ESG, a factor in sustainable investment

ESG: the sustainability indicator that sees through the window-dressing

Heralded as a ‘new lens’ into a company’s performance and work culture, ESG metrics (Environmental, Social and Governance) are attracting attention among investors.

ESG data measure how well a company is performing as a steward of the natural environment, in its relationships with staff, suppliers, customers and the wider community, and in the way it is led.

Many investors now recognise that ESG factors can affect the performance of their investments, both in terms of risks and returns, amid evidence showing that companies with strong ESG scores can deliver better financial returns. ESG data can also highlight potential risks such as those related to climate change. 

Another factor is that the millennial generation is more demanding in wanting to know that their investments are responsibly sourced and are not contributing to climate change or supporting corrupt governments.

Investment strategies

The United Nations-supported Principles for Responsible Investment, agreed by 100 investors in 2006, provide a framework that investors can use to incorporate ESG into their decision-making and ownership practices.

The number of signatories to the principles has grown strongly over the past ten years, and now stands at more than 1,500, including 300 institutional investors.

Governments, regulators and ratings agencies are also putting increasing emphasis on ESG reporting.

In December 2015 France became the first country in the world to adopt a law requiring large institutional investors to disclose information about the way they manage climate risk and how they integrate ESG into their investment strategies.

Meanwhile, the European Union has agreed a directive on the disclosure of non-financial and diversity information that will require large companies to report ESG data.

And in May, Standard & Poor’s, Moody’s and four other ratings agencies announced that they would start including ESG risks in their assessments.

Positive practices

ESG requirements are now increasingly being written into investment and lending agreements, and companies are producing more data to allow potential investors to screen them for ESG factors.

Companies themselves may also insist that their suppliers respect their own standards, with the result that positive practices spread through the supply chain.

ESG measurements cover an extremely wide range of topics. In terms of environment, issues include carbon emissions, energy use, raw material sourcing and recycling. The social component embraces human rights, employee relations, diversity issues, and health and safety. And the governance segment looks at factors such as executive pay, board structure, shareholder rights, and bribery and corruption.

There is therefore a need for accurate, consistent and independent data on a whole range of questions. And investors need sophisticated analytical tools to enable them to integrate ESG into their investment strategies.

This has led to the development of new indicators from data providers such as Thomson Reuters and data-driven analytical tools like BNP Paribas’ ESG Risk Analytics solution. André Chanavat, Senior Product Manager for ESG at Thomson Reuters, explains how ESG data is different from other sustainability metrics, and why companies and investors need to know.

Why is it important for companies to pay attention to ESG?

André Chanavat: If you’re a large cap company, you need to have some pretty good reporting on ESG fields and metrics. It opens up new capital flows in terms of potential shareholders. It’s not just about being perceived as a very good corporate citizen. It can also attract new capital flows. It’s also about operational efficiencies. There are companies that want to look at sustainability, not as just a window-dressing exercise, but to understand where they can improve in terms of energy efficiency or maximising the happiness of their workforce.

Is it being driven by demand from investors or pressure from governments or customers?

It’s a combination of things. The investment community are under pressure from asset owners to integrate ESG as a criterion in their investment decision-making process. We can’t ignore the regulatory landscape which has seen tremendous change. And if you are a large cap company, you want to meet all the standards that are out there and that’s another stimulus for transparency.

Tell us about the data you collect and produce at Thomson Reuters. 

For our ESG database we look at the annual report, corporate social responsibility report, company website and relevant filings. We cover over 5,000 publicly listed companies and we provide over 400 measures for each company within that universe. This goes back to fiscal year 2002, so we have been collecting this ESG data for quite a long time.

We also have other databases that are relevant to ESG.  For governance, for example, officers’ and directors’ information is important.  If you want to know about the board’s gender or cultural diversity, or the diversity of age in the boardroom, we have a separate officers and directors database. This covers every publicly listed company out there, so over 65,000 companies. We also monitor all issuers of green bonds.

We have trained over 150 content research analysts spread about various regional content operation centres. They know their industries inside out. They get alerted to when the ESG data become available and then start to process the 400+ measures that we look at. The analysts carefully process the data and then make sure that the final output is standardised. We provide overall ESG scores and scores for the components.

Are others doing similar work and is there any sort of common standard emerging?

The ESG data vending space is quite niche. Obviously it’s not easy data to collect. There are a handful of pure play ESG data providers today and their approach probably differs in the way they normalise or maybe because of the underlying data itself.

The reporting of ESG has improved massively over the years but it’s still in its adolescence really.  We’re still making strides to improve the meaningfulness of scores and the data. Everyone’s moving in the right direction, but it’s all going to take time.

Is it possible to draw any overall conclusions on how companies with higher ESG ratings compare, in terms of profit, stock market performance and ability to raise finance?

Well, there are numerous research reports showing that companies with high ESG ratings exhibit equal or better returns than some standard benchmark. You don’t necessarily have to be penalised for investing in good ESG stocks.  Whether high ESG ratings equal abnormal returns, maybe the jury’s still out on that for now, but we’ve seen a lot of evidence to show that companies with high ESG ratings are good beta stocks, so they exhibit low risk. ESG in general is a window into other operating metrics around the company which are not really being fully factored in today.

Does it also have any impact on their ability to attract clients and new staff?

If you’re an HR Department, you want to attract the best talent and you want to have diversity of thoughts within your company because that’s also been shown to be positive for the company and that would eventually work its way into profitability. We’ve done research that shows that gender diverse boards tend to outperform those that have no diversity in their boardrooms. 

Can you give some examples of the questions covered within each of the three components, starting with the environmental component?

Well in France, there’s an Energy Transition Law where asset managers and the investment community in general must demonstrate some understanding of their exposure to carbon in their investment portfolios, so they need the raw CO2 data to be able to accurately model their exposure. I hope to be a key player in helping them make those decisions. Elsewhere in the world there are funds that want to offer some sort of a carbon-neutral or CO2-hedged investment portfolio.

And what about the social component? 

In the social component, we include issues around human rights and engagement in the community. We have clients that are very focused on their supply chains. To give some concrete examples – Does the company have a policy to avoid the use of child labour? Or do they claim to comply with the fundamental conventions of the ILO or support the UN Declaration of Human Rights? When it comes to the workforce, there are lots of interesting topics such as compensation, not just about senior execs but also the salary gap. Also, what’s the turnover of employees?  And things like injury rates.

And the governance component?

A lot of the governance component is about management, or things like the size of the board. Having too big a board might be a hindrance to making effective decisions but having too small a board might not be great either. Gender diversity plays a role, but we also calculate cultural diversity. We also look at whether CEO compensation is linked to total shareholder returns.

And finally, how are investors using ESG?

Investors have their own values and it’s about matching the ESG criteria we have to their values and then putting their own lens on it.  I don’t think there is a one-size-fits-all approach to ESG. Investors have a very specific thematic investment approach or they may overweight certain governance fields based on their own experience. I see our ESG data as a bit like fundamental content, just as you would look at a company’s income statement. Investors are educating themselves more about how best to integrate this in their normal, investment decision-making processes. It’s a lens into the company’s performance and its culture that you cannot get through normal fundamental data.