Synopsis
Investors are expected to shift their attention from ESG disclosure to performance measurement, in part to ensure their investments’ transition progress is aligned with their own ESG demands.
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Focus shifting from year end disclosure to momentum.
In the last twelve months investors’ voracious demand for ESG disclosure appears to have moderated. In part this reflects economic and political factors but we believe most investment managers have now shifted their ESG efforts from gathering data to using it. In the first instance this will likely come from measuring how companies are delivering their transition plans to ensure that their progress is aligned with the investment manager’s own ambitions.
Background
Two years ago ESG related investing was on a high with record amounts of investment inflows and the creation of new products. The first wave of investor demand was followed by the twin rollers of regulation and consumer demand. Together these forces created a powerful surge for corporates to up their ESG game and for the most part industry responded.
The mood appears different today, which in part reflects the weaker economy and significant global uncertainty with wars in Europe and the Middle East. There also appears to be an increasing gulf between European expectations and the all-important US investment market. In the USA supporting ESG measures has almost become a political statement with the SEC’s path to adopting compulsory ESG disclosures lagging the ECRD and the FCA.
To look at whether this represents a significant shift in investors’ approaches to ESG and what they might do next we used Annual Reports in the UK Investment Trust sector. These employ a wide variety of investment managers and so indirectly reflect a broad range of ongoing ESG strategies.
ESG is recognised as an important component of most Trust investment strategies
Virtually all the trusts surveyed stated that ESG was an important part of its investment process. It was argued that understanding ESG issues was key to understanding an investments’ risk-reward profile, and that long term investments needed to be sustainable. ESG was embedded in the trusts’ investment process.
ESG was described as a ‘source of alpha…sustainable growth is a key to investment strategy’ (1) and in private equity there was ‘a strong link between companies with high ESG standards and those able to achieve long term sustainable business growth’ (2).
For some trusts incorporating ESG was a byproduct of its standard approach: ‘ although it was not a sustainable fund it expected to align with ESG principles’ (3) and others were keen to stress ESG was not just a marketing exercise (4).
Other trusts saw net zero transition as a key system change providing both risks and opportunities. ESG, particularly climate change, has become a significant theme behind investment activity. One example was a trust focusing its investment activities on three ESG related areas: (1) renewable energy, (2) enabling transition and (3) investing in infrastructure with social benefits (5).
However unqualified support was not universal. ESG was ‘an incredibly complex landscape with its own language and metrics and sometimes conflicting narratives’ (6). There was ‘a lack of consistency in ESG implementation and articulation across the industry’ (7).
Different geographies and company sizes are highlighted as sources of inconsistency ‘Within emerging markets landscape varies considerably from meaningful targets to zero’ (8). Smaller companies are not covered so well or at all (9). UK small cap material risks means that it cannot be outsourced (10) ‘When it comes to small cap investing, much of the box-ticking approach to ESG undertaken in the portfolio realm is neither accurate nor helpful’ (11).
These latter issues demonstrate that there is still much to be done to raise the universal quality of ESG reporting and to close the disclosure gaps to allow meaningful comparisons between all sectors and companies.
Furthermore at the investment manager level there was recognition that not all investors wanted to use an ESG filter at all, and typically these managers highlighted that they would follow their investors’ mandates which in some cases included no ESG-related constraints. Whereas previously the latter was seen to reflect a generational view it has increasingly become a cultural/ political view and it was noticeable that these statements were often targeted at North American investors.
Collecting and understanding ESG data is highlighted as an important attribute
As a result of the data quality issues most investment managers conduct their own research. Either collecting the data using their own ESG analysts or the investment managers themselves. Some investment managers have devoted considerable resources to ESG. These teams can comprise as many as 50 ESG specialists (12).
This work is in most cases supplemented or supported by third party collected data. In some cases third party data was used to populate proprietary tools. Frequently from MSCI or Morningstar (Sustainalytics) but numerous other providers were mentioned including: Bloomberg, ESG Solutions, ISS, Moody’s, RepRisk and Thomson Reuters. These providers can often source some of their data from other third parties, so that tracing the original source of the data used is not always straightforward.
Some investment managers are more transparent on their ESG approaches than others. All typically focus on material factors ranging from 8 to over 40. The granularity of the analysis can reflect different levels of resourcing, the breadth of coverage (it easier to be more detail specific in a homogenous sector) and also timing. These approaches are evolving as data coverage and quality improve.
How investment managers use the data
Once collected the data is often analysed to produce a screening or graded approach. Examples include a three level ‘RAG’ (red, amber, green) (13) classification system or the more refined: best in class, above average, average, below average and laggard (14). These grading structures are also used in third party ratings.
The impact of the classification on whether to invest can vary depending on the trusts’ philosophies. For those trusts that market themselves on their green credentials the internal classification can show where the investments fit either under the current EU taxonomy where a significant proportion of Schedule 8 or Schedule 9 investments within a portfolio is important, or the pending SDR classifications due to be adopted imminently in the UK (15).
A number of trusts adopt an exclusion policy which typically cover investments in industries or parts of industries associated with some of the following: alcohol, autos, fossil fuels, fuel generation, gaming, pornography and weapons. In some parts of the world exclusions can also be extended to certain individuals.
The majority of trusts which are not ESG ‘badged’ have a less proscribed investment universe. Looking for ‘red flags not lines’ (16). Here the ESG analysis is part of a stock research process alongside quantitative measures such as growth, quality of earnings, balance sheet, management and shareholder values. E and S can be tagged under management with G under shareholder values (17).
As a result many investors are as interested in a business’ ESG journey as its absolute score. They believe poor performing businesses should not necessarily be shunned but be rewarded if making strides to improve, or engaged with through the stewardship process.
The complexity of interpretation can be seen in another observation that ‘Some of the companies that are most important to the decarbonisation of the economy will have the highest footprints. For this reason we do not believe the environmental scores… tell the whole story’ (18).
Where most investors are on common ground is that ESG factors form part of any investments’ risks and opportunities profile. As in most analysis there may be differing views of its significance but one result is that it may impact an analyst’s view of a business’ underlying future cost of capital. Another approach is for an investment strategy to exclude all companies that lie in the bottom quartile by ESG score.
How trusts report ESG data
Investment Trusts typically report two sources of ESG data: those for its own operations and those from its investments. The demands of the former are relatively modest, whereas the latter are usually much more significant. This is due to the fact that most of the trust’s material risks and opportunities lie within its investments.
Typically there is an explanation of the position of the Board and the investment manager on ESG, the trust’s Responsible Investment policy (including ESG factors), how ESG is incorporated in the investment process, whether there is an exclusion policy and whether the trust/ investment manager has signed up to any targets or ESG initiatives.
One common approach is to set out the trust’s share of its underlying investments’ emissions in absolute terms compared to the relevant benchmark (in most cases it is lower) and the same for its WACI (weighted average carbon intensity) (19). This is particularly significant for those trusts that have published Targets to have net zero carbon investments by a future date (normally 2030 or 2050).
This can be followed by a section on stewardship and the trust’s voting actions during the year. This disclosure brings the trusts in line with the UK Stewardship Code a voluntary principles-based code introduced in 2020 and where there are now 273 signatories (20). This section is often supplemented with a number of case studies.
What next?
Although corporates may currently be receiving less ESG enquiries than in recent years we believe this mainly reflects the increasing maturity of the sector. Investment managers have established the infrastructure to collect the data and are now focused on developing ways in which how best to use it. As data quality issues and inconsistencies are ironed out this will come increasingly significant.
Internal impetus for more action comes from commitments to numerous ESG initiatives such as the International Finance Corporation Performance Standards (21), CSRD, ISSB (TCFD) and United Nations Principles of Responsible Investing (22). As well as issue-focused commitments such as the Net Zero Asset Managers Initiative (with a goal of net zero emissions) (23) or Climate Action 100+ (focused on the worst GHG emitters) (24).
External impetus continues to come from regulation and the recently adopted ESG accounting disclosure demands of ESRS and IFRS. These create greater comparability in mandatory reporting and enable a shift from disclosure to performance, as a measure of ESG success. In addition numerous other independent pressure groups such as ShareAction (25) or less well known but very effective combinations of individuals such as the Swiss Senior Women for Climate Protection. The latter took the Swiss government to the European Court of Human Rights and won its first ever climate case in April 2024.
As data quality improves and faced with the need to meet their own climate commitments investors are increasingly likely to focus on momentum and how companies are not only committing to net zero targets but delivering on their transition plans. Over time this will include Nature (TNFD) and additional social impacts (internal and external). Some of this is already covered under the Investment Manager’s stewardship initiatives.
The increased focus on ESG momentum may also make it easier for portfolio mandates to include some of the poorer scoring ESG corporates, if it can be seen that these businesses are successfully reducing their harmful impacts.
CEN-ESG Conclusions
Many factors are likely to see the demand for transparent and good quality ESG data continue to increase. Those corporates ahead of the curve will likely benefit as investors’ approaches become increasingly sophisticated. Those businesses where ESG disclosure lag industry norms are likely to be doubly disadvantaged as investors’ shift their ESG spotlight from disclosure to track record.
For references see Appendix below.
CEN-ESG SUPPORTING INVESTORS
Ade Roberts, Associate Director. Ade is Head of Distribution of CENintel, our proprietary ESG assessment tool. He joined the team in 2021 with over 15 years financial markets experience, most recently as a long/short portfolio manager. He is a CFA charter holder, holds a BSc in Mathematics and Investment from London Metropolitan University, and is currently studying at Cranfield University for an MSc in Sustainability.
Bridging The Data Trust Gap
The volume of ESG data has continued to grow as new sustainability reporting regulations and standards emerge. Yet concerns about ESG data quality persist amongst asset managers given the time-consuming and resource-intensive process of gathering and analysing large amounts of often inconsistent, unclear, and unreliable corporate ESG disclosure.
The development of artificial intelligence (AI) tools is proving to be no panacea for navigating the ESG research challenge. Many AI tools do not disclose the sources of their information, a lack of transparency that can introduce investment, regulatory and reputational risks for asset managers. Misleading outputs are still commonplace with some AI models.
At CEN, humans are firmly in the driving seat of our ESG research with AI considered a supplementary tool to enhance efficiencies in our data collection and analysis. Our team of trained analysts assess and verify the credibility of corporate ESG commitments and performance with a level of transparency that gives clients confidence in the reliability of our scores. All our assessments are based on publicly available information which can be traced back to the source documents for data integrity.
We consider the building blocks of our ESG assessments to be unrivalled in terms of quality (accuracy), breadth (covering 29 categories) and depth (400+ datapoints). The wide reach of our proprietary tool is complemented by a focus on the financial issues that are most relevant to a company’s business model. We regularly evaluate new datasets such as SFDR PAIs, monitor emerging ESG issues like double materiality assessments and explore new technologies, including automated data extraction, to improve our research process. Until regulations and standards mature with audited metrics, the trust gap with ESG data can be narrowed with improved quality, greater consistency, and human oversight of AI tools.
CEN NEWS
We continue to be busy. Martin Green joined as a Director, he strengthens the team with his significant financial, corporate and legal experience. CEN-ESG continues to broaden the services it offers to clients such as assistance with CDP reporting.
Martin Green
Martin spent most of his career at Videndum plc, a media technology group and sat on the Board from 2017 first as Group Business Development Director and latterly as Group Finance Director. He graduated in law from Trinity Hall, Cambridge, is an ACCA qualified accountant and has an MBA from Cranfield School of Management.
CDP services at CEN-ESG
CDP (formerly Carbon Disclosure Project) is the gold standard for corporate environmental reporting, which aims to “focus investors, companies, cities, and governments on building a sustainable economy by measuring and acting on their environmental impact.”
In 2023, CEN-ESG assisted clients with 12 Climate Change and 2 Water Security submissions. Of the 11 submissions that weren’t first-time responders, 64% saw an increase in letter grade, with no scores falling, and two of our first-time responders scored B’s. This included a significant upgrade from a D to a B for one client.
Moving forward to 2024, CEN-ESG has refined its offering and plans to scale the number of submissions it supports. We are in the process of becoming an Accredited Solutions Provider with the CDP, validating the quality of support we offer.
For more on the CDP and its updates in 2024 please refer to our website’s insights page or our LinkedIn page.
CEN-ESG is part of CEN Group Holdings, a fast-growing consultancy with financial focus with three underlying businesses: CEN Advisory, an Investor Relations and Board Advisory firm supporting companies to navigate financial markets; CEN-ESG, a sustainability consultancy helping businesses maximise their ESG potential, performance and disclosures; and, CEN Data, ESG data and research solutions for investors, enhancing understanding of investments as well as managing material ESG-related risks and opportunities. More details can be found at https://www.cengroupholdings.com .
Appendix
References
Schroder Mid Cap Fund
3i Infrastructure
Unicorn AIM VCT
Pershing Square Holdings
Sequoia Economic Infrastructure Income Fund
European Opportunities Trust
European Smaller Companies Trust
Templeton Emerging Markets
The Global Smaller Companies Trust
Rights & Issues Trust
abrdn Asia Focus
Schroder Investment Managers
GCP Infrastructure Fund
North American Income Trust
Sustainability Disclosure Requirements (SDR); investment labels, disclosure and marketing rules for UK asset managers, as well as targeted rules for the distributors of investment products to retail investors in the UK. Anti-greenwashing rules for distributors of recognised funds ( applies 31 May 2024); Distributor rules apply (recognised funds) 2 December 2024; ongoing product-level and first entity- level disclosures: AUM >£50bn (2 December 2025), first entity- level disclosures AUM >£5bn (2 December 2026). Firms can start using sustainability labels from qualifying funds earlier if they wish (31 July 2024).
Ruffer Investment Company
Schroder Japan Trust
Scottish Mortgage Investment Trust
WACI calculated as tCO2e/ £m revenue
FRC UK Stewardship Code 2020 is a voluntary principles-based code of best practice which provides a framework for asset owners, asset managers and service providers to report on their stewardship activities over a 12 month period. There are currently 273 signatories to the Code (AUM £43.3tn). There are 12 principles for asset managers and owners. The FCA requires asset managers and insurers to state whether they comply with the UK Stewardship Code, and if not, their alternative investment strategy. The FCA also requires asset managers & investment managers to develop and explain how they have implemented an engagement policy for their listed equity investments.
International Finance Corporation (IFC) Performance Standards: founded in 1956 and part of the World Bank. It published its latest standards to provide guidance on how to do business in a sustainable way in 2012. The eight standards cover: (1) environmental and social risks and impacts, (2) labour and working conditions (3) resource efficiency and pollution prevention, (4) community health, safety and security, (5) land acquisition and involuntary resettlement (6) biodiversity (7) indigenous peoples and (8) cultural heritage.
UNPRI Most investment managers were signed up to its six Principles
NZAMI: established in 2020 to support the Investment Management industry to commit to a goal of net zero emissions by 2050 or sooner. As part of these commitments signatories will (1) take account of portfolio scope 1 and 2 emissions and, to the extent possible, material scope 3 emissions and (2) prioritise the achievement of real economy emissions reductions within the sectors and companies in which they invest. There are commitments to provide information and analytics on net zero investing and climate risk and opportunity, stewardship and engagement, and publish TCFD disclosures.
Climate Action 100+ : an investor-led global initiative (700 signatories) to ensure the world’s largest corporate GHG emitters (currently 170 in focus) take the necessary action on climate change. Encourage companies to halve their GHG emissions by 2030 and deliver net zero emissions by 2050 by (1) strong governance framework articulating board accountability and oversight of climate change risk, (2) take action to reduce GHG emissions in the value chain consistent with Paris Agreement and (3) provide enhanced corporate disclosure and implement transition plans to deliver on robust targets.
ShareAction evolved out of a People & Planet project in 2005. The charity works with institutional investors to push for action on issues including climate change, workforce equality and health. It aims to define ‘the highest standards of responsible investment and work tirelessly until these standards are universally upheld.’
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