As environmental, social and governance (ESG) investing continues to gain interest, so do the ESG scores and ratings that are used to measure risk. With ESG data providers using different methodologies and rating scales, it can be challenging and create confusion for investors to fully understand and compare the scores.
What does ESG data show?
Something that may have become lost along the way is that ESG data is just that, data. It is non-financial information that helps describe the activities, products and operations of a company. The good news is that ESG data allows for more information to be included in the investment process and decisions. ESG scores—regardless of the provider—are simply one interpretation of that data. What third-party ESG data does not show is a company’s impact on the world. It’s up to investors to understand the provider’s methodology to understand which information the score is showing.
Materiality is key to understanding the impacts of ESG data on the future performance of the company. Material information is any information that would impact an informed investor’s opinion of the company. Examples of this might be the amount of water that a company uses to make its product. Water is important to a soft-drink maker, but not all that important to a technology company.
As ESG data continues to grow, and regulations become more concrete, it will provide more opportunities for investors to achieve ESG integration into their portfolios with additional information.
Using data to build portfolios
Investors are increasingly interested in what’s in the company beyond the traditional financial statements, and ESG data can help add the additional lens. But there is no widely accepted rating system to determine what makes a company good or bad when it comes to ESG-related factors being tracked.
It is important to understand that ESG rating providers look at all factors that fall into the three categories. A company may receive a strong score for its positive impact on environmental but concerns of social and governance issues may impact the overall ESG rating. In turn, investors need to determine if the data being reported reflects their values in what they want to invest.
Translating third-party scores
Interpretation of the methodology being used is key to understanding ESG data and scores from third party providers and the impact they may have on a company’s future performance.
For example, you might get a rating of 20 from one company, an AAA from another, and an E-2, S-2, and G-3 all for the same security. This lack of correlation has led to the ambiguity around ESG ratings.
It is important to understand the process of how each provider looks at the information. Additionally, rating firms can change their own methodologies over time, which leads to different scores for securities.
Often, ratings will vary from industry to industry for a provider’s methodology. Take energy and technology as examples of industries that may portray different levels of risk to ESG than others. Some rating providers use a relative-to-industry measure, while others might not consider the industry’s impact overall. Plus, ratings often depend on the amount of information and data available from the company for the rating provider to score.
An investment firm’s use of ESG ratings
Processes and frameworks are continuing to be built out and enhanced at many investing firms as the demand for ESG investing continues to grow from clients. We think understanding how ESG data is applied to an investment process is the most important decision that needs to be understood as opposed to the overall ESG score of the portfolio.
Many investment firms use third-party ESG ratings to supplement their in-house data and expertise. Third-party ESG data can provide an additional lens into a company’s ESG risks, involvement and analysis. This qualitative measure can be useful for investors looking to align their portfolios to their values.
More regulations relating to ESG are coming as the industry matures
Regulation of ESG is still in the very early stages and a global push for guidelines is in the works. Standards and disclosure requirements will help investors as they analyze ESG inclusion in investment portfolios. Regulations will help provide investors with more reliable and transparent data for the ESG industry. Improved disclosures will allow better access to data over time for third-party data providers, investment firms and investors alike.
Until then, it’s important for investors to work with their financial and investment advisors on understanding how ESG data is applied to investments when developing their ESG portfolios.
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