Behind the numbers: getting to grips with ESG data

Ninety One is an asset management company. Hargreaves Lansdown may not share the views of the author.

Many investors want to allocate capital in a way that helps – or at least does no harm to – the environment and society. But how can you be confident that a fund or company is truly sustainable?

To answer that, it’s necessary to get to grips with what the investment industry calls sustainability metrics, or ESG data. ESG stands for environmental, social and governance, which includes things like a company’s carbon footprint and pollution track record, how it looks after its employees and treats local communities, and whether it is organised in a way that ensures there are appropriate checks and balances on the management team. This is a complex area and, as we’ll explain here, it’s essential to bring a very critical eye to the numbers.

More data, but not always better data

ESG data has proliferated in recent years. The good news is that it has improved significantly in terms of quality, relevance and (to an extent) comparability. Investors can now get much deeper insights into how a company is performing from a sustainability perspective. But there are some big challenges, specifically that ESG data is typically not verified or standardised, and that it is often backward-looking, even sometimes out of date.

These difficulties are enough to make some portfolio managers shy away from incorporating ESG analysis into their decisions. However, we think you simply can’t afford to hide from the challenge of dealing with ESG data: increasingly, sustainability issues can have a major influence on the risk and return potential of an investment.

So what’s the right approach? Assessing a company’s sustainability is a complex exercise. As well as analysing ESG data, it’s important to consider companies’ broader disclosures, strategic leadership and direction of travel. Just as investors dig deep into the meaning of traditional financial data, the real value in ESG analysis lies in the interpretation of the available information.

ESG data providers

Over the past decade there has been significant growth in aggregated ESG data from data vendors, rating agencies and other service providers. For example, a vendor may rate a company on a scale from ‘Poor’ to ‘Excellent’ at managing certain ESG risks. These ratings are based on proprietary methodologies, and as a result two vendors may make very different assessments of the same company. Academic research suggests that the correlation of ESG ratings (a measure of how similar they are to each other) is around 54%, compared to perhaps 90% for credit ratings on bonds.

ESG ratings are important for investors looking to make a start on ESG analysis. But today, professional research analysts increasingly look behind an ESG rating to try to understand the underlying data. Ultimately, we believe no active investment manager should rely solely on the views of external data vendors.

Passive ESG-focused investment funds, in contrast, are often based on vendor ESG ratings or scores. Although this ignores the fact that ratings may vary between vendors, it eliminates any subjectivity applied by active managers to ESG data, which some investors will welcome. Active managers are able to integrate a wider range of sources of ESG information, including some of the emerging datasets such as those based on satellite imaging of the Earth’s natural assets. However, this does mean that investors face the challenge of judging how well a portfolio manager takes ESG factors into account.

Since Ninety One is an active manager, we thought it might be helpful to share some of the ways we use ESG data. All of our investment teams incorporate ESG-related data, which means we can build risk systems that help us detect outliers or companies that appear to be moving in the wrong direction. It has also allowed us to more accurately measure impact (for funds that intentionally target a positive environmental or social impact). As an active manager, we spend a lot of time talking to companies and management teams, and we find these discussions are very useful in informing our overall ESG assessments.

Be careful of the numbers

While we believe strongly that ESG data is important, we also think you have to be very careful in how you use it. Inappropriate use of ESG data can lead to negative outcomes – both in terms of investment performance and from a sustainability perspective.

For example, many investors today worry about the carbon footprint of their portfolio, with many large investment organisations setting targets to reduce the emissions associated with their investments to ‘net-zero’ over time. One way to make the numbers look better is simply to change the sector allocation of your portfolio – for example, investing more in technology companies and less in utilities. But does it really help the planet to buy more shares of a digital company and less of an electricity company that is working to make the energy system sustainable? We don’t think so: the sustainability data may tell a good story, but the real-world impact is different. Reducing allocations to certain emerging markets can also make portfolio-level carbon data look better, but to what end? Simply put, you can’t reduce the world’s sustainability challenges and targets to a number. You need to think carefully about the real-world impacts of any investment.

Social issues can be particularly difficult to translate into data. For example, the issue of modern slavery has recently been brought to light. Ultimately, we think engaging directly with a company is necessary to understand its commitment to eliminating bad labour practices from its supply chains. Again, we don’t think it’s possible to boil a company’s social risks and impacts down to a single number. Board diversity – another commonly tracked (and much discussed) metric – also doesn’t necessarily tell you anything about a company’s real diversity culture. Again, you have to look beyond the numbers.

An evolving field

ESG data will continue to evolve and improve, and in time it will likely be considered in a similar light to traditional financial data. As that process continues, we think it’s important that all stakeholders, including investors and companies, engage closely with the development of sustainability data, both so that it is useful for investors and to enable positive real-world impacts. But we also think that investors will always need to use their judgment and make careful assessments. There’s simply too much at stake to put blind faith in the numbers.

This article isn’t personal advice, if you’re not sure what’s right for you, seek advice. Remember, all investments can fall as well as rise in value so you could make a loss. Past performance isn’t a guide to the future.

More about ESG investing

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