As responsible investment moves from niche to mainstream, a lot of new and loud voices at the table often show little understanding of the mechanics of successful sustainable investing.

November 30, 2020

10 Lessons From 10 Years of Helping Investors to Tackle Climate Change

In 2010, ISS ESG’s head of Climate Solutions Max Horster started one of the first companies to measure the climate impact on investments. From investment carbon footprinting to climate scenario analysis, from climate-linked proxy voting to climate neutral investments via offsets: Over the years, the team pioneered a wide range of today’s leading methodologies and approaches across all asset classes. In 2017, Max and his team joined ISS ESG to form the first climate specialist unit of a global ESG service provider. Today, they cover over 25,000 issuers on up to 600 individual climate-linked data points and have screened over $4 trillion of AUM on their climate risks and impact. On the occasion of its 10th anniversary, the ISS ESG Climate Team shares 10 lessons from 10 years of helping investors to tackle climate change.

Lesson 5: Market growing pains can lead to losing gains

Did you know that ESG rating agencies are the biggest hindrance for sustainable investments? And that only regulation and making data freely available will enable investors to invest sustainably? Those beliefs are the essence of an absurd myth that is currently making the rounds in the market.

In Shakespeare’s Henry V, the Boy famously quotes Plato: “the empty vessel makes the loudest sound.” As responsible investment moves from niche to mainstream, a lot of new and loud voices at the table often show little understanding of the mechanics of successful sustainable investing. Funds leveraging ESG data have grown from USD 22.9 trillion in 2016 to over USD 40 trillion in 2020. 

Graph based on: Opimas, ESG Data Integration by Asset Managers: Targeting Alpha, Fiduciary Duty & Portfolio Risk Analysis, June 2020.

This means not only more assets but also more attention. Suddenly, thousands of new voices have joined the discourse on sustainable investing, and not all of them seem fully up to speed. This can result in somewhat bizarre discussions.

The above-mentioned tale of ESG rating agencies hindering sustainable investing goes somewhat like this: a lot of investors want to invest sustainably, but they can’t – because of data providers. How so, we might ask? To invest sustainably, the investor needs extra-financial data, and in most cases that analysis comes from data providers. Such data providers don’t only provide raw data, but also rate companies. And in that process, they – unlike credit rating agencies – produce different results. This variation in results across providers is presented as an obstacle to adopting responsible investment practices.

When confronted with such arguments, investors who have worked with quality ESG data providers and rating houses over the years must wonder if critics really comprehend the process of ESG research. These misconceptions seem to stem from the growing pains of a market that is exploding in size. Let’s dissect the story above via two key misconceptions.

Pain 1: ESG ratings should all come to the same conclusion

There is no shortage of studies that compare the ratings from different providers on the same company and observe that they are differing in their outcome (and that this is less often the case with credit ratings agencies). While the observation is correct, the conclusion typically is not. Namely, either that all the ratings must be wrong or that only one rater gets it right and the others don’t.

This is like observing a highway, seeing a lot of different vehicles and concluding that they can’t all be cars because they don’t all look the same.

Ratings come in all forms and shapes: There are disclosure ratings, performance ratings, risk ratings, impact ratings and many more. All these ratings come about by rolling up hundreds of indicators with different weights into one number or letter. This allows for countless variations, depending on the emphasis of different topics, yielding different results. None is right or wrong, they just stand for different views of the world and prioritize different issues.

A fossil-heavy climate utility in the U.S. will have a different risk profile before and after a new Biden energy transition legislation and an ESG risk rating should reflect this. An ESG impact rating, however, might not change as the impact on the environment remains the same. Diversity in ESG ratings is not only good, it is essential if we are to accommodate all investors’ needs.

What is more worrisome than the limited understanding of the nature of ESG ratings is that these voices are calling for regulation: Let’s regulate ESG rating agencies to ensure that their rating results look the same. This is like calling for the regulator to decide what a car should look like. Everyone remembering cars from Eastern Europe before the fall of the iron curtain will know that this isn’t a compelling idea.

Germany 1989: A car produced by West German free market competition (left) and by East German government requirements (right). (From: )

Instead, the regulator might want to ensure that ESG rating agencies adhere to certain standards and a code of conduct, and otherwise leave them to organize for a competition of ideas and products to best serve the market. Investors, on the other hand, should develop the expertise to choose in an educated manner between different ratings to find the one that best suits them – or even create an ESG house view based on individually chosen and weighted indicators.

Pain 2: ESG data should be free

This leads to another argument about ESG data that is currently floating around: ESG data should be free for investors. Only then will the key hurdle to using the data, cost, be removed. Consequently, the public hand, such as the Swiss government, as well as industry initiatives compete in sourcing free data for investors.

The issue is, of course, that the data is not really free. The taxpayer is paying for it. This leads to a potentially reputation-damaging situation for the finance industry: this margin-strong sector claims that climate change is an essential topic, yet but happily lets everyday people pay for the analysis!

Above all, such government support runs the risk of killing innovation among professional data providers. It is not only the regulator, though. Large investor groups build coalitions such as Climate Action 100+ to jointly use data for measuring or engagement. This is potentially quite powerful, but it often seems odd that, after strong statements on the importance of climate change, they ask for “in kind” and “pro bono” data, which typically means publicly funded solutions.

One of these “free data” ideas is to make sure that raw data is reported directly by companies to a public entity that investors can access for free.

The idea of companies reporting to a centralized agency is compelling. All data is in one place and can be used by investors right away without expensive data providers standing in between. It is, however, not a real need but merely a “nice to have.” The information that could be found in such a data repository is already available today, albeit with one key difference: today it costs money, as ESG agencies go through the effort of data collection, comparison and standardization. Making it free means, again, offloading the cost to taxpayers.

What’s more, such a centralized data repository will not make life easier for investors. The data will only be available for one jurisdiction (a country or region) in a harmonized manner and it will still be individual data points that need a judgement call to roll up into a rating that is actionable.

If the argument is that such a repository will make more companies report, it falls short. The regulator has many more means to get companies to a certain reporting transparency without being the data collector or aggregator.

The Aspirin: Truth does not belong to the one who shouts the loudest

The frequently repeated argument that ESG ratings should look alike or be free of charge are typical for the growing pains of an exploding market. All of a sudden, there are players at the table who feel the winds of change and need to react hastily, so they run the risk of leaping to false conclusions:

  • Investors, who have no ESG expertise yet and apply concepts that aren’t relevant (why is my credit rating different than my ESG rating?);
  • Lobbyists, who see their role as defending the status quo by pulling up arguments for stagnation (so long as ESG ratings cost money and don’t rhyme, we have no choice but to keep investing as we always have);
  • Researchers, who are jumping on the ESG bandwagon and run studies with little subject matter expertise (we compared different ratings and the results were different);
  • Regulators, who are being influenced by agents of the status quo or misled by spurious research (we read a study and met with industry associations, now we want to regulate ESG rating outcomes).

The growth in sustainable investing is breathtaking and potentially good news for the environment, people and profit. The arrival of regulators globally to channel this growth for the greater good of humankind has the potential to accelerate this momentum – or to lose it.

It will all depend on to whom the regulators lend their ears. Currently, some of the loudest sounds seem to come from the empty vessels at the table. At the same time data providers, who are in the business of locating and understanding the relevant data points with hundreds of analysts, have been grossly underrepresented in the regulatory discussions. Aspects like sustainability taxonomies have been a core competence of ESG data houses for 30 years – after all, an ESG rating is nothing if not a taxonomy of different data points. Yet there was not a single technical expert from an ESG data house admitted to the Technical Expert Group on the EU taxonomy – which might explain why the translation of the taxonomy from theory to practicability is currently so challenging.

To whom to listen or to whom not to listen, that is the question regulators are facing.

By Dr. Maximilian Horster, Head of Climate Solutions, ISS ESG

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