The ESG Data Challenge

The lack of quality data based on a common standard for sustainability reporting is a major – if not the biggest – barrier when it comes to sustainable investing.

Sep 05, 2023

Sustainability

Isabella S. Rasmussen

"Why data remains the biggest ESG investing challenge"

"Data is the biggest challenge currently to ESG integration"

"Lack of consistent ESG data is a big challenge for investors"

"Opening the black box of ESG data"

These are just some of the headlines you come across on Google when delving into the ESG area. There is a widespread consensus among banks, asset managers, rating agencies, researchers, and investors that the lack of quality data based on a common standard for sustainability reporting is a major - if not the biggest - barrier when it comes to sustainable investing.

In this article, we focus on the ESG-Data Challenge, providing an overview of the challenges in the field and their consequences. We also take a closer look at the efforts being made to address the challenge and how you, as an investor, should approach it.

Global Warming and COVID-19 Increase Interest in Sustainable Investing

Only with a rapid and significant reduction in greenhouse gas emissions is there a possibility to limit global warming to 1.5-2°C.

This is according to a report from the Intergovernmental Panel on Climate Change (IPCC), a UN entity aiming to provide member countries' governments with the scientific information they need to develop climate policies.

The report, compiled by 234 scientists from 66 different countries, clearly states that global warming is caused by human activities. If no drastic measures are taken to prevent it, the global temperature rise will reach or even exceed 1.5°C within the next 20 years.

The increasingly urgent need for action against climate change has brought responsible investing into the forefront of most investors' minds. Moreover, the interest in sustainable investments has grown even further during the COVID-19 crisis, as investors now focus more on the social aspect of sustainable investing.

Furthermore, several studies indicate that sustainable investments actually perform better than conventional ones and that investing sustainably does not negatively impact returns.

The interest in sustainable investing is on the rise, but the lack of comparable and transparent data remains a significant barrier for many, as it hinders making investment decisions on a solid foundation.

But why are there such substantial challenges with ESG data? There are primarily two reasons, which we will discuss in the following section.

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There is no global standard for reporting and ratings

One side of the data challenge is the absence of global guidelines on how companies should report on sustainability. The entire regulatory landscape for ESG data is marked by fragmentation with varying rules in different countries and parts of the world. For global companies, this poses a considerable challenge, as they must comply with different requirements in different parts of the world.

Moreover, most data at present is self-reported, and in many cases, not verified by a third party. Consequently, investors find it challenging to assess the credibility of companies' sustainability reporting. Additionally, some companies, aware of their insufficient efforts in this area, may intentionally choose not to report ESG data or only highlight areas where they perform well.

The other side of the data challenge is the lack of a global standard for evaluating a company's sustainability. The absence of a common ESG ratings standard, combined with the fragmented regulation of companies' reporting, means that rating agencies do not have access to comparable ESG data from different companies. As a result, rating agencies have had to develop their own methodologies for measuring sustainability. Since environmental, social, and governance aspects are more abstract concepts than, for example, a company's revenue, different raters have varying definitions and measurement approaches.

Furthermore, there is a lack of transparency in the agencies' ratings.

Not only do agencies rate companies differently, but they also are not equally transparent about their rating methodology, often resembling a "black box."

Consequently, it is not just the inability to compare different ratings. Investors also sometimes lack the ability to investigate precisely what underlies a company's rating.

The challenge with ESG data ultimately stems from a lack of a common standard worldwide – for companies' sustainability reporting as well as for rating those companies.

The Consequences of the ESG-Data Challenge

The lack of a common standard for companies' sustainability reporting and the rating agencies' ratings has several consequences for both investors and companies. The following section go through some of these consequences.

1. The same company can have vastly different ESG scores depending on the rating agency consulted

A study from 2020 compared the scores of a range of companies provided by two large and reputable rating agencies. The table below provides an overview of how much difference there is in a company's rating depending on which rating agency is asked. The most significant differences are highlighted in red.

Source: Own creation based on data from Li, F. & Polychronopoulos, A. (2020): What a Difference an ESG Ratings Provider Makes! (https://www.researchaffiliates.com/publications/articles/what-a-difference-an-esg-ratings-provider-makes)

And if even two of the major and well-respected rating agencies do not agree on their evaluation of a company, then what is the case for the more than 600 other different raters worldwide?

It is no wonder that many investors find the area to be somewhat of a jungle to navigate.

2. Greenwashing: Are sustainable investments truly sustainable?

The lack of a common definition of sustainability, a unified approach to ESG ratings, and transparent ESG data have also led to so-called greenwashing, where financial products are marketed as more environmentally sustainable than they actually are.

For example, several rating agencies only compare companies with other companies in the same industry. This means that, in principle, you can end up investing in "the best of the worst," as a company can receive a top score for sustainability even if it is not particularly sustainable compared to companies in other industries.

Over the years, it has been reported quarter after quarter that the amount of capital going into sustainable investments has reached new records. But if you look closer at the statistics underlying the many positive headlines, some of the good news loses its luster.

A report from the Global Sustainable Investment Alliance shows that out of $98.4 trillion managed in the markets of the USA, Canada, Japan, Australasia, and Europe in 2020, $35.3 trillion, equivalent to 35.9%, was invested in sustainable investments.

At first glance, these are impressive numbers, but the vast majority of the $35 trillion is categorized as sustainable investments due to being invested through negative screening, as well as the strategy of incorporating ESG data into their financial models. Incorporating, but not necessarily acting upon them.

In comparison, less than $2 trillion out of the $35 trillion is invested through the strategy of sustainability-themed investing, nearly $1.4 trillion is invested through positive or best-in-class screening, and around $0.3 trillion is invested in impact investments.

Own visualization based on data from GSIA's Global Sustainable Investment Review 2020 (http://www.gsi-alliance.org/)

The impact of different ESG strategies can be discussed and we argue that the effect of simply excluding undesirable companies from the portfolio is limited, as other investors may still invest in the company.

Despite the many positive headlines about record-breaking sustainable investments, it can be debated how well it actually goes in channeling capital into genuinely sustainable investments.

3. Subjective ESG scores complicate investors' research process

The many different ratings mean that as an investor, you cannot blindly rely on the score a company is assigned by any random rating agency.

Instead, you need to investigate further whether the specific rater's approach and method align with your preferences. Otherwise, you risk investing in something that does not truly align with your view of sustainability.

However, obtaining the necessary insights is a significant task, and thus, the data challenge is a significant barrier for both individual and institutional investors when it comes to sustainable investing.

4. It can be challenging for asset managers to comply with your sustainability requirements

For your asset manager, it can be challenging to invest in line with your sustainability preferences when there are different assessments of the same company, and the manager may not always see precisely what underlies a company's score.

You should also be aware that your asset managers have the option to obtain data from different rating agencies and choose the data that best aligns with their own interests.

Your ESG strategy should be as specific as possible, leaving no room for interpretation, and it should be clear what sustainability means to you.

5. ESG performance is not reflected in stock prices

There is a risk that the ESG performance of sustainable companies is not reflected in their stock prices because the many different scores make it difficult for investors to make sense of how sustainable different companies are and to make investments accordingly.

6. Varying ratings can negatively affect companies' sustainability efforts

The mixed signals from rating agencies can be demotivating for companies, as they do not receive clear goals to strive for and may, as a result, become less ambitious in this area.

What is being done to address the ESG data challenge?

The lack of robust, transparent, and comparable ESG data and a common definition of sustainability has significant consequences.

The good news is that there is growing agreement globally about the need for consistency in companies' reporting. Consequently, there is currently a lot happening in the area of regulation related to sustainability reporting at both the global and national levels.

However, this does not change the fact that as the situation stands now, it is not an easy task to invest sustainably. Nonetheless, there are things you can do to ensure that your wealth is invested in line with your sustainability requirements. We will look at these in the following section.

How should you, as an investor, approach the data challenge?

Take control of your portfolio's sustainability with a concrete strategy

If you create a strategy with clear and specific demands for the sustainability of your portfolio, it eliminates any room for interpretation from the manager's side. They will be responsible for managing your wealth in strict accordance with your defined sustainability criteria.

Once the strategy is implemented, it's essential that you continue to monitor your portfolio in order to ensure that your investments stay aligned with your desired sustainability profile. In the Aleta platform you'll be presented with sustainability metrics alongside the traditional risk and return metrics.

Have your portfolio screened by an analytical agency with a transparent methodology

We have observed that asset managers occasionally, by mistake, invest in some products that do not align with the customer's responsible investment requirements. Therefore, it is crucial that you regularly screen your portfolio to ensure that there are no investments that contradict your strategy.

Of course, it is essential to use an analytical agency with a transparent methodology, so you obtain concrete insights that you can understand and act upon.

At Aleta, we have formed a strategic partnership with Matter, who, with advanced technology, gather ESG data from more than 13,000 companies worldwide. The sustainability insights in our platform come from Matter's comprehensive database.

Matter does not merely rate the companies in your portfolio. Instead, they analyze them based on over 50 different ESG criteria and compare them to relevant benchmarks. Unlike many raters, their analysis is not solely based on the information companies report. Instead, they draw on data from leading NGOs, academic institutions, and relevant international and reputable organizations. So, you do not just receive a subjective score without knowing what lies behind it.

With an ESG analysis, you gain objective, transparent, and detailed data that provides you with in-depth insights into the sustainability profile of each company you have invested in and how they stand out compared to the rest of your overall portfolio – all presented in clear and understandable reports. And then it is up to you to assess whether the companies meet your requirements.

An ESG analysis is more comprehensive than the screenings from your asset manager. If you have more than one manager, it can also be a very good idea to obtain an analysis from an independent third party, providing you with an overall and consistent screening of your total portfolio since the managers' screenings can vary greatly from each other.

If you are responsible for capital management, an ESG analysis can alert you to red flags before others notice them and provide a solid basis for giving relevant stakeholders insights into your portfolio's sustainability profile.

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