Regulatory Focus on ESG Ratings
The focus of European regulators is turning to the world of ESG ratings; but can active managers get ahead and find investment opportunities?
Will Bryant, Head of Advisory
This week, in the latest wave of regulatory focus the French finance regulator AMF and Dutch AFM weighed in on one of the most significant issues within the Responsible Investment arena – ESG data and ratings. The regulators urged that companies that are looking to provide ESG data and ratings related services to European companies should be subject to supervision by ESMA. Within the regulation they are seeking a mandatory regulatory framework, transparency on methodologies and conflict management, without stifling innovation and diversity within products.The lack of consistency and transparency of methodologies between ESG ratings providers[1] is a challenge that has been discussed for a number of years and has gained greater prominence recently with the increased focus on ESG investing and reliance on ESG ratings providers. In the conversations that we have had at NorthPeak Advisory, the issue of ESG data and ratings is the one that comes up most regularly.It is probably worthwhile explaining the issue around ESG ratings and data and why there is a lack of consistency. Typically, corporate disclosure of ESG data is inconsistent, often hard to compare and not audited; something I wrote about in 2019 while at Albourne. This has resulted in a significant industry growing around the collection and aggregation of ESG data and ultimately presentation of this data to clients in the form of ESG ratings, rankings or scores.Different participants in the ESG data and ratings industry use different approaches for deciding what ESG information to collect and which techniques to apply for doing so. This process might be based on the a view of materiality and the most commonly reported metrics, and then collected through questionnaires, screening of corporate filings, scraping the web or other methods. Then, once this data is collected the methodologies of aggregating and assessing that data differs based on the approach of each individual firm. Unsurprisingly, this has resulted in varying outcomes, with the same company often receiving differing relative scores from different ratings providers. A recent PRI academic blog highlighted the issue estimating the average cross correlation of ratings between six ESG ratings providers at 0.46.A recent survey of 135 hedge fund investors carried out by the Barclays Prime Services team focusing on interest in ESG within hedge funds addressed the issue of ESG rankings. Interestingly, the result of the survey was that 47% of investors (where ESG plays a meaningful role in their allocation decisions) preferred their managers to have a proprietary ESG ranking system, with 13% preferring managers to rely on external data vendors; the balance preferring a mix. Within active management and particularly due to the strong investment research process employed by hedge funds, the current opacity around data and lack of consistency among ratings provides a significant opportunity for fund managers.When focused on corporate securities, investors are increasingly expecting financially material ESG data to be a part of any robust and detailed investment research process. Integrating that data within other more traditional investment research processes and engaging with investee companies to further manage financially material traditional and non-traditional risks and opportunities is starting to become more common practice. Hedge funds, across a range of strategies, have the human capital and technological resources to be able to ascertain what ESG factors may be financially material and should therefore be integrated in their traditional investment approach.Transparency and consistency of ESG ratings is something to be welcomed to the investment universe as it will allow investment managers to confidently integrate ESG ratings and data into their investment research processes. Hedge funds are particularly well positioned to integrate existing ESG data with their talented investment teams and approach to unstructured data. Currently, there is also the ability to take advantage of the price inefficiencies that are present due the current disparate ESG rating system with assets following the ESG ratings of various providers.[1] These firms may also provide products such as raw ESG data, scores, assessments of controversies and other ESG material.