ESG 2.0: Crowdsourcing Standards and Mass Customization

ESG 2.0: Crowdsourcing Standards and Mass Customization

June 2020

By Corinne Neale

More transparency, flexibility and responsiveness to investor needs will yield tremendous gains in advancing ESG standards in a post-pandemic world.

With net flows into sustainable funds nearly quadrupling in 2019, attracting a record $20.6 billion1, last year was widely heralded as a breakthrough year for Environmental, Social and Governance (ESG) investing. The dramatic growth provided yet more proof of the heightened demand for ESG investment options from institutional and retail investors alike. With the outbreak of the COVID-19 pandemic, ESG focused funds now face their first real test since entering the mainstream.

 

The initial signs remain encouraging: assets under management continued to grow in Q1 20202 and, relatively speaking, there is some evidence that ESG funds performed better than broader market indices3. There are still a number of underlying challenges to be overcome, however, and the fallout from the pandemic could prove to be an inflection point for ESG investing.

 

One of the key issues with ESG investing is that it is – by definition – a broad range, encompassing a huge number of factors, even within each of the over-arching environmental, social and governance themes. As such, ESG can often mean different things to different people. In Europe, for example, ESG is typically viewed through more of an environmental lens with climate change and carbon risk the primary focus while in many APAC countries social factors, particularly those related to financial inclusion of under-served communities, tend to take center-stage. In North America, there has traditionally been a greater emphasis on governance issues, particularly around management quality. At an individual level, it becomes even more complex and disparate; one investor may be interested in carbon emissions, while another may be interested in diversity.

 

This dynamic and multifaceted lens is reflected in the dizzying array of ESG data available and the lack of commonly accepted standards that define ESG. At last count, there were more than 300 vendors supplying data and analytics to score sustainability. Each focuses on a particular set of issues or reflects different priorities, applying different interpretations of those issues and employing a variety of methodologies to score them. As users of ESG data are well aware, many also suffer from data quality issues. This results in vast differences in scores; one company may get an excellent score for sustainability from one vendor and a terrible score from another. Some, for instance, will provide points for transparency alone, whether or not a company is progressing on a path toward sustainability. The hard-to-discern nuance between differing data sets presents anyone trying to conduct an objective analysis with a major headache.

 

It’s a widely recognized problem. According to research from the Chartered Financial Analyst Institute and United Nations Principles for Responsible Investment (UN PRI)4, the lack of standards around ESG data verification and the demonstrability of the ESG factors shaping investment portfolios are among the key barriers to greater ESG integration into investment processes. The lack of standards can also lead to claims of “greenwashing” or “social washing,” which chips away at the credibility of the entire segment.

 

Beyond the scrutiny into ESG data, the COVID-19 pandemic creates a new unknown. On one hand, market volatility and the likely recession threaten to divert attention away from ESG as investors retrain their focus on capital preservation. But on the other hand, the outbreak and impact on portfolios could instead sharpen the focus of investors on environmental and social issues. Already there have been profound shifts in people’s social attitudes more generally. Just the idea of who qualifies as “essential” employees in a “shelter-in-place” world has added new thrust to the $15 minimum wage debate in the U.S., for instance. Additionally, anecdotally, investors are increasingly looking for evidence that their specific ESG objectives, preferences and values are reflected in their investments and the COVID-19 pandemic may accelerate that process.

 

New Tools of the ESG Trade

 

In practical terms, to achieve a greater alignment between investor objectives and the investment process will require:

 

  • A deeper understanding of investors’ interests and concerns when it comes to ESG, allowing them to define relevance on their own terms;
  • An ability to “open up the box” to explore and identify the underlying components of ESG, how they’re scored, and how they can inform and support specific investment strategies and objectives;
  • Customized portfolio construction to reflect investor preferences and needs;
  • Demonstrability to ensure preferred ESG factors are represented in the portfolios or fund investments.

 

Without existing common standards and the disparity across ESG’s data universe, a consensus will likely only form through greater transparency into what investors are doing, which will, in turn, inform best practices.

 

At BNY Mellon Data and Analytics Solutions, for instance, we are developing an application to leverage the power of the BNY Mellon network to learn how portfolio managers and business users are interacting with and interpreting ESG data. Effectively this will provide crowdsourced guidance around the preferred ESG factors and priorities to determine the materiality of specific data sets and in the process create standards that both guide future ESG investments and continually improve and optimize the effectiveness of ESG metrics to complement traditional fundamental analysis or facilitate non-financial goals.

 

In time and as these efforts achieve critical mass, we expect to see a consensus form around the most reliable and valuable data, with the consequence that data may become more streamlined over time. This clarity, too, will likely expose gaps in the market where current priorities are not being met. With greater transparency and a deeper understanding of how data is being applied, users will be better placed to shape, refine and optimize standards to meet their specific goals and produce the greatest possible impact based on their specific definition of success.

 

The benefits of “opening the box” will also likely play through into investment portfolio construction. As asset managers gain a deeper understanding of the factors their investors are interested in, they will take this cue and tailor their portfolios to better reflect these priorities. Ultimately, this has the potential to pave the way for ‘mass customization,’ in which a wider range of products tailored to the ESG profiles of individual investors are made available. This will represent a fundamental change in how institutions and individuals invest.

 

The caveat is that as portfolios are tailored to needs of investors, asset managers will be held more responsible for making sure that their funds are delivering performance and providing “demonstrability” to validate the factors most supportive of the goals. If fund managers prioritize diversity, for example, they will need to demonstrate the specific diversity factors included in portfolios and report that back to investors.

 

The impact of this will be wide-ranging, influencing everything from how funds and investment products are marketed and distributed, to providing evidence that proxy voting is consistent with the ESG factors that match investor preferences. This would have a knock-on effect on companies as they would also need to ensure the reliability, clarity and alignment of disclosure on relevant ESG factors.

 

The impact of the crisis caused by COVID-19 on ESG investing will be interesting to follow. One possible outcome may be that it exacerbates the ESG factors that individuals may have always cared about, but never focused on. This has the potential to heighten the need to understand investments through an ESG lens, with greater granularity and definition. It may also highlight that ESG factors are not static as some assume and that people’s perceptions and priorities are also mutable. For example, whereas climate risk is a key factor in Europe, market watchers will be interested to see if a shift occurs in which social and governance factors assume greater importance as business preparedness issues become more prominent. Alternatively, climate change could get more attention in the U.S. and APAC regions to the extent that it would likely require a similar global response.

 

Not to be overlooked, the economic impact of the virus may also lead to a greater appreciation of what is financially material. For instance, investors may further scrutinize governance and business continuity plans to identify supply chain risks, and working conditions could become an area of emphasis.

 

Despite the recent popularity of ESG-themed investing, a number of challenges remain, particularly around standardization and the granularity of data. These ongoing hurdles create a degree of dislocation between the needs of investors and available solutions.

 

The global crisis caused by COVID-19 could have a profound impact; it’s probable that awareness of ESG issues will increase, putting a greater focus on investing through an ESG lens. People will likely emerge with stronger views on the type of world they want to live in, and this will play through into their investment decisions. These individual voices will need to be heard.

 

This has wide-ranging implications for asset management and the concept of stakeholder capitalism more broadly. There’s an opportunity for asset managers to better understand investor priorities, and respond to that by offering more tailored, “mass” customized products. This greater understanding could also lead to the emergence of more tightly defined ESG standards, as well as improved clarity and accuracy of when it comes to corporate disclosures, ultimately embedding ESG principles more fundamentally in the entire investment process.

Corinne Neale

Global Head of Business Applications, BNY Mellon Data and Analytics Solutions


https://www.morningstar.com/articles/961765/sustainable-fund-flows-in-2019-smash-previous-records

 

2 https://www.morningstar.com/articles/977328/despite-the-downturn-us-sustainable-funds-notch-a-record-quarter-for-flows

 

3 https://www.morningstar.co.uk/uk/news/201071/esg-equity-funds-in-the-sell-off.aspx%20&%20https://www.funds-europe.com/news/esg-rating-linked-to-outperformance-amidst-coronavirus-pandemic

 

4 https://www.unpri.org/download?ac=6036

 

BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may be used as a generic term to reference the corporation as a whole and/or its various subsidiaries generally. This material is for general information purposes only and is not intended to provide legal, tax, accounting, investment, financial or other professional advice on any matter. Unless stated otherwise, this material does not constitute a recommendation or advice by BNY Mellon of any kind. You should discuss this material with appropriate advisors in the context of your circumstances before acting in any manner on this material and make your own independent assessment (based on such advice). This material may not be comprehensive or up to date and there is no undertaking as to the accuracy, timeliness, completeness or fitness for a particular purpose of information given. BNY Mellon will not be responsible for updating any information contained within this material and opinions and information contained herein are subject to change without notice. BNY Mellon assumes no direct or consequential liability for any errors in or reliance upon this material.

 

This material may not be reproduced or disseminated in any form without the prior written permission of BNY Mellon.

 

© 2020 The Bank of New York Mellon Corporation. All rights reserved.

Ready to grow

your business?

Speak to our team.

Ready to grow your business? Speak to our team.