFDR, are adopted. Consequently, what the investor community requires from its technological tools is rapidly changing.
Further, as new conversations happen with stakeholders, we still don’t have a complete picture of what the European taxonomy will look like. This naturally leads to the question: how do we create the right technological tools and build the most effective processes for an uncertain regulatory environment? That question remains open; the expectations of regulators and market are still unsettled, and those expectations will impact the technology involved.
What we would suggest at this point, before the urgency escalates, is to carry out scoping exercises within your organisation to determine the parameters for any internal transformation needed to meet these objectives, whether those changes are in technology procurement or in fine-tuning processes and procedures. Creating a working group that can put this into practice, with a reporting line to the board where possible, will ensure that you have a well-resourced team to act proactively rather than reactively.
FINBOURNE: Focusing on standardisation for a moment, what impact do you feel the Big Four’s ESG reporting standards will have in providing the Buy Side with greater clarity around their technology, data and processes?
Caitlin McErlane: What people might not realise when reading the headlines around the Big Four and their ESG reporting standards is that, within these companies, some individuals were already pushing the ESG standardisation initiative forward. At the start this wasn’t easy because the Big Four are natural competitors, so they really had to come together and propose a solution that was workable. A lot of joint effort took place between the firms and the World Economic Forum into the creation of a draft standard, which demonstrates the importance of getting this right from an accounting perspective.
A settled set of accounting standards enables the market to quantify ESG risk much more easily and uniformly. For that reason, there has been a lot of activity in the accounting space. For example, the IFRS is in the process of establishing an International Sustainability Standards Board to set IFRS sustainability standards. However, there is a danger that different accounting standards may go in divergent directions.
Asset managers, particularly global institutions, would not want a different standard to apply under IFRS than that which applies under GAAP, because this creates further complexity. In general, these solutions are helpful and will assist with data standardisation, as well as potentially help to drive progress in the sustainability agenda more generally.
There is, however, an argument that these accounting standards only go part of the way toward resolving the ESG data standardisation problem insofar as they are granular and fail to provide a more expansive description of the overall cost to the community or the environment that corporates are operating in.
FINBOURNE: On that last note, do you feel there is an opportunity for technology to solve the standardisation issue, as well as data integrity and reporting?
Sue McLean: Of course. In fact, Accenture recently stated that “…sustainable finance starts with data and technology”2 (Accenture). Technology itself is a key tool in helping companies drive their achievements against their sustainability goals, whether that be in measuring fuel consumption or tracking energy utilisation across the supply chain. For asset managers, implementing good technology means getting better and richer data, with the potential for real-time reporting. Access to quality data also enables managers to look back in time, to see how they performed in certain areas, delivering value-added analytical insights to their ESG investment strategies.
Technology offers great opportunities for the sector in general, but when it comes to actual ESG data, it is a necessity, to enable the investment strategy to properly take off and contribute to the global sustainability agenda. To do that, some of these technologies need to be refined, to more effectively address data collection and governance requirements, all the way through to producing insights and analysis. As Caitlin says, there are already tech companies and start-ups focusing on data management, including FINBOURNE, as well as those attempting to use Big Data and AI to produce more accurate and innovative ESG measures of impact.
The regulatory challenge at the moment exists because there are inconsistent standards. At present, technology providers have to make decisions as to how to collect data from myriad sources, the formats to focus on and the requirements to build into the solutions in order to translate the data clearly and create a formidable overview. Over time, as those requirements become clearer and more consistent across the industry, there will be a better environment for continued technological development.
The other technology opportunity is in digital transformation. There are going to be more fundamental and foundational changes to internal processes and systems for investment managers, which will create demand for innovative data-led solutions. Stakeholders will go beyond the standard business users to include roles like the Chief Technology Officer, Chief Data Officer and the technology team because they are going to have to help with digital transformation.
The focus is not just on saving costs and gaining efficiencies, but also helping implement optimal operational change when it comes to compliance with upcoming regulatory requirements around sustainability. If digital transformation is a key trend in tech, then sustainability is absolutely another key trend which is going to keep tech providers busy over the next few years.
FINBOURNE: That is a great summary of the technology trends in the ESG space, do you see any specific areas for development where technology can be an enabler of ESG investment success?
Caitlin McErlane: The market is hungry for solutions that will help firms to stay on top of emergent regulation. Disclosure requirements inherently provide some clarity, but with such divergence among data vendors the longer-term opportunity for the technology sector in relation to asset management is going to be in refining data processes, namely in data aggregation. Any firm managing assets in the EU, as well as those with EU investors, must post portfolio data on a range of granular issues, including for example board diversity, CEO pay ratio, gender pay gap, and so on.
Data standardisation is a significant issue. Across the industry, buy-side firms, as well as the data vendors supplying those firms are reporting data from different viewpoints and in differing formats. This lack of standardisation will necessitate an aggregation layer (with a holistic view) that allows for a single and accurate account of interpretation, similar to what is happening with aggregation in post-trade data, which is becoming integral and routine in trading. Demand for aggregation – in particular, for a more complete, live view of aggregated data in one common language – will only continue to grow, not just in relation to sustainability but also from a whole portfolio perspective.
In conclusion, the core challenges around ESG disclosure for asset management are focused on the availability, standardisation and integrity of data across a number of reporting fields. As regulations are tightened and investor demand for transparency solidifies, the value of a transparent and standardised view, across multi-asset strategies, including ESG, will become ever more significant.
Technology that can ingest and virtually consolidate large volumes of ESG data from different sources and formats into one common language will be vital in solving the reporting difficulties faced today, and for creating meaningful insights and analytics that can enhance ESG strategies going forward.
It is clear in both the short and the long term that technology, data and processes are critical in driving ESG investment success. This success ultimately enables the Buy Side to align the investment strategies it delivers investors, fulfilling not only investment objectives but also contributing to overall profitability.
Sue McLean is a partner in Baker McKenzie’s Technology Group. Sue advises on a wide range of technology matters, including outsourcing, cloud, digital transformation, technology procurement, development and licensing, digital commerce, AI, blockchain and data privacy. She has a key focus on the financial services sector and is co-chair of the firm’s Financial Institutions industry group in EMEA and co-chair of the firm’s FinTech Group in London.
Caitlin McErlane is a partner in Baker McKenzie’s Financial Services & Regulatory Group. Caitlin advises asset managers, banks, major corporates, exchanges, clearing houses and payment institutions on navigating UK and EU financial services regulation, including MiFID II, EMIR, the Investment Firms Regulation, ESG reforms, AIFMD and the Market Abuse Regulation. Caitlin is a member of the Baker’s ESG and sustainability taskforce, and advises a range of clients on the drafting and implementation of ESG policies.