Examining the ESG Data Challenge

Q. Today, a wide variety of environmental, social and governance (ESG) and sustainability data is available to asset managers. As you represent a variety of asset classes, I am interested in hearing your different perspectives. Tell us about your organization’s general approach to using this data—what are the key use cases and main challenges you are facing?

Robin: We use ESG data to evaluate companies that we are considering investing in or to engage with companies and management teams. It’s important to be selective. Not all the data is good. Private data vendors like MSCI and Sustainalytics view information with different lenses. Their datasets show low correlation in how they view public companies, and they often give the same company different evaluations. As active managers, we focus on what is most material to the companies we own, meaning what issues matter most to their financial performance. Our sector analysts apply the datasets carefully, with the ability to understand what data are material to a company and to its specific industry.

Reina: Our first question is typically what data is most material to our investment process. Sovereign fixed income data (derived from government issued debt) is incredibly large and deep, and it is a challenge to cover all of it. We also find there is tension between lagging and leading indicators. At Brandywine, we place more focus on lagging indicators, whether they are economic, macroeconomic or ESG-related. We then use a fundamental overlay to apply data to our investment process, country research and portfolio management.

Amanda: Benefit Street Partners specializes in private credit (debt issued by private companies not on a stock exchange), including direct lending, CLOs [collateralized loan obligations], high-yield special situations and commercial real estate. Our biggest challenge is accessing data and finding data that is material and relevant, because much of the third-party ESG data in the market does not apply to where we invest. We find that much of the ESG information we can use is qualitative rather than quantitative. We try to focus on how ESG factors can help us evaluate financial and operational risk in the companies that issue securities we own.

Q. Research has shown a poor correlation between ESG scoring systems offered by different third-party vendors. Do these packaged ESG scores still have a place?

Reina: We use ESG scores because clients consistently ask how the portfolios score relative to benchmarks. At the same time, we think it’s important to steer the conversation away from benchmarks. Most of the government bond benchmarks are skewed toward securities with high ESG scores. Our process focuses on improvement—issuers that are making progress—and our portfolios tend to have more median scores. In our investment process, we also use country-level ESG scores.

Amanda: ESG scores are less available for private credit than for other asset classes, but clients still expect to see the outcome of our ESG process. Since we use a lot of qualitative data, we avoid using numbers and instead use broader descriptions of red, yellow and green to highlight the materiality of risks. Our focus is on identifying operational risk and the borrowers’ ability to service loans over time. For investments in distressed debt, many securities will have red flag risks at the outset. We can then highlight the improvements we expect to see. 

Q. Let’s shift our discussion to the environment, specifically climate risk. My team has recently developed a data-driven tool to help investment teams understand what a net zero commitment might look like for their portfolio, and we are now working on developing a climate scenario analysis dashboard. How are you approaching climate risk and impact?

Robin: ClearBridge is a signatory of The Net Zero Asset Managers initiative. We are focused on the pathway to net zero greenhouse gas emissions by 2050, in line with the Paris Agreement. We are working with our portfolio companies to meet interim targets. We don't expect every company today to be able to have a clear path to net zero. By talking with companies, we can help them make progress. Part of being an active manager is really engaging with companies and tracking their improvement over time to reach their targets.

Reina: The Paris Agreement requires a reduction in real-economy greenhouse gas emissions to achieve net zero by 2050. This is a big challenge for sovereign bond issuers. No country is on track to achieve this by 2050. Our opportunity set includes about 70 countries, and we note that some of them have pushed their climate commitments out to 2060 or 2070.  We also evaluate the effects that climate policies and actions will have on the real economy, and as of now, no sovereign is adequately funding the transition.

Q. Another environmental topic rising on the agenda for many investors and clients is biodiversity, how the variety of living species is declining in many regions, and specifically how we can use data to understand risks, impacts and dependencies. It’s also important to recognize the interconnectivity between different themes. How are you approaching this nuanced topic?

Reina: Biodiversity is a very broad topic and there is no universal data set that provides a framework for evaluation. The way that we think about it at a sovereign level for now is to use greenhouse gas emissions as a proxy for biodiversity degradation. We consider greenhouse gas emissions material because deforestation, for example, causes emissions and reduces biodiversity simultaneously.

Data is likely to improve in the future. The private sector is innovating with geospatial tracking to provide very clear, transparent, real-time data on land preservation or degradation. It may take three to five years for adequate innovation, funding and scaling for geospatial data to be ready for the market and available to investors. 

Q. Moving over to the S in ESG, let’s discuss your approach to social factors or human capital.

Robin: Social factors tracked in ESG data include gender diversity within the workforce, management positions and boards of directors. Another big topic is parental leave policies. Racial diversity data is more difficult to obtain. In the United States, companies must disclose racial data to the government but not to the public. Less than 10% of companies in the S&P 500 publicly disclose the racial makeup of their employees. When we engage with companies, we explain why these disclosures are important. Globally, many governments require companies to disclose racial data.

Investors care about what companies are doing and whether diverse groups of employees have opportunities not just to be hired but to advance. They ask about diversity at the top levels of the organization. We work with companies to help them understand whether their workforce is representative of the communities where they operate.

Amanda:  Private credit has a special set of challenges with social factors. In our diligence process, we look at social risks, like employee health and safety, from a reputational risk perspective. Our process will look for any incidents or lawsuits or other challenges. OSHA [Occupational Safety and Health Administration] is a regulatory source for current and historical information that can help us understand what effects these risks can have on a company. We consider whether the company is managing these risks sustainably over the expected time horizon of our investment. We can engage with companies to a certain extent, although as private credit investors, we are not in the position to change diversity or board seats. But we are taking initiatives to request social data, which we think can help establish priorities for companies to think about. 

Reina: For Brandywine Global, our internal proprietary sovereign score includes over 20 social factors. They are important because they drive all kinds of conditions that affect economic activity. For example, unionization and the freedom to organize and engage in collective bargaining has a financial impact on the private sector. Food and energy prices affect households and underlying conditions of civil society, governance and elections. These factors can contribute to public discontent, which has an impact on a country at a macroeconomic level. The same is true for decent wages and labor productivity, which a country really needs to support its economic growth. 

Q. Clients often ask how investment teams select ESG data. Of course, part of the answer is to start by considering what you want to learn using the data and to evaluate the underlying methodology used to collect it. What else would you add?  

Reina: For sovereign data, we run regressions against the indicators made available to us. Regression analysis helps us identify which data is meaningful for our research questions and which data is less relevant. We choose the factors that have a statistical relevance, or R-squared, of 0.5 or higher. The result is that we use 68 of the 200 factors that were available.

Robin: Our first question is the reliability of the data. Different data providers have different intentions. We think about how materiality differs across sectors. For a retailer, wages are important in how we evaluate companies and their supply chains. For technology companies, that factor is less relevant, but water usage, energy efficiency and data privacy are more relevant. It is challenging to use any one data provider. Governance data, on the other hand, is generally material across all sectors. Executive compensation, M&A and capital allocation are types of material information contained in public disclosures.

Q. What are your thoughts about increasing regulation for corporations and asset managers? Is it helpful or a hindrance?

Robin: Different countries are instituting regulations. Some are helpful, but some have good intentions that might not achieve the desired outcomes. The EU’s SFDR [Sustainable Finance Disclosure Regulation] initiative was intended to improve portfolio transparency, but some of the key concepts were materially amended by later iterations of guidance after the initial launch, and there is concern that this uncertainty has led to differing interpretations across the industry and caused less investor confidence in the results. The European Commission has recognized these challenges and is currently consulting on a fundamental review of the legislation.

Reina: For a sovereign bond investor, emerging regulation coming out of the EU requires global trading partners to disclose a lot of information, which will be incredibly beneficial. However, a strong pushback is likely, so we can expect delays. I would like to have our community be part of those discussions and make specific requests. For example, we would like to see certain airlines increase their disclosure of sustainable aviation fuel usage. 

Amanda: As we monitor regulations globally, we see what our investors must report on for their obligations from a regulatory perspective. Knowing this helps us refine where we need to have data. We're building up our capability to deliver what investors need.