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Regulatory changes, government incentives and changing consumer behaviour have seen global investments moving away from fossil-fuel sectors to sustainable projects. With sovereigns and countries racing to achieve Net Zero, funds are looking to get directed towards sustainable investments.
In this context, investors and hedge funds need data to identify low-risk investment opportunities based on the company’s sustainability aspects. Governments and regulators want to ensure that the companies and issues claims on those aspects stay true to what they are purporting to be and not greenwashing.
However, a dearth of credible and consistent data on which fund managers can measure the integration of business practices with ESG is throwing a substantive challenge to ESG investors, regulators and governments.
“If you can’t measure it, you can’t improve it,” noted Armin Geltinger, Director, ESG Trainer, Fitch Learning, twisting a famous quote of management guru Peter Drucker to underscore the inadequate availability of reliable ESG data.
Asset managers globally are expected to increase their ESG-related assets under management to $33.9 trillion by 2026, from $18.4 trillion in 2021, according to PwC’s Asset and Wealth Management Revolution 2022 report. With a projected compound annual growth rate (CAGR) of 12.9 percent, ESG assets are on pace to constitute 21.5 percent of total global AUM in less than five years.
The International Organisation of Securities Commissions (IOSCO) Board in a report last year took cognisance of growing demand for ESG ratings while flagging the risk in terms of multitude of methodologies used by data providers as well as disparate regulations and standards.
“Given that the activities of ESG ratings and data products providers are not generally subject to regulatory oversight at the moment, increasing reliance on these services raises concerns about the potential risks they pose to investor protection, the transparency and efficiency of markets, risk pricings, and capital allocation.”
The report also referred to a KPMG estimate of there being 160 ESG ratings and data providers worldwide, that include both profits and non-profits, providing large or specialised ESG-related products. Another 30-40 regional-level data providers domiciled in the European Union have been identified by the European Commission.
Understanding challenges of ESG data
Fitch Learning’s Geltinger noted that a key challenge to integrating ESG analysis in the investment process is that “there is no global standard definition of what are these E, S and G issues.”
The next challenge is awareness, which he explained as follows:
‘ESG factors can affect the price performance of a bond and its credit risk at different levels. Some of the factors may impact a bond’s price performance but they may not actually influence an issuer’s creditworthiness. For ESG-incorporated methodologies of credit scoring to yield meaningful results, these factors need to be accounted for. Moreover, these have to be factored in doing multi-level scoring at issue and company levels as well as industry and geographic levels.’
A limited understanding of such issues is among the biggest barriers to integrating ESG issues to credit risk analysis. Either there is limited availability of data, or the data is not comparable as they pertain to different time duration or there is sparse historical data.
“While we might have good data for the last couple of years, we don't have anything for 20, 30, 40 years ago which would obviously help with incorporating ESG,” said Geltinger.
Too much of non-material information is another hurdle. In the context of fundamental credit analysis, a piece of information on ESG may or may not be material and relevant to an issuer, transaction, or a programme’s credit profile.
Limited credit research from CRAs (Credit Rating Agencies) is yet another barrier to the integration of ESG issues in credit risk analysis.
A fact-finding report of IOSCO noted lack of clarity and alignment on definitions of what they intend to measure; and lack of transparency on methodologies supporting the ratings or data products among the challenges.
Further, gaps in information arising out of uneven coverage of products offered resulting in some geographical areas and some industries getting an advantage from more coverage given to them than others are a major challenge faced in leveraging ESG data for investment decisions.
An entity associated with the data provider may be consulting the very companies that are the subject of the ESG ratings, which results in a conflict of interests and pose a challenge to sifting through the data for reliable information.
The need for better communication between the data providers and the companies that are subject to ESG ratings is another challenge identified by the fact finders.
Given all these inconsistencies, there is a growing clamour to draw the attention of the regulators to the issues related to the ESG data provider industry.
International Financial Reporting Standards (IFRS) trustees has presented the International Sustainability Standards Board (ISSB) with two prototypes to help set the standards for comparable and consistent sustainability disclosures.
The US’ Securities and Exchange Commission (SEC) is also framing rules specifically concerning ESG disclosures, which are expected to be ready in the coming years.
ESG for project financing
Given that ESG scoring parameters are yet to be standardised, investors, bankers and financiers have to rely on their own ESG policies.
Nneka Chike-Obi, Director, Sustainable Finance, Fitch Ratings said ESG incorporation into project finance due diligence is not usually based on ESG scores, particularly as such scoring cannot exist for a greenfield project.
“Financial institutions usually have their own ESG sector policies that exclude the most harmful activities, such as new coal-fired power plants or projects that threaten indigenous land or sensitive ecosystems,” she said.
Chike-Obi pointed out that Fitch Ratings considers factors including ecological impacts, extreme weather and climate change, land rights, and social resistance to projects in its ESG Relevance Score framework for infrastructure and project finance issuers.
“In my view lack of standardisation in ESG ratings is not hugely important for this asset class, compared to listed equities or corporate bonds,” she added.
With regards to Belt and Road Initiative (BRI) projects, Chike-Obi said those are mostly funded by Chinese development banks or state-owned entities, with some participation from Chinese commercial banks.
“I am not aware of the types of ESG analysis that these organisations use specifically for BRI; however, they do finance a significant amount of green projects,” Chike-Obi said, adding that the Ministry of Commerce and Ministry of Ecology and Environment published guidelines in 2021 on environmental sustainability for Chinese overseas investors, with specific attention paid to biodiversity and clean energy.
(Reporting by Syed Ameen Kader; Editing by Anoop Menon)