Investors need more trustworthy sustainability data. Regulators should leave space for better products to emerge, while remaining alert to well-known patterns of misconduct in capital markets.
Capital reallocation towards sustainable
investments is viewed as essential to Europe’s low-carbon transition.
The European Union has already developed global standards with its taxonomy of sustainable activities
and disclosure rules applying to financial market firms. But data on
the environmental, social and governance (ESG) characteristics of
companies, which are used extensively in asset management, remain a
source of much frustration, and are increasingly in the regulators’
spotlight.
ESG quality means many things to many investors
ESG-focused investment has been a key
trend in capital markets over the past two years. Outside the United
States, the share of ESG-dedicated retail funds has jumped
to 13% of total assets under management (though this share is only 1.5%
within the US). While many existing funds have been simply re-labelled
as sustainable by excluding certain industries, a big boost to this
expansion came from EU requirements under the 2019 Sustainable Finance
Disclosure Regulation (SFDR,
(EU) 2019/2088) to label sustainable investment funds as either
promoting positive environmental or social practices (so-called Art. 8
funds), or having such factors as their primary investment objective
(Art. 9 funds).
Ratings and metrics that measure the ESG
qualities of companies guide investor capital allocation and risk
management. A metric for the environment pillar in an overall ESG score
could for instance be based on carbon emissions, energy efficiency,
other pollution or investment in low-carbon technologies. Computation of
such data is of course based on extensive subjective judgements about
which metrics to include, how to weigh data and what amounts to
acceptable or desirable benchmarks in individual industries. Unlike for
credit ratings, which is an opinion on a company’s ability and
willingness to pay, there is no well-defined ESG outcome that confirms
the initial assessment. History is a poor guide to climate risks.
The ESG data industry is undergoing a
rapid expansion and is changing as methodologies are improved. The
product offering has broadened beyond ratings and rankings and now
includes screening services, indices and benchmarks. Data inputs and raw
company data are a major constraint, though the accounting bodies are
rapidly developing sustainability standards. For now, EU plans
for more detailed and wider corporate sustainability disclosures,
perhaps accessed through a centralised data platform, offer little
immediate benefit to investors and data providers. Technological
innovations are rapidly evolving and may fill some of these gaps, also
for smaller companies. New tools draw on earth observation data, automated analysis of company reports, and carbon footprint accounting based on payments data.
For financial markets to function
efficiently, data should be of uniform quality, updated regularly and
free from bias: eg arising from company size, geography or industry.
Current ESG data falls well short of this ideal. Divergence
between ratings from different providers can be attributed to the
inclusion of different categories, different measurements and different
weighting, and also to the rating provider’s other unrelated assessments
of the same company. A portfolio of securities highly rated on issuers’
ESG scores is not necessarily one with low carbon emissions. A high
score in the ‘E’ pillar may not equate to low carbon emissions, as good
intentions and forward-looking transition plans are often taken into account.
Will ESG data repeat the credit ratings debacle?
It all sounds similar to credit ratings,
which played a major role in fuelling excessive investment in
mortgage-backed securities ahead of the global financial crisis. The
current surge in sustainable investing could lead to a green bubble and
erosion of the quality of investment advice and sales practices, which
are familiar from earlier boom-bust cycles.
No doubt, the boom in sustainable
investment products can give rise to new patterns of market misconduct,
which is the traditional realm of securities markets supervisors, such
as the European Securities and Markets Authority. Misconduct could take
the form of mis-selling (of products inappropriate for the
end-investor’s sustainability preferences) or mis-representation (the
deliberate distortion of true sustainability characteristics).
Greenwashing securities is one form of the latter, in which marketing is
used to portray an organisation’s products, activities or policies as
environmentally friendly when they are not. Better ESG data that is
transparent and explained clearly to end-investors could stem this
practice, though in the first instance the capital market or
intermediary (the asset manager or broker) is at fault.
The European Commission may be emboldened to examine ESG data and data providers given its experience of regulating credit ratings.
It was the first major jurisdiction to do so after the global financial
crisis, with comprehensive rules, designed to address conflicts of
interest and inadequate credit rating methodologies, taking effect in
2013. Yet, the parallels are more limited than they appear. ESG data
does not have the same significance in financial regulation as credit
ratings once did. There is also not the same degree of industry
concentration, which could give rise to correlated rating actions.
Indeed, the ESG industry seems highly competitive as start-ups enter and
new products are offered, though mergers of ESG data providers with
established credit rating agencies should be watched....
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