Exploring the materiality of ESG data, part one

Environmental, social and governance (ESG) investing has arguably 'gone mainstream'. This round table discussion asks participants from across the private and listed equities arena: what are the different ways of using ESG data, which metrics are proving material for investors, and what are its limitations?

Peter Cripps: Has ESG gone mainstream?

David Harris: When I joined FTSE back in 2002, ESG was seen as niche. It was basically retail funds and ethical investors.

Now almost every large asset owner and asset manager is taking this very seriously.

But the sophistication is still developing, everyone has different approaches and everyone is still learning.

I also think things happened earlier on the active side and with equities. What we have seen, particularly in the last couple of years, is much more focus on the passive side as well, how to integrate ESG parameters effectively into core equity benchmarks. We are also seeing a move into fixed income too.

Peter Cripps: So when ESG began, really, it was an ethical screening tool, and now it has become more material for investors?

David Harris: Yes. Now what investors need is investment grade data, which has the same controls and approaches as data provided in annual accounts. And the thinking and the due diligence around that data, the way it is prepared, needs to completely change, and we are right in the midst of that.

Peter Cripps: What is driving demand for more ESG?

Andrew Howard: In 2002, there was very little information available, in general, so it was all essentially a series of judgements, conversations with companies – it was very difficult to call it systematic in the same way that it is today.

I think people's awareness of social environmental issues and the impact that they can have on businesses has grown.

And I think there is a demand from asset owners who believe that these things matter, which is prompting people all the way through the chain.

David Harris: Clearly we are in a very different place to where we were when we first launched FTSE4Good 15 years ago, but equally we have to be open and honest in that the data reported by companies is still highly problematic.

In February we are looking to launch guidance for issuers globally, both for equity issuers but also for debt issuers, looking at what is good practice, in terms of reporting, what are the data points they should be publishing.

Andrew Howard: There is another dimension which is: 'Why are you doing this?'

Are you doing this because you believe that there are certain kinds of activities that you do not want to be associated with as an investor, or are you doing it because you believe that by doing that effectively, you can make better investment decisions?

This is, generally speaking, not very well articulated by people on any side of the fence, which I think is going to have to change quite quickly.

There is this general sense of 'you keep it slightly vague because you feel like you have hit all markets at the same time', and it is the sort of 'do well by doing good' type of philosophy, whilst also having an impact and also mitigating reputational damage, while also doing all these other things. And that is not helpful to actually progressing the quality of what we are doing.

Hamish Chamberlayne: Ethical is purely, really, based on what the company produces and you are making a judgement on that. But now it has almost gone to the other extreme, where external data providers are adopting sector neutral approaches and really just focussing on the operations of a company.

David Harris: There is a real need to separate two pieces; a company's operational performance, versus a company's goods, products and services and whether the utility of these products helps enable the transition to a sustainable and low carbon economy. This second part is all about revenue breakdown. We spent three years with 20 analysts going through over 10,000 companies' reports breaking down their green revenues over a seven year history. It is not necessarily small pure play renewable energy companies which are driving this, it is often very large, very diversified businesses, which are slowly changing their business output, companies like Siemens, GE, ABB.

Now, for those companies, between about 15–40% of their revenues are now coming from green sectors and subsectors. Siemens for example has activity across 18 Low Carbon Economy sub-sectors. Many institutional investors are trying to understand this change in industrial output linked to this transition, and it needs to be seen in a very different way to understanding a company's ESG operational performance.

Shami Nissan: From a different vantage point, private equity in emerging markets, the investment beliefs are really primary because these challenges around data providers and data sets do not exist in my world - because the companies are private. They are much younger in their evolution and they can lack resources and systems to gather and report the detailed ESG metrics a large public company would do.

So it is a different game entirely. As head of RI, with my team and the support of third parties we are making those assessments ourselves.

It is about educating the deal teams to understand which types of ESG issues are material to which sectors and which geographies, the "hot spots", so that they are as aware of it as early on as possible, so they bring it to our attention.

Ryan Macaskill: I think of ourselves as a very concentrated investment fund, so instead of maybe owning 100 stocks, we own, let's say, a dozen stocks, and we often own 100% of them, and so the operational angle becomes everything to us.

And Shami is right in saying there is no big database of private company ESG metrics we can use, but we can ask a company directly for the information that we need.

And I am very impressed with how far the listed segment has come in terms of generating that amount of data. That sounds like a big journey, which in the private equity world we have not had to go down because we usually just get the data we need, or we walk away.

Bear in mind, if we thought something was bad, that does not necessarily turn us off a business, because we might think, 'Well, we can fix that'.

Shami Nissan: What is so interesting about the private equity world is that you have such a huge ability to make that change in really quite a short space of time, because you have a controlling stake and if you want to elevate the standard of whatever it might be – safety, corporate governance, bribery, corruption, whatever – you have the power to transform the business.

For example, what we do in our energy business is basically mandate that a head of ESG needs to be put in at the earliest stage.

So for us, ESG issues are not just a risk mitigation. It is definitely about value creation.

Within Actis' geographic areas, which are all emerging markets, doing your ESG gap assessment can be daunting. But, for me, that is the exciting bit. But you need the alignment of mindset with management because if you do not have that, you are not going to get anywhere.

Hamish Chamberlayne: And that is a challenge for listed equities because a lot of the time investors rely on the external data providers to provide an ESG risk assessment.

A lot of the time ESG analysis is quite subjective in nature, and there is no one truth. One of the things that I worry about is that one of the index providers, or one of the data providers, becomes dominant and then there is this universal truth.

For us, it is a much longer process because we use ESG as a tool for engaging with companies. And obviously that is a much, much longer process than what PE can do.

Andrew Howard: Schroders has very different, distinct, approaches to ESG within different parts of the business. And the idea that there is one ESG answer that is going to fit all of those approaches just instinctively does not make any sense.

If we get away from the ESG tag for a moment and just think about this in terms of how a company engages with its workforce, its supply chain, its communities, its regulators, that is essentially what we are trying to look at.

Asking 'what are you doing and why are you doing this?' is more effective than an off the shelf, generic approach, and it should raise the industry's ability to actually analyse, think about, create a market for ideas in ESG analysis in a way that has not really existed in the past.

Peter Cripps: Can ESG really lead to outperformance?

David Harris: With the analysis we have done, there is not evidence that ESG is a detriment to performance and we see very strong correlation with lower volatility. However, relative to other quant analysis you have very limited periods of history with ESG data.

Ryan Macaskill: Our view is if a management team is not thinking about these things, it is unlikely they are running their business very well.

And if we, as an investor, are not thinking about these things and not checking that management teams are doing it, it is not very likely that we are doing our job very well either.

But it is very difficult to prove on an investment that our ESG approach has had a directly quantifiable x% impact on the returns that we have made.

Emma Englén: From the private equity perspective, the main focus is not only to find the financial returns to investors, but also invest responsibly in good companies and to develop them into successful and long-term sustainable businesses. Thinking about the ownership period, which lasts for Nordic Capital, I would say an average of five to seven years, this could be too short to prove that you isolated get financial returns on your ESG investments.

In the pre-due diligence phase, still the major focus is on capturing risks. Once you have done that, you can start looking at the upsides and opportunities before, possibly investing.

Douglas Farquhar: In terms of private equity and listed equities, is there a difference in terms of how you are able to value the additional return that you get from the ESG assessment?

Hamish Chamberlayne: Valuation, in and of itself, is not an exact science. So the idea that there is going to be a really direct quantitative way of adding ESG into your valuation, I think you have to treat that with caution.

For me, it is about understanding when is a company thinking about the long term? Has it got the right governance structure? Is it thinking about the relevant environment and social risks inherent both to its operations and its products?

And then, if you do get comfortable with that, is there an argument to say: 'I would reduce my discount rate because I would be happy giving it a higher relative valuation in the marketplace.'

Peter Cripps: Do you feel that the private equity side is catching up with the listed equity side in terms of the amount of ESG data being used?

Emma Englén: Yes. I would say that the impression among portfolio companies is to reach up to a level with the good listed companies. At least on the Scandinavian stock exchanges, that is the level that private companies within our sphere should perform, and hopefully we will get there very soon.

Shami Nissan: There are some PE houses that are using software tools for reporting from the portfolio company to the PE house and they are reporting in the order of 80 plus key performance indicators (KPIs). And, I do wonder, who needs 80 KPIs? And are they PIs, or maybe Is, but they are not KPIs, are they?

I just hope that proper scrutiny is being applied to why we are throwing so much resource at gathering all of this data; what are we doing with it in aggregate? And I think you can get lost a bit in this endless search for as much data as possible, which ultimately is not going to yield real insight or help you get to your answer any faster.

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